Cloudflare: High Revenue Growth With Cybersecurity Tailwinds

Summary

• Cloudflare is a leading content delivery network (CDN) which has achieved high revenue growth of over 52% in the past year.
• The company has strong tailwinds from Zero Trust Security industry which is forecasted to grow at a 17.4% CAGR until 2026.
• The stock price has pulled back by 59% since November and plans to announce earnings for Q12022 on May 5th 2021.
• The stock is overvalued intrinsically, but trading at one of the lowest forward price to sales ratios historically.

Sundry Photography/iStock Editorial via Getty Images

Cloudflare (NYSE:NET) is a leading content delivery network [CDN] which helps websites to provide content faster and in a more secure way. The company has increased their focus on “Zero Trust” security which is a growing industry forecasted to be worth $51.6 billion by 2026. This growth is driven by major tailwinds such as the popularity of remote work and enterprises are shifting their IT workload to the cloud. Cloudflare has seen their revenue grow at a 51% CAGR over the past 5 years and the share price has been on a meteoric rise, increasing by 1072% up until the highs of $211 in November 2021. However, high inflation numbers and a forecasted rise in interest rates has caused a compression in valuations for growth stocks. The share price has now pulled back a significant 59%, despite the company increasing revenues by 52% in 2021 and having the aforementioned tailwinds ahead. The valuation is still very high both intrinsically and relatively, but the stock has found what I like to call “valuation support” at its current price to sales ratio, which is low relative to history. Let’s dive into the business model, financials and valuation for more details.

Cloudflare stock (ycharts)

Cloud Business Model

Cloudflare's mission is to “help build a better internet” and they move towards this by being one of the world's most popular Content Delivery Networks [CDN’s] and Cloud Security Providers. A content delivery network [CDN] provides websites with a faster and more secure way to distribute their content to visitors. They accomplish this via a network of data centers globally which distribute a “cached” version of a website to visitors from a local data center. For example, if you're in Austin, Texas and the website you’re visiting is hosted in Japan, you will be served a version of the website from your local cities data center. This means a faster, more responsive and more secure experience.

Cloudflare network (Investor Presentation Q42021)

To give you an idea of the scale of Cloudflare's capacity, they estimate 95% of the world's population is within just 50 milliseconds of one of their data centers. They have a footprint in 250+ cities, 100+ countries and even mainland China. The company also plans to link over 1000+ office buildings and multi dwelling units directly to their network.

Cloudflare's CDN operates with a Freemium model which attracts many smaller website publishers (I use them for my own website). However, the company then uses a “land and expand” approach to up-sell to larger customers which now make up over 50% of their revenue. Cloudflare defines “larger customers” of those with >$100k of annual revenue.

Cloudflare stock (Investor presentation)

Network Services

The company also offers a variety of products to help enterprises transform from a traditional pure hardware player to cloud based. Their “Cisco as a service” products reduce the need for companies to buy extra on premises hardware and gives them greater flexibility to expand their network. For example, their “Network Services” segment includes:

• Magic WAN (Wide Area Network)

• Magic Firewall

• Network Interconnect

• Magic Transit (Protection from DDoS attacks)

• Argo Smart Routing

Zero Trust Network - Large TAM

Zero Trust Networks are the next generation of cybersecurity for enterprise networks. Traditional IT networks “trust” by default anyone and anything inside the network, while a Zero Trust architecture trusts no one and nothing. According to Markets Research, the Zero Trust Security industry which is forecasted to grow at a 17.4% CAGR until 2026, reached a valuation of $51.6 billion. This growth is due to a number of tailwinds which include an increasing number of cyberattacks, increased connectivity, more cloud applications and the trend of remote working.

Zero Trust Network (Cloudflare website)

According to Sonicwall, Ransomware attacks increased 148% from Q2 of 2020 to Q2 of 2021. 80% of organizations were hit by a ransomware attack in 2021 according to Claroty on Forbes. In addition, IBM research estimates that the average cost of a single data breach is an eye watering $3.86 million.

