Cloudflare: Sustained Growth And Fair Valuation

May 06, 2022 11:31 AM ETCloudflare, Inc. (NET)12 Comments6 Likes

Summary

  • Continued sustained high growth shows that NET is executing very well in its top-down strategy and in its monetization of its huge user base.
  • The valuation looks about fair, but there is no doubt this has the opportunity to become an Internet-defining company.
  • As a business, NET has solid operating leverage even with most of its user base being unmonetized.
  • Looking for a portfolio of ideas like this one? Members of Asymmetric Tech Investments get exclusive access to our model portfolio. Learn More »

TechCrunch Disrupt SF 2015 - Day 2

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1Q22 ER Summary

NET continues to impress and beat revenue expectations, largely driven by excellent execution in its top-down strategy targeting large enterprises. This is nicely complimenting its bottom-up origins and it also seems that a good chunk of this sustained 50%+ growth is generated by gradually monetizing its huge freemium base. In fact, if NET went all out and aggressively monetized its 4+ million free user base it could probably be generating close to 100% YoY growth. This insight indicates that 50%+ growth might be doable for a few quarters to come.

One of the 1Q22 highlights is the sustained YoY growth of 54%, however, a significant driver of this was the 10% QoQ growth in the number of paying customers. This is a big jump up compared to the previous quarters and it highlights what I was previously alluding to that NET is steadily monetizing its large free user base. The notable improvement in the Net Dollar Retention Rate (rose to 127% from 125% in 4Q21) highlights NET's success with large enterprises - the growth in the number of customers spending over $500k was 68%, and the number of customers spending over $1m grew by 72%.

Below we've put together a table summarizing the key financials over the past five quarters and past three fiscal years.

Figure 1 - NET Key Financials Summary

Cloudflare's Key Financials

Convequity

In his opening speech in the 1Q22 earnings call, founder and CEO Matthew Prince spoke about NET's early cyber threat warning signals that were triggering before Russia's invasion of Ukraine and then explained how various vulnerable organizations chose NET to protect them amid the elevated threat environment. He also mentioned how the free 1.1.1.1 DNS app became the most downloaded app in Russian app stores. Stuff like this is great brand promotion, but I'm sure I'm not alone in thinking that this is genuine and that NET truly wants to make the Internet a better place first and foremost, even before business success.

Valuation Considerations

We like applying the EV/GP/NTM Growth metric for high-growth and GAAP unprofitable software firms spending aggressively to dominate its market - it works similar to the PEG factor so a value of 1.0 can be considered fair value. As shown in the table below, compared to some other high-growth BoB peers NET isn't the most attractive following the drawdown but it does finally look about fair value, according to this measure.

Business Execution & Forward Multiples Assessment

Convequity

We also like checking the revenue per employee number because in essence it's about the rawest metric one can use to assess the operating leverage of a business, and is especially useful for aggressive GAAP unprofitable SaaS firms. We think NET's $299k per employee, especially considering that the majority of its user base is still unmonetized, is impressive and investors should expect this to edge up higher as the company matures. Interestingly, I'm sure we're not alone in seeing parallels between NET and GOOGL, and the latter's revenue per employee is c. $1.8m, so that indicates it's possible that NET could become highly profitable when it begins maturing and deliver market-beating returns for investors along the way.

In the table we've also presented the GP-Adjusted Magic Number calculated as: Net new rev * 4 * GM/S&M (t-1). This is very insightful for assessing how quick the company can recoup the costs of acquiring customers, aka the S&M expenditure. In other words, it shows how effective the S&M is. In a similar vein to revenue per employee, NET's six-quarter average of 0.67, especially when considering most of its user base is unmonetized, is impressive and this will likely go higher with time. And it just validates that NET's S&M % of revenue of 47% is being spent efficiently.

Sidenote: DDOG looks very attractive at these levels and considering the huge operating leverage of the business as implied by the revenue per employee and Magic Number.

To summarize NET's current valuation, given that the EV/GP/NTM Growth is still > 1.0 after the chaotic drawdown, there are better bargains available right now. However, NET is still likely to generate market-beating returns for investors.

Business Strategy Recap

Last year we did a deep dive into NET's technological competitive advantages, so here we'll just recap on the company's strategy. In essence, NET aims to be the all-in-one vendor that can deliver cloud-delivered networking, cloud-delivered security, and help web applications improvement their performance.

NET's SASE strategy is highly differentiated. Whilst all other SASE vendors rely mostly on the traversing connections across the Internet, NET is giving organizations the opportunity to use NET's own global private network, thus delivering more speed and security. No other vendor is in the position to do this and hence this is a very sustainable advantage for NET to leverage and possibly become the number one SASE vendor eventually.

NET's acquisition of out-of-band CASB vendor Vectrix helps NET to finally complete its SASE - or what Gartner is now referring to as SSE, which consists of SWG, CASB, and Zero Trust. NET had been toying around with a beta out-of-band CASB product for almost two years, and we surmise that this is because in-line security vendors find it difficult to switch to out-of-band stuff that requires a different skillset involving heavy API usage and analytics of data-at-rest. Now that they have Vectrix they can complete the SSE/SASE portfolio which should put them in a Gartner Magic Quadrant for SSE and help increase its security sales with enterprises.

NET's Workers and Pages - alleviating many pain points for developers in back-end provisioning and front-end web development, respectively - is revolutionizing web development. Thanks to NET's talent, culture, and global scale, no other vendors are close to taking market share away in the edge compute space. And all the application performance solutions such as load balancers and accelerators along with all the networking and security options, is creating a very rare moat.

Future Research

At Asymmetric Tech Investments we're shortly going to do a mini-series on security, including, 1) cloud security, 2) an assessment of the entry barriers of various areas within the security industry, and also 3) a report on why the NGFW is far from dead and why that keeps FTNT and PANW in a strong position going forward.

Then beginning on May 20, we'll begin our Tech Stack Investing research project. This will likely be a 12-month long project where we search for investment opportunities right through the tech stack, from sand to silicon to chips to hardware to software to superclouds and the various associated themes emerging. The other objective of this research project is to break down a lot of the knowledge barriers for investors.

Conclusion

NET has continued to impress with its 1Q22 ER, showing sustained high-growth that has been driven by:

1) NET's top-down enterprise strategy that is working incredibly well.

2) NET's steady monetization of its huge c. 5 million free user base.

To us the valuation looks fair at the moment, and if we had more spare funds we would invest. However, at present there are many more attractive valuations available for BoB software vendors, so our limited funds are going to these opportunities.

Become a member of Asymmetric Tech Investments to gain the information edge required to maximize long-term returns in the tech sector. Receive 50% time-limited legacy discount - this equates to $380 per year, fixed for life. Offer ends when we reach 50 members.  

This article was written by

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Long-time tech investors with special interests in cybersecurity and cloud-related stocks. Recently we decided to turn our passion into an equity research business called Convequity. We combine quantitative and qualitative methods to gain a deep understanding of a company's business, products, and markets, and the stock's intrinsic valuation. Our process aids us to identify companies in-process of developing wide and sustainable moats with the promise of exceptional long-term returns. 

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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.

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