Cloudflare Stock Surged 360% in 2020: Is It a Buy for 2021?

Shares of internet infrastructure technologist Cloudflare (NET -0.23%) had a monster run-up in 2020 -- the stock has gained 360% with just a week remaining in the year. To put that in perspective, the company started 2020 with a valuation of just over $5 billion. Now, it's worth over $25 billion.   

As a result of that rapid appreciation, Cloudflare stock is undeniably "expensive" now by many valuation metrics, but I wouldn't be quick to call this a bubble, or suggest that the shares are to be avoided. As we head into 2021, it's worth reviewing this disruptive tech outfit to see why so many investors are willing to pay such a steep premium for it.

Image source: Getty Images.

A ridiculous price tag when looking backward

Cloudflare is a content delivery network and web security firm. It delivers its various services at the "network edge," meaning data gets moved out of central data centers and stored in servers that are closer to the end-users. Think of it as modern infrastructure, but instead of moving people and goods, Cloudflare helps deliver and secure the data and services traveling across the internet.

Its next-gen edge networking platform has been in high demand during the pandemic as both businesses and individuals shifted more of their everyday activity -- work, school, shopping, socializing -- online. As a result, Cloudflare's already-enviable growth rate held steady amid the spring lockdown phase of the crisis, and has accelerated since.  

Data source: Cloudflare.  

This company is certainly doing something right, but it now trades for a whopping 64 times trailing 12-month sales. It also operates at a loss. Cloudflare burned through $82.3 million during the first three quarters of 2020 (including acquisition costs of $13.7 million). As good a year as it has had, this is one high-priced stock.

The next decade looks ripe for disrupting

However, given how fast Cloudflare is growing, looking backward is not the right way to gauge its true worth. If it can continue expanding at a similar pace next year and beyond, its shares may not appear so expensive after all. And there's reason to believe its hypergrowth story isn't finished.

One key to Cloudflare's momentum is its go-to-market strategy for new products. It releases a new service -- often for free -- for use by individuals and small businesses. Then, once that offering's early kinks get ironed out, the company starts trying to sell it to larger organizations, often with additional premium features. As a result, Cloudflare has amassed hundreds of thousands of users, many of them using its free-to-use products. (Just shy of 101,000 were paying customers at the end of Q3.) But it now has a massive base of users that can fuel its paid-customer growth as the needs of these individuals and small businesses grow increasingly complex. It was this strategy that got my attention. 

Case in point: In the third quarter alone, the number of businesses spending more than $100,000 annually on Cloudflare's offerings grew by 99. The company also inked a deal with its first-ever $10 million-a-year customer. However, with its diversified base of users, no single customer accounts for more than 5% of Cloudflare's revenue, and the top 20 customers account for less than 20% of revenue. Put another way, this web delivery and security firm is not at risk of taking a major financial hit from any single client suddenly changing its spending habits. (Contrast that with the situation of its peer Fastly (FSLY -0.47%), which has been on a wild ride due to the drama its top client, TikTok, has been going through lately.)  

Cloudflare also continues to roll out new disruptive services at the same free-to-use tier for users who are just getting started. Its latest offering is Cloudflare Pages, a tool that allows them to build websites embedded with all of the company's basic security features. Paired with its Workers platform, this gives web developers a powerful collaborative tool to build sites and applications, and then deploy them using Cloudflare's edge computing network.

"Internally, we believe it's only a matter of time before an individual developer builds a billion-dollar company on their own," said CEO Matthew Prince. "We hope Cloudflare Pages will provide the building blocks to help make our belief a reality."

Whether Pages delivers on that particular ambitious target, it's yet another service building on Cloudflare's edge computing expertise -- an increasingly important function given how large a share of the global workforce has shifted to working remotely due to COVID-19.

Also of note: The company is armed with $1.05 billion in cash and short-term equivalents, and only has $375 million in debt on the books. That gives it an ample war chest from which to draw as it attempts to build on its suite of services and disrupt public cloud computing providers like Amazon (AMZN -1.64%) Web Services and Microsoft (MSFT 0.37%) Azure. This internet tech outfit isn't short on ambition, and given its solid execution so far, I wouldn't bet against its further success.  

Should you buy Cloudflare?

At this juncture, it's hard to say Cloudflare stock is a screaming deal that investors should buy immediately. However, history shows that winning companies tend to keep winning.

Operating at the forefront of next-gen cloud and edge computing, and in possession of plenty of liquidity to fund its efforts to disrupt the status quo, Cloudflare has no shortage of options to continue its fast expansion in the next decade. Its long-term potential is great enough that I'll nibble on a few shares here and there in spite of the sky-high premium.

But since this is a high-growth business, share prices are likely to remain extremely volatile in 2021. If you decide to buy, keep those positions small to give yourself room to purchase more (perhaps on a quarterly basis) of this disruptive internet infrastructure company.