Shares of many growth-oriented companies are down despite those companies reporting strong results in 2021. Cloudflare (NET -1.48%) is no exception, down over 50% from its all-time high set in November. It's an especially intriguing situation given that its 2021 results showcased how strong of a position Cloudflare is in.
Management also gave positive 2022 guidance, further validating Cloudflare's bull case. While market sentiment is currently negative, I think there are three good reasons to own Cloudflare's stock in 2022 and beyond.
1. Strong revenue growth and guidance
Cloudflare's internet solutions allow its customers to host websites on its servers in more than 250 cities. As the website code is stored across every location across the world, anyone navigating to the website is routed to the nearest data center, which increases connectivity speeds. Additionally, using Cloudflare reduces the need to purchase expensive networking equipment and also gives companies access to top-notch cybersecurity solutions.
This solution has proven popular, and Cloudflare's revenue has increased significantly over the last few years. In 2021, it grew revenue 52% year over year to $656 million. This matches the 51% annual sales growth rate Cloudflare achieved over the last six years. Management is guiding for 42% revenue growth over 2022, which would mark a deceleration. However, when management initiated 2020 and 2021 guidance, it only projected 36% and 37% revenue growth, respectively, yet exceeded its own expectations by reporting 50% and 52% growth each year.
While previous beats have no impact on the future, they have built a guidance-exceeding trend. I believe Cloudflare can continue this pattern and report near-50% growth throughout 2022. In order to achieve a beat, Cloudflare must see continued growth in its large customer cohort. If management doesn't continue its trend of exceeding expectations, 42% is growth is still a strong growth rate for Cloudflare.
2. Large customers are increasing
Another key Cloudflare metric is large customers, which it defines as those who spend more than $100,000 annually. Throughout 2021, large customers increased 71% to 1,416 from 828, which was faster than its 69% annual growth rate achieved over the last four years. These customers are also making up a large percentage of total revenue as more than half of Cloudflare's sales come from these large customers.
Customers spending more than $1 million annually grew an even stronger 75% with 56 customers now crossing that threshold. Much of this growth comes from customers expanding their usage with Cloudflare. The company's net retention rate was 125% during Q4, which meant customers spent $1.25 for every $1 they spent during the same time frame in the previous year.
As more customers cross significant revenue thresholds and integrate Cloudfare's offerings into their systems, it becomes more difficult for them to leave. Cloudflare's customers are growing at a rapid rate, which bodes well for the company's future.
3. Improving margins
Cloudflare maintains a healthy 78% gross margin, but still has some work to do on the bottom line. Its 2021 non-GAAP (adjusted) operating margin was negative 1%, which was an improvement over negative 8% (2020) and negative 25% (2019) over the previous two years. For 2022, management is projecting a profitable 1% operating margin.
However, a significant amount of Cloudflare's operating expenses is wrapped up in stock-based compensation. In 2021, Cloudflare racked up $117 million in stock-based compensation which accounted for 18% of revenue or 23% of gross profit and caused Cloudflare's share count to rise 4%. Stock-based compensation is a great way for young companies to acquire talent as shares can be created by the company for no cost. This allows Cloudflare to provide a top-notch compensation package for its employees. On the flip side, it prevents profitability under generally accepted accounting principles (GAAP) and dilutes shareholders through increased share count.
Cloudflare cannot continue this path over the long term, but as it builds out its solution the revenue will eventually outweigh the stock-based compensation. For the time being, it isn't too much of a cause for concern.
At its valuation peak, Cloudflare's price-to-sales (PS) ratio reached an astonishing 112. Even the most bullish Cloudflare investor would have a hard time justifying that price. Luckily, it has come down since then.
Still, a P/S of 46 conveys sky-high expectations, and Cloudflare must execute flawlessly to keep its lofty valuation. Cloudflare has a strong future ahead and the market sentiment reflects it.
Cloudflare's stock is not without risk. Its valuation and high stock-based compensation bill are reasons to be concerned. However, with Cloudflare's total addressable market increasing to $100 billion by 2024, the stock has a huge expansion opportunity. Its revenue and customer count are trending in the right direction and management is projecting more of the same growth, putting Cloudflare on a path to capture some of the $100 billion market.
Investors looking to purchase Cloudflare should probably ease into the stock, as valuations are prone to spike and fall when companies are priced as extreme as Cloudflare is. Additionally, only those with a strong appetite for growth and the ability to handle 50% or more price drops should invest in Cloudflare. If you can handle those stomach-churning movements, I think Cloudflare is an attractive stock for 2022 and beyond. Holding the stock for three to five years will give investors the best chance to see a positive return.