A Zero Trust Networks helps to prevent these attacks by running an “intelligent switchboard” which authorizes each user to connect to the desired application only, this is called “least privilege access” as it gives users access to only what they need. Other benefits include:

• Continuous Monitoring and Validation

• Device Access Control

• Micro-segmentation

• Preventing Lateral Movement

• Multi factor Authentication.

Cloudflare One SASE [Secure Access Service Edge] is the company’s flagship Zero Trust network-as-a-service platform. This solves all the problems mentioned previously, in addition to replacing slow VPN’s [Virtual Private Networks] and costly MPLS [Multiprotocol Label Switching].

Cloudflare TAM (Investor presentation)

Growing Financials

Cloudflare operates a SaaS subscription based model, which is my favorite model due to the high operating leverage. They have grown revenue at a 51% CAGR over the past 5 years. Moving forward the company is guiding for 42% revenue growth in 2022 and 48% in Q1. The company does have a history of “sandbagging” earning expectations and then exceeding them, so I wouldn’t be shocked to see this again.

Cloudflare Revenue (ycharts)

The company has achieved a high gross margin (non GAAP) of ~78% historically but moving forward they are expecting this to be slightly lower at 75% to 77%. I have compared Cloudflare to competitor Zscaler (ZS) it is clear to see they are operating at a similar Gross margin of 77% but Cloudflare has a better operating margin (-19% vs -34%).

Cloudflare vs Zscaler Margins (ycharts)

Their operating income [non GAAP] has improved from $14 million loss 2 years prior to ~$2 million in profit. This is a positive but the company still has plenty of room to improve profitability as they scale. The company spent $189 million on R&D in 2021, without this spend they would have produced $62 million in operating income. However, I do believe this R&D spend is the right thing to do as companies with high R&D spend tend to create greater shareholder value over time, it is also more tax efficient.

Comparing R&D spend with competitors such as Zscaler and Akamai (AKAM) it is clear to see Cloudflare and Zscaler are spending similar ($189 million and $174 million), whereas Akamai is spending substantially more $335 million. This is a greater risk for Akamai when it comes to short term profitability but could lead to greater growth in the future.

R&D Cloudflare competition (ycharts)

In terms of Cash Flow, their Free Cash Flow margin has jumped from -4% in Q12020 to 4% margin which is a good sign, but again they still have a long way to go.

As the company plans to scale and move “upmarket” with their customer base this should help to improve profitability and revenue consistency. They have been on track so far with their number of “large customers” those paying >$100k annually in revenue growing 70% in 2021. Cloudflare also has a high dollar based net retention rate of 125%, which indicates customers are staying with them and spending more.

Customers Growth (Cloudflare presentation)

On their balance sheet Cloudflare has $1.8 billion in cash and short term investments with just $12 million in current debt which is a good sign. However, I did notice fairly high long term debt of $1.4 billion but I imagine the company is using this as fuel to expand and grow operations.

High Valuation

In order to value Cloudflare I have plugged the latest financials into my discounted cash flow model. I have estimated 42% revenue growth for 2022 inline with the company’s own guidance and 40% for the next 2 to 5 years.

Cloudflare stock valuation (created by author Ben at Motivation 2 Invest)

I have predicted the operating margins to expand to 25% in 4 years, which is above the 18% average for the software industry.

Cloudflare stock valuation (created by author Ben at Motivation 2 Invest)

Given these factors I get a fair intrinsic value of $41, given the stock price trades at $86 it is currently overvalued.

Relative to historic multiples the stock is trading at a low forward price to sales of 29. This is still not “cheap” but it is in a low value support zone relative to history. However, the company is trading at a valuation higher than competitor Zscaler which trades at a PS (forward) = 27. I suspect this difference is due to the better operating margin Cloudflare offers. In comparison Akamai (AKAM) trades at a price to sales of just 4, however that company is growing slower at just 8% but on higher revenue of $3.4 billion and profitability.

Cloudflare stock valuation (ycharts)

Risks:

Competition

Cloudflare has a lot of competition in the CDN and Zero Trust industry. Their competitors include; Zscaler, Akamai, Palo Alto networks, Okta and Twingate. In addition to Cisco, recently acquired Duo, a leader in access management which has helped to focus their zero trust approach.

