Cloudflare, Inc. (NET +6.60%) is a cloud services provider which delivers a wide range of solutions to customers worldwide. The company is a leader in Edge Computing, cybersecurity, and Internet of Things (IoT) solutions. Cloudflare has been public since September of 2019, and investors have been handsomely rewarded. An investment of $10,000 the day following the IPO would be worth over $100,000 today.
Cloudflare's stated mission is to "build a better internet," and it seems to be achieving this. Businesses thrive on efficiency, and slowly running applications are not only annoying, but they also cost companies money. The beauty of edge computing is the speed. It turns out data can only travel so fast across fiber optic cables, so distance is a factor in receiving timely data. Cloudflare has a data center in over 250 cities and is within 50 milliseconds of 95% of internet users, according to the company. 50 milliseconds is literally several times faster than you blink your eyes. This is just one example of the differentiated and superior performance of Cloudflare products. They also repel massive DDoS cyberattacks, replace your clunky VPN, secure email accounts, and replace on-premise hardware, among others.
Source: Getty Images.
The stock is experiencing a major dip that may not last
As mentioned above, Cloudflare shareholders have enjoyed massive gains since the company went public. Many of those happened over the last six months. Even so, the market is currently running a special after a near 20% pullback from the stock's highs. Concerns over inflation, interest rates, and the stock's valuation have trimmed the share price.
Source: YCHARTS
The forward PS ratio is still running above 90 despite the recent pullback. This figure drops to 65 on a forward one-year basis. Any way one slices it, this valuation is high. However, long-term investors can still be rewarded. Incremental purchasing is always advisable for high-flying growth stocks in order to take advantage of short-term dips. This is not the first time Cloudflare stock has pulled back sharply. In late September 2021, the stock dropped over 17% on no news. Since that time, it has gained nearly 64%. Obviously, that tumble was an opportunity to purchase or accumulate shares on sale.
The metrics support a company with an undoubtedly bright future
One cannot talk about a software-as-a-service (SaaS) company without discussing three major metrics. First, a successful SaaS company must have a strong gross margin. This allows for the company to scale to profitability as sales and marketing expenses normalize. Cloudflare is beating most of its competition handily with a 78% gross margin. This is higher than other growing SaaS companies like CrowdStrike (CRWD +0.61%) and Palo Alto (PANW 0.18%), and identical to the highly successful and more mature ServiceNow (NOW 2.51%).
Next, Cloudflare's revenue is growing at prolific rates. The revenues have increased nearly 50% each year for three years and are expected to increase another 37% next year.
SOURCE: Cloudflare, YAHOO
Cloudflare's revenue is expected to more than quadruple between 2018 and 2022. This doesn't even begin to tap into Cloudflare's total addressable market, which the company expects to reach $100 billion by 2024. Just a 5% market share should cause its price-to-sales (P/S) ratio to drop down to only 12.
Finally, every successful SaaS company must grow its customer base quickly due to the immense competition in the industry. Cloudflare has an impressive 132,000 paying customers at last report. The company also has a growing number of customers who provide more than $100,000 in annual recurring revenue. These customers have increased from just 451 at third-quarter 2019 to 1,260 at Q3 2021, a 67% compound annual growth rate. Cloudflare is also monetizing customers effectively. The 124% net retention rate indicates that Cloudflare is increasing the amount of revenue from customers much faster than customer churn.
Cloudflare has clear inroads into China
The Chinese market is fertile, profitable, and extremely complex. In order to be successful, a company must manage political risks and deal with the strained relations between the United States and China. Often a partnership with a Chinese company is the best path to success. JD.com (JD 1.09%) is China's largest retailer, and they have partnered with Cloudflare to bring data centers to over 130 Chinese cities.
The Verdict
There is no doubt that Cloudflare has valuation concerns in the short term. However, the long-term bull case is strong. The company is growing annual recurring revenues at a rapid pace, along with the customer base and the revenue received from each customer. The gross margin is high and indicates scalability with an enormous and growing TAM. The partnership with JD.com should assist with increasing the company's presence in China. For long-term investors, the current dip is likely an opportunity to generate increased profits in Cloudflare stock.
