Shares of Cloudflare (NET 4.71%), a fast-growing cloud computing company that specializes in protecting and speeding up websites, have crashed nearly 80% since peaking late last year. That dismal performance has nothing to do with the company itself -- revenue has continued to surge higher, and Cloudflare's long-term growth prospects remain bright.
There's a lot to like about Cloudflare for long-term investors, but there's one glaring risk that shouldn't be ignored.
1. Buy: A massive addressable market
Cloudflare started out focused on protecting websites from malicious traffic. The company's edge network spans 270 data centers and is capable of absorbing even the largest distributed denial-of-service attack. A customer sticks Cloudflare's platform in between end users and their servers, and Cloudflare does the rest.
This edge network is useful for other things beyond security. Cloudflare can cache static assets close to users, making response times lightning fast and freeing servers from needing to handle those requests. Bits of code can be run directly on Cloudflare's platform, and with the addition of data-centric products like R2 object storage and a D1 database, developers can host entire applications on Cloudflare without the need for one of the big cloud platforms.
In addition, Cloudflare offers zero-trust services for companies looking to secure employee access to resources and data. And for enterprises with on-premises or hybrid networks, Cloudflare can protect those networks against attacks and improve network performance.
Cloudflare's knack for constantly building products on top of its network has greatly expanded its total addressable market. The company estimates that its market opportunity has grown from $32 billion in 2018 to $115 billion today, and it sees a path to get to $135 billion by 2024. That number could soar even higher if some of Cloudflare's newer products take off more than expected.
With annual revenue expected to come in just below $1 billion this year, Cloudflare is in the very early innings of its growth story.
2. Buy: A sticky platform
Beyond opening new revenue streams, the deluge of new products built on top of Cloudflare's network makes the whole platform stickier. The more of Cloudflare's platform a customer uses, the harder it becomes to rip it all out.
A customer's journey may begin using Cloudflare's free tier, which includes basic protection from attacks and caching. That customer may then upgrade to a paid plan to unlock more advanced features or start using the Workers product to run bits of code on Cloudflare's platform. Various data-related products integrate with Workers, providing additional functionality. If that customer has employees that need secure access to resources, Cloudflare's zero-trust services then come into play.
Before long, Cloudflare has become deeply embedded in that customer's IT infrastructure. It's not impossible to switch providers, but it would be disruptive. Cloudflare's net revenue retention rate hit 127% in the first quarter of this year, driven higher by larger enterprise customers who have embraced the platform. That's a strong indication that Cloudflare's platform is sticky, and that it naturally leads customers to expand usage over time.
Cloudflare's free plan brings in users by providing a valuable service, and Cloudflare's culture of innovation and constant rollout of new products goes to work converting those users to paying customers and getting them hooked.
3. Sell: A lofty valuation
Despite the beating Cloudflare stock has taken this year, there's still a hefty dose of optimism baked into the valuation. Based on the company's 2022 revenue guidance, Cloudflare trades for around 15 times sales. A year ago, that valuation wouldn't have raised any eyebrows. But today, with growth stocks tanking and a recession looking like a real possibility, Cloudflare is undoubtedly an expensive stock.
To be fair, the company is growing quickly. Revenue shot up 54% in the first quarter, and Cloudflare may still be able to produce solid double-digit growth during a recession. But profits are nowhere to be seen, and cash flow hasn't yet become consistently positive.
Profitless tech stocks have fallen out of favor, so it's not unthinkable for Cloudflare stock to tumble further if there's any sign of a growth slowdown. Cloudflare's long-term growth prospects are top notch, but it may take quite a while for the company's financial results to grow into its current valuation.
