Is It Too Late to Buy Cloudflare Stock?

Cloudflare's (NET 1.44%) stock rallied to all-time highs after the content delivery network (CDN) and cybersecurity services provider posted its second-quarter earnings on Aug. 5. Its revenue rose 53% year-over-year to $152.4 million, beating estimates by $6.3 million, and its adjusted net loss narrowed from $9.6 million to $7.3 million, or $0.02 per share, which also cleared expectations by two cents.

Cloudflare expects its revenue to rise 44%-45% year-over-year in the third quarter, then grow 46%-48% for the full year. Both top-line estimates exceeded Wall Street's expectations, but Cloudflare's bottom-line estimates -- which call for adjusted net losses for both the third quarter and full year -- were weaker than expected. Nonetheless, investors seemed to focus on Cloudflare's impressive revenue growth instead of that red ink, and the stock remains up more than 200% over the past 12 months.

Image source: Getty Images.

Cloudflare's business looks healthy, but its stock trades at over 60 times this year's sales. Does that frothy price-to-sales ratio indicate it's too late to buy Cloudflare's stock, or will it grow into that valuation?

What does Cloudflare do?

Cloudflare's services sit between a company's website and its visitors. Its CDN optimizes a website's delivery of images, videos, and other media; its domain name server (DNS) service connects user-friendly website addresses to the correct IP addresses; and its cybersecurity services prevent DDoS (distributed denial-of-service) attacks from knocking a website offline.

Cloudflare serves data from 200 cities in more than 100 countries, and it processes an average of 25 million HTTP requests every second. Most people have likely encountered Cloudflare's defenses, which ask them to prove they're not bots by performing various tasks, while browsing the web.

More than 80% of websites that balance their loads with reverse proxy services use Cloudflare's CDN, according to W3Techs. That equals nearly a fifth of all websites worldwide, and makes it the clear market leader in the CDN space. Its closest competitors include Fastly (FSLY 4.43%), Akamai (AKAM -0.11%), GoDaddy's (GDDY 0.70%) Sucuri, and Amazon's (AMZN 3.43%) Cloudfront.

The key growth rates

Cloudflare mainly gauges its growth with its dollar-based net retention rate, which measures its ability to retain customers and cross-sell additional services; its adjusted gross margin; and its overall revenue growth. Cloudflare's net retention rate and gross margin expanded sequentially and year-over-year during the second quarter, while its revenue rose at its fastest rate in three quarters:

Data source: Cloudflare. YOY = Year-over-year.

Cloudflare attributed most of that growth to its large enterprise customers, which contribute over $100,000 in annualized revenue. It ended the second quarter of 2021 with 1,088 large customers -- compared to 828 at the end of 2020, 526 in 2019, and just 294 in 2018. It now generates over half of its revenue from those large customers. 

Growing faster than Fastly

Cloudflare's results looked much better than Fastly's dismal second-quarter report. Fastly suffered a major service outage in June, which resulted in the loss of a top-ten customer and delayed projects with its existing customers. As a result, Fastly's revenue rose just 14% year-over-year last quarter, compared to its 35% growth in the previous quarter, and it anticipates just 17%-20% growth for the full year.

Cloudflare also suffered a service disruption in June, but it was minor compared to Fastly's outage, which affected nearly all of its websites for almost an hour. Cloudflare's hiccup also didn't impact its sales growth or cause any major customers to leave.

Cloudflare is also generating stronger sales growth than Akamai and GoDaddy, which both operate more diverse internet software businesses than Cloudflare. Analysts expect Akamai and GoDaddy to grow their revenues 7% and 13%, respectively, this year. 

But is Cloudflare worth the steep premium?

Cloudflare's business is firing on all cylinders, but its upside potential will be limited as long as its stock trades at more than 60 times this year's sales. By comparison, Fastly, Akamai, and GoDaddy trade at 13, five, and three times this year's sales, respectively. 

However, Cloudflare could gradually grow into its valuation as it maintains its "best in breed" reputation in the CDN market while helping more companies secure their websites against hackers and bots.

Mordor Intelligence expects the CDN market to grow at a CAGR of 27.3% between 2021 and 2026, so Cloudflare's annual revenue could more than triple from its guidance of $631 million this year to $2.1 billion in 2026 if it merely matches the market's projected growth rate over the next five years.

That forecast suggests it isn't too late to buy Cloudflare yet, but investors should nibble on this volatile stock instead of taking a big bite -- a market crash could easily cut its pricey stock in half.