Cloudflare (NET +2.30%) has had a terrific 2021 while many technology companies have struggled. The stock has jumped 160% year to date, and after its strong third quarter, the company is showing no signs of slowing down.
After such a massive run, however, many investors are worried about how much steam it has left. The company says it is on a mission to "build a better internet," and it has been quite successful at doing so thus far. Despite its stellar rise, here's why I think there is still time to add this disruptor to your portfolio.
Image source: Getty Images.
What does Cloudflare do?
While its mission doesn't tell you exactly what the company does, it is quite accurate: It operates in multiple realms of the internet, offering a suite of products that allow security and speed for everything you need on the internet. Cloudflare started as a content delivery network (CDN), focusing on making the websites it supports faster. Now, it has expanded into edge computing, cybersecurity, and much more.
With dozens of products, including CDNs, zero-trust security, and serverless applications, Cloudflare really is helping to improve parts of the internet. The company has found a way to balance speed and security, blocking 76 billion cyberthreats every day while having 95% of the world's population within 50 milliseconds of a Cloudflare data center.
This vast range of products has attracted over 132,000 paying customers (growing 25% annually since the third quarter of 2018) across more than 100 countries. Because of its broad adoption across the world, 47% of its revenue comes from outside the U.S., showing that the problems that Cloudflare fixes are not domestic, but global. The company is also quite valuable to larger enterprises, growing its number of large customers with contracts worth more than $100,000 per year by 69% annually since the third quarter of 2018 to 1,260.
Its third-quarter performance
Cloudflare has been doing an amazing job retaining customers and expanding its relationships with them. In the third quarter, its churn rate was less than 10%, and its net retention rate was 124%, which has been steadily growing over the past year. The company's revenue grew 51% from the year-ago quarter to $172 million, and its adjusted gross margins surpassed 79%, signaling immense operating leverage in the future.
Management has a history of beating and raising guidance. This quarter, the company beat its internal revenue guidance by 4% and its earnings guidance by $0.03 per share. it also raised its full-year guidance from $631 million for 2021 revenue to $647.5 million.
The downside of its recent third quarter is that the company continued to lose lots of money: $107 million, representing 80% of gross profit. Even worse, this is going in the wrong direction: In the year-ago quarter, the net loss made up only 30% of gross profit. The good news from this, however, is that $72 million of this net loss came from debt reduction. Free cash flow for the year is negative, but a cash and short-term securities balance of $1.8 billion is enough to subsidize both its net loss and its cash burn.
The remaining growth opportunities
There are some risks with this disruptive company. For starters, its nosebleed valuation of 113 times sales might scare off plenty of investors (and I don't blame you). Considering that the company's path to profitability is looking a little hazy, investors could quickly dump it, and that could be a rough ride down in the short term.
It also faces immense competition from numerous companies, the downside of expanding into so many markets. Competitors include Fastly (FSLY +5.64%) on the CDN side and Zscaler (ZS +0.01%) on the security side, just to name two. Many of these rivals are innovative growth stories in their own right.
Despite these risks, Cloudflare's "beat and raise" mindset, combined with continuous innovation, is impressive, and this has allowed for immense growth in its business. In 2018, its addressable market was just $32 billion, but it is now expected to be $100 billion by 2024 -- driven primarily by its innovation and product expansion. With this massive market in mind, the company has huge potential to continue expanding within its current markets.
However, with its innovative culture, it is reasonable to believe that Cloudflare will keep expanding into new markets as well. If it can expand its offerings while monetizing its user base more, the strategy could unlock continued growth.
While this stock might not be the right choice for short-term investors looking to get in and out within the next few months, those willing to hold Cloudflare through rough times for the next five years could see amazing appreciation by the end of that period.
