It's hard to fathom that the speed of light isn't fast enough in our digital world. But sending vast amounts of data over long distances isn't efficient. Data can only travel so fast, and bottlenecks from limited bandwidth also hinder performance. Network Services provider Cloudflare (NET -2.46%) has data centers near more than 270 cities worldwide to solve this problem.
Ninety-five percent of internet users are within 50 milliseconds of a Cloudflare center. This allows Cloudflare to maximize its customers' website efficiency, security, and performance. The cloud platform replaces costly onsite server hardware for its 154,000 paying customers. Cloudflare has also made inroads into the Chinese market with its partner JD.com. This partnership has allowed the company to service 37 cities in China thus far.
Source: Getty Images
Cloudflare is on the front lines of the cybersecurity fight, including in Ukraine. The company is incredibly proficient in defending against distributed denial-of-service attacks. DDoS attacks take place when a bad actor attempts to knock a website offline by overwhelming it with malicious traffic. In addition, its Zero Trust platform can be integrated with CrowdStrike's Falcon Zero Trust Assessment program, providing customers with terrific defense.
Phishing is behind some of the most disruptive cyberattacks in history, such as the recent Colonial Pipeline incident. While ransomware is the ultimate method of attack, it is widely assumed that the malicious software was planted using access gained with a simple phishing scheme. Cloudflare has acquired Area 1, a company specializing in email security, to strengthen its email protection package. Businesses can provide intensive training to employees, but it only takes one click on a malicious link for a phishing attack to be set in motion. Cloudflare's solution is to discover and derail these emails before they hit the user's inbox.
Q1 results better than advertised
Cloudflare reported Q1 earnings earlier this month, and the results were impressive, although not particularly well received. The company beat analysts' average revenue estimates by posting $212 million for the quarter. The company achieved a non-GAAP (generally accepted accounting principles) gross margin of 79%, which bodes well for future profits. The company also raised its projection for 2022 revenue from $930 million to a range with a midpoint of $957 million. If Cloudflare meets its forecast, it will represent $300 million in added revenue for 2022, or 46% more than in 2021.
Some have lamented the predicted decline in the growth rate of Cloudflare's income; however, much of this is a function of the laws of large numbers. Pictured below is the year-over-year growth rate of Cloudflare's sales.
Data source: Cloudflare. Chart by author.
Growth is declining on a percentage basis. But that may not tell the whole story. Cloudflare's sales growth is accelerating on a dollar basis, as shown below.
Data source: Cloudflare. Chart by author.
Tailwinds from large customers
Much of this growth is due to Cloudflare's ability to attract large customers and monetize existing customers over time. Cloudflare reported 1,537 large customers that provided over $100,000 in annual revenue in Q1. Since Q1 2019, the large customer base has increased at a compound annual growth rate of 66%. This is critical to Cloudflare's future profitability. It is much more efficient to service a couple thousand large customers than to service hundreds of thousands of small customers. The company receives more than 50% of its revenue from these large customers.
Cloudflare also monetizes its customers over time. Its dollar-based net retention rate (DBNR) reached a record 127% in Q1 2022. The DBNR essentially measures the increased spending of current customers with an amount over 100% indicating an increase. The rising DBNR is a terrific sign for future sales growth.
Is it time to invest in Cloudflare stock?
While Cloudflare's business is booming, its stock is not. The stock has lost more than 70% of its value since its 52-week high but still trades at more than 30 times sales. This is particularly unattractive because of the current macroeconomic backdrop of rising rates and inflation. As shown below, the stock has consistently traded at a higher valuation than other fast-growing tech companies like CrowdStrike.
NET PS Ratio data by YCharts
The valuations are converging, indicating that we may soon see a compelling entry point. However, Cloudflare should probably remain on the watch list until the state of the market for growth stocks comes into focus.
