Is Cloudflare Stock a Buy Now?

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Cloudflare‘s (NYSE:NET) stock hit an all-time high of $221.64 last November. But over the past two months, it plunged nearly 50% as interest rate fears overshadowed the company’s impressive growth rates.

But does that deep pullback represent a good buying opportunity for investors who missed out on Cloudflare’s massive gains last year? Let’s take a fresh look at its business and valuations to find out.

Understanding Cloudflare’s business

Cloudflare’s services are wedged between a website and its visitors. Its content delivery network (CDN) accelerates a website’s delivery of images, videos, and other media for its users. Its domain name server (DNS) service directs website addresses to the correct IP addresses, while its cybersecurity services block bots and distributed denial-of-service (DDoS) attacks.

Image source: Getty Images.

Cloudflare serves data from 250 cities in over 100 countries while processing an average of 28 million HTTP requests every second. Nearly a fifth of all websites worldwide now use its services, according to W3Techs.

Cloudflare’s services are growing in popularity for two reasons. First, its CDN caches copies of digital media on servers that are located closer to a website’s visitors. This enables media-heavy websites to load much faster.

Second, websites have been increasingly targeted by bots, DDoS attacks, and data breaches. Instead of requiring a website’s host and visitors to rely on updating their own cybersecurity software, Cloudflare’s platform acts as an online “filtration system” that proactively filters out malicious attacks.

How fast is Cloudflare growing?

Cloudflare’s revenue has risen more than 50% year-over-year for five consecutive quarters. Its dollar-based net retention rate — which gauges its year-over-year revenue growth per existing customer — has also stayed above 120% for the past three quarters, while its adjusted gross margin expanded to a record high of 79.2% last quarter.

Period

Q3 2020

Q4 2020

Q1 2021

Q2 2021

Q3 2021

Revenue Growth (YOY)

54%

50%

51%

53%

51%

Dollar-Based Net Retention

116%

119%

123%

124%

124%

Adjusted Gross Margin

77.3%

78.1%

77.6%

78%

79.2%

Source: Cloudflare. YOY = Year-over-year.

Cloudflare expects its revenue to grow 46%-47% year-over-year in the fourth quarter, and increase about 50% for the full year. Analysts expect Cloudflare’s revenue to rise another 37% next year.

Cloudflare’s growth is gradually decelerating, but it’s still growing at a much faster rate than its other CDN competitors, which include Fastly (NYSE:FSLY), Akamai (NASDAQ:AKAM), and GoDaddy (NYSE:GDDY).

Estimated Revenue Growth (YOY)

Current Fiscal Year

Next Fiscal Year

Cloudflare

50%

37%

Fastly

20%

20%

Akamai

8%

9%

GoDaddy

14%

11%

Source: Yahoo Finance, Jan. 6.

Cloudflare’s long-term prospects also look promising, since the CDN and cybersecurity markets are both booming.

The CDN market could still grow at a compound annual growth rate (CAGR) of 27.4% between 2021 and 2027, according to 360 Research Reports. Mordor Intelligence expects the cybersecurity market to expand at a CAGR of 14.5% between 2021 and 2026.  

However, Cloudflare still remains unprofitable on an annual basis by generally accepted accounting principles (GAAP) and non-GAAP measures. Its GAAP net loss also more than doubled year-over-year in the first nine months of 2021.

Then why did Cloudflare’s stock crash?

Cloudflare wields plenty of pricing power in an inflationary environment. Unfortunately, inflation also reduces the value of a company’s future sales and profits — which is particularly painful for high-growth tech companies that are valued by their future growth.

Rising interest rates, which kick in to tame inflation, will also likely increase the borrowing costs for unprofitable companies like Cloudflare. They will also spark a rotation from pricier growth stocks toward safer investments like bonds, which will sport higher yields as interest rates rise.

When Cloudflare’s stock hit a record high last November, its market cap hit $69.9 billion, or 79 times next year’s sales. That nosebleed valuation was unsustainable, so its stock deserved to be cut in half.

Today, Cloudflare trades at 51 times next year’s sales. That’s still a very high price-to-sales ratio compared to its slower-growth peers:

Price-to-Sales Ratio

Current Fiscal Year

Next Fiscal Year

Cloudflare

70

51

Fastly

11

9

Akamai

5

5

GoDaddy

3

3

Source: Yahoo Finance, Jan. 6.

Therefore, Cloudflare’s stock could continue to slide until its forward price-to-sales ratio cools off to more sustainable levels.

I believe Cloudflare’s stock won’t stop dropping until that ratio drops below 30, since many higher-growth tech companies are already trading below that level. For example, analysts expect the cloud-native cybersecurity company CrowdStrike (NASDAQ:CRWD) to grow faster than Cloudflare for the foreseeable future, but it only trades at 23 times next year’s sales.

Don’t pay the wrong price for the right company

Cloudflare is a solid company, but it’s a stock I’d avoid as long as inflation and interest rates are rising. If it gets cut in half again, I’ll definitely consider accumulating some shares. But for now, it’s still a dangerous falling knife.

 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.