High Valuation

Despite the pullback in share price, the stock is still trading at a high valuation both intrinsically and relatively, as shown prior.

Rising Interest rates

Due to consistently high inflation [CPI] of 7.9%, which is well above the Fed’s 2% target, the Fed has outlined plans to raise interest rates. Morgan Stanley predicts up to 6 rate hikes in 2022. Higher interest rates, mean a higher discount rate for stock valuation. This higher discount rate especially impacts “Growth stocks” such as Cloudflare as their valuation weighted more towards future growth in cash flows.

Final Thoughts

Cloudflare is a tremendous company which is a leader in the CDN (Content Delivery Network) industry. Their increasing focus on the “Zero Trust” industry, offers a larger TAM to attack moving forward. The company’s share price has pulled back substantially, but the valuation is still very high both intrinsically and relatively. They have a strong business model with great fundamentals, but the valuation and rising rate environment add a greater risk of more volatility. In my eyes, the stock is a hold right now, as the company’s share price does seem to have found what I like to call “valuation support” at its current price to sales ratio. Given the sheer number of opportunities in the market right now (see my other posts) I think there are better value opportunities.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Steve Kamman]

Cloudflare is no more a CDN or a security company than AWS (which also sells CDN and security services). Cloudflare is building "the 4th cloud" alongside AMZN AWS, MSFT Azure, and Google GCP. General porupose compute, storage, netowrking, and supporting services such as database, streaming data, etc.... It is just starting to show traction there, but it is also creating a distinct, defensible market space where AWS/Azure/GCP don't play. I disagree with @onkd that it will be "bigger" than AWS (grin). But AWS is running at a ~$70B revenue run rate and will end up in the hundreds of billions of revenues in 5-10 years. Cloudflare will also end up over $100B of revenues given its TAM. A $30B market cap prices in some of that expectation, but this write up reflects how poorly understood the company remains. When the same piece is written in 2-3 years, it will start with "Cloudflare's 4th cloud strategy continues to show traction" and there will be no mention of CDN or Security.
To the author - no snark intended. BUt have a look at Cloudflare Workers (compute offer which also powers all of NET's higher-order services), the upcoming launch of R2 storage, Durable Objects, and the likely launch of database/streaming. That is where you will find the valuation disconnect. Growth will have accelerate as a $650m revenue company starts to chew into a $300B TAM with a one-of-a-kind offer.Also note that MSFT just started using Cloudflare in its Edge browser. If it were easy to replicate Cloudflare's services, Microsoft (who owns the Azure Cloud) would have built it itself.

[onkd]

@Steve Kamman I respect your opinion, and agree with most of your points. Thanks for sharing!

[AdAstra91]

@Steve Kamman do you mind elaborating a bit more on the 4th cloud strategy? Like what exactly does that look like vs the big 3 - differences, need, possible competitive advantages etc.
Thanks

[davidrich77]

@Steve Kamman im retired but a few years back i ran Akamai in Asia Pacific. I hold NET, OKTA, ZS, AKAM, AMZN amongst others. Your comments are very well informed. NET has price potential which should be realised when their diverse capabilites mature and we see a better overall market.

[Millennial_Tyler]

Excellent article. Mid 80s seems to have a ton of support. Only thing I'd argue against is that Duo and Okta are not competitors (yet) as they hjave stayed away from IAM.
Certainly cisco's vpn/sase products are though. Zscaler, Akamai, IAAS storage, and SDWAN products are where the biggest competition is coming from.

[onkd]

I would feel stupid selling my $NET shares at these prices.

$NET in 5-10 years will be bigger than AWS.

$100B+ company incoming.

Many investors know this, which is why this stock has held up comparatively well despite the high valuation in the near-term.

Go ahead and sell for a short-term down swing. I'll be here to take your shares off of you, smiling every step of the way. :)

[cdgingrich]

If you think it is a $41 stock you should be shorting it big-time.