To say that Cloudflare (NET 0.35%) stock has gotten off to a rough start in 2022 would be quite an understatement. Just ask shareholders who have seen a 24% drop in price since the first of the year. But it isn't unusual for growth stocks to take investors on a roller-coaster ride. The big question is whether this stock is an excellent long-term investment at its current price.
Cloudflare delivers services around the globe that make connecting to the internet faster, safer, and more reliable. The company's solutions include Zero Trust, and network and application services. It provides its services through the cloud and is relied upon by more than 132,000 paying customers. The company has benefited significantly from the needs of employees to be able to work remotely and now has data centers located in more than 250 cities to support its global network.
Image source: Getty Images.
The bull case
Cloudflare is a company built for the future, not the past. Its solutions are innovative, needed, and relied upon by thousands. Its customer base is multiplying, including its base of large customers, which has grown 71% year over year as of its third-quarter earnings report. Cloudflare defines large customers as those that contribute more than $100,000 in annualized revenue. And its customers love the product. This is apparent from the company's 124% dollar-based net retention rate (DBNR). A DBNR over 100% signals that customers are expanding their paying relationship with Cloudflare as time goes on.
Data Source: Cloudflare. Chart by author.
Substantial revenue growth has come along with the gains in customers. Sales for Q3 2021 came in very strong at $172 million, a 51% increase over Q3 of the prior year. In fact, the compound annual growth rate (CAGR) since 2016 has been 50%, a monumental achievement that shows management's vision is working. Overall, the company predicts a total addressable market (TAM) of $100 billion by 2024. This offers an extremely long runway for growth. While the company is not yet GAAP profitable, it has all the makings of a scalable business model. Cloudflare's GAAP gross margin reached 78% in Q3 2021.
The bear case
The bear case for Cloudflare is simple and comes down to two major concerns, macroeconomic conditions and valuation. There is no doubt that Cloudflare is growing revenue at an impressive clip; however, that alone does not make it a buy. When inflation is on the rise, it's typically a rough time in the market for growth stocks. These stocks are valued based on estimated future cash flows, which are discounted based on rising interest rates. Inflation has recently breached the 7% mark, and the Federal Reserve is now set to make four rate hikes in 2022. However, if inflation continues to rise, the Federal Reserve may be forced to raise rates even faster. This could further crunch growth-stock valuations.
And Cloudflare's valuation is still high, even with the stock more than 50% down from 52-week highs. As shown below, its price-to-sales ratio is also higher than that of many other once high-flying tech names. This may signal that the stock still has more room for correction.
NET PS Ratio data by YCharts
The bottom line
Buying Cloudflare stock may come down to each investor's timeline and conviction, as with many investments. If one believes in management's vision and has a long-term outlook, Cloudflare may be an incredible long-term investment opportunity after the recent downturn. On the other hand, there may be better entry points ahead, as the growth sell-off doesn't look quite finished. For believers, incremental buying is a great strategy to take advantage of the downturn without trying to perfectly time the bottom.
