Cloudflare's (NET 0.04%) stock plunged 18% on Nov. 4 after it posted its third-quarter earnings report. Revenue for the cloud-based content delivery network (CDN) and cybersecurity provider rose 47% year over year to $253.9 million, beating analysts' expectations by $4 million. Its adjusted net income rose from $1.4 million to $19.1 million, or $0.06 per share, which also cleared the consensus forecast by $0.06.
The company expects its revenue to rise 41%-42% year over year in the fourth quarter and 48%-49% for the full year. It also expects to generate a full-year adjusted profit of $0.11-$0.12 per share, compared to its loss of $0.05 in 2021. All those estimates either matched or surpassed analysts' expectations.
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Cloudflare's growth rates were solid, but investors seemed to fret over its slowing revenue growth, ongoing losses on a GAAP (generally accepted accounting principles) basis, declining gross margin, and high valuation. Should investors brush aside those concerns and buy this hyper-growth stock after its latest pullback?
A high bar for Cloudflare now
Cloudflare's CDN accelerates the delivery of photos, videos, and other digital content for websites and apps. It accomplishes that by storing cached copies of that digital media on regional edge servers located physically closer to end users than the origin server. Cloudflare also secures those connections with bot-blockers and other security tools.
Cloudflare serves up that data from 275 cities across more than 100 countries, and it processes an average of 39 million HTTP requests every second. About a fifth of the internet currently relies on its security services, which makes it one of the digital cornerstones of the world wide web.
The market's demand for Cloudflare's services has skyrocketed over the past few years, driven by faster internet speeds, more media-intensive websites, and an escalation in bot-powered cyberattacks. Its revenue rose 49% in 2019, 50% in 2020, and 52% to $656.4 million in 2021.
Those high growth rates -- along with the perception that Cloudflare's business was naturally insulated from macro headwinds because companies couldn't afford to turn off its mission-critical services -- caused analysts to maintain high expectations for the company, driving investors to continuously buy the stock at premium valuations.
When Cloudflare's stock closed at an all-time high of $217.25 last November, it was valued at $69.9 billion -- or a whopping 107 times the sales it would actually generate in 2021. Today, Cloudflare is worth $13.5 billion, or 14 times the sales it expects to generate in 2022. That price-to-sales ratio seems a lot more reasonable, especially compared to other hypergrowth stocks, but it still demands near-perfect results in this tough market.
So what could go wrong?
The first major issue is that Cloudflare's 47% sales growth, while impressive, ended its eight-quarter streak of more than 50% growth. Its outlook for the fourth quarter and the full year suggest its gradual slowdown will continue. Analysts expect Cloudflare's revenue to rise 48% this year, but to grow just 36% in 2023.
It's unrealistic to expect a company to generate 40%-50% growth over the long term, but some investors are likely afraid that Cloudflare might experience an abrupt slowdown like its rival Fastly (FSLY 1.68%). Fastly's revenue surged 45% in 2020, but grew just 21% in 2021 and is expected to rise 20%-21% this year. At its peak in Oct. 2020, Fastly was valued at $18.3 billion, or 63 times the sales it would generate that year. But today, it trades at just $1 billion, or 2.5 times sales.
Another issue was Cloudflare's dollar-based net retention rate, which gauges its year-over-year revenue growth per existing customer. That key metric stayed flat year over year at 124% in the third quarter but fell sequentially from 126% in the second quarter. Cloudflare still believes its dollar-based net retention rate will surpass 130% over the long term, but that slight slowdown suggests big companies might be reining in their spending in this tough market.
Cloudflare's non-GAAP gross margin also declined 110 basis points year over year and fell 80 basis points sequentially to 78.1% in the third quarter. CEO Matthew Prince admitted that inflation was "hitting some of our costs" during the recent conference call, but noted that the gross margin remained above its target range of 75%-77%.
Lastly, the bears will point out that Cloudflare remains deeply unprofitable by GAAP measures. Its net loss narrowed only slightly year over year, from $182.8 million to $147.5 million in the first nine months of 2022. That ongoing lack of profitability, which was exacerbated by the stock-based compensation expenses that gobbled up 22% of its revenue, could make Cloudflare an unappealing stock to own as interest rates continue to rise.
Cloudflare's stock is still worth buying
Cloudflare's stock was ridiculously overvalued last year, but I believe it's still a great buy after its latest decline. Its third-quarter report wasn't perfect, but it could still easily generate more multi-bagger gains over the next few years as it locks more websites and apps into its industry-leading CDN and bot-blocking services.
