Companies are ditching clunky on-premises box servers in favor of cloud-based software-as-a-service (SaaS) platforms in droves. The switch saves space, cuts costs, reduces capital expenses, gives businesses more flexibility, and is generally more efficient.
But we need to be able to access cloud applications and websites when we need them. Cloudflare (NET -0.84%) provides one of the largest global Content Delivery Networks (CDN) to make connections fast, safe, and reliable. Website performance is essential, which is why Cloudflare reports more than 151,000 paying customers.
The stock has plunged in 2022 along with other fast-growing but unprofitable tech companies. With shares down 60% year to date, here are the two sides to Cloudflare's story that investors need to know.
Buy reason #1: Massive scale
When Cloudflare says it has a "global network," there is no false bravado here. Customers in 275 cities in over 100 countries rely on it, and 95% of the world's population is near one of its data centers. Why is proximity so important? Even data has to operate within the parameters of physics, meaning data will experience lag and underperformance if traveling long distances. Moving the data center close to end users allows systems to run faster. This is the essence of edge computing and the reason Cloudflare's 275-city network is a tremendous advantage.
China is a difficult market for U.S. companies. Geopolitical relations make doing business there increasingly tricky, but the market potential is gigantic. Cloudflare has partnered with Chinese internet company JD.com to give it an edge. This has helped revenue growth in the Asian Pacific (APAC) region to accelerate four straight quarters, rising from 23% year over year in the second quarter of 2021 to 43% most recently.
Cloudflare's next frontier is to expand its network into 1,000 of the most bustling office buildings, such as some of the largest in Chicago and New York. More and more customers rely on Cloudflare each period, which could lead to great things for shareholders.
Buy reason #2: Financial metrics
Cloudflare's sales growth is massive, just as we would expect from its increasing scale. Revenue has grown at a compound annual rate of 51% since 2016 and hit $656 million in 2021. When companies are first getting started, percentage growth can be misleading, so I also like to track the amount of revenue added each year in dollars.
The chart below shows the rise of total revenue on the left and the incremental revenue being added each year on the right.
Even better, Cloudflare's growth is still strong. Sales were up 54% year over year in the second quarter, and management is guiding for about 45% growth in the third quarter.
Having 151,000 paying customers is fantastic, but making a living servicing many small customers is challenging. A key to Cloudflare's future profitability will be its ability to grow its large customer base (those providing over $100,000 in annualized revenue). This is a big management focus, and the effort is paying off. Large customers increased 61% in the second quarter to make up more than 50% of total sales.
Cloudflare isn't profitable yet, so investors need to use other metrics to gauge the potential of future returns. The company posts gross margins of over 75%, which is excellent. Still, cash flows are inconsistent due to expansion-related spending. However, management believes the company can deliver 20% adjusted operating margins long term.
Sell reason: Lofty valuation in a challenging market
Cloudflare stock is battling two significant obstacles now. The stock market of 2022 is not kind to unprofitable growth stocks, and Cloudflare's valuation is elevated, even after its sell-off. Growth stocks fell out of favor when it became clear interest rates would rise significantly to contain inflation. Wall Street values growth stocks based on future cash flows, which are further discounted when interest rates go up. This is one reason Cloudflare stock has fallen 60% in 2022 and almost 70% from a year ago, even though its results are terrific.
The other reason for the decline is its nose-bleed valuation. The stock once traded for a ridiculous 90 times sales and has retreated to 18 times sales recently. This is more palatable but still higher than other high-growth SaaS companies like DigitalOcean and Palantir, and in line with cybersecurity star CrowdStrike, as shown below.
There is a lot to like about Cloudflare, from its technology to the rapidly expanding large customer base and stellar sales growth. But the market may not be ready to turn bullish on the stock. Long-term investors interested in Cloudflare should consider dollar-cost averaging during this volatile period. The company has a bright future, but its stock may not be done swooning just yet.