Cloud services company Cloudflare (NET 1.63%) has been one of the hottest stocks this year, up more than 60% since the beginning of 2021. After the company reported its 2021 second-quarter earnings recently, its stock is now pushing all-time highs. Is Cloudflare a buy? Here are three things to consider before making a decision.
1. Growth through innovation
Cloudflare is a content delivery network (CDN), which has servers and data centers located around the world. When a website uses Cloudflare's CDN, the website is serviced by the server closest to it, resulting in faster load time and performance.
The company is developing computing and security services on its network to become an all-in-one network solution for businesses. Customers can get an integrated internet experience that is faster and more secure on top of Cloudflare's network -- all within the cloud and without the need for on-premise hardware/software.
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According to management's estimates, this innovation will expand Cloudflare's addressable market from $32 billion in 2018 to $100 billion by 2024. Customers are spending more on Cloudflare's network over time due to the steady flow of new products/services, spending 115% more on average in 2020 Q2, and now 124% as of 2021 Q2.
2. A stellar earnings report
The company's recent 2021 Q2 earnings were the latest sign that Cloudflare is executing its growth strategy. Revenue for the quarter was $152 million, an increase of 53% over 2020, and the company added 140 new "large customers" during the quarter, which Cloudflare defines as customers tracking to spend $100,000 or more on the platform -- its most ever.
Cloudflare also continues to see its revenue growth outpace its costs, which puts the business closer to profitability. In 2021 Q2, the business was still burning cash. Free cash flow was negative $9.8 million compared to negative $20.2 million in 2020, but we are heading toward positive free cash flow as time progresses.
Management's guidance for full-year 2021 suggests revenue of $629 million to $633 million, which would represent almost 47% growth over 2020. The company's revenue grew 50% from 2019 to 2020, so this forward-looking guidance would mean that growth is slightly slowing down -- though Cloudflare is clearly still a rapidly growing business.
3. Is Cloudflare a buy?
The stock has responded well to the earnings report, trading near all-time highs. But the near-term enthusiasm doesn't necessarily mean that investors should jump in with two feet. Consider that Cloudflare traded at a price-to-sales (P/S) ratio of less than 15 in early 2020, before the pandemic-induced crash.
Now, the stock is trading at a P/S ratio of about 58 using the upper end of management's revenue guidance for this year. So the stock price has outrun the company's actual growth by nearly four times over the past 18 months! A P/S ratio this high is among the highest in the stock market. Since Cloudflare's revenue growth has decelerated from 18 months ago, it's hard to make an argument that the stock can support this high of a valuation forever.
When the market experiences turbulence, it's often the expensive stocks that can be among the most volatile. Investors could get a better entry point if we see a correction in the broader market, and it may be smart to wait on the sidelines until then because there may be more downside than upside at the current share price.
