After a couple of years of elevated revenue growth of over 50%, Cloudflare (NET 1.44%) finally dipped below that rate. Sales expanded "only" 47% year-over-year in Q3 2022, bringing the company's annualized revenue to over $1 billion for the first time.
The initial market reaction to these results was not great. Cloudflare stock went from $50 to $41 in a snap, although some of those short-term declines have since been reversed with the U.S. Bureau of Labor Statistics' read on inflation showing signs that multi-decade high cost of living increases are easing. Investors are hopeful this will mean an end to the Federal Reserve's aggressive interest rate hikes.
Nevertheless, economics aside, Cloudflare's business is obviously still rocking and rolling. But besides all-out revenue growth, this small company's financials aren't perfect. Are shares a buy at this point?
No profit, and more stock-based compensation
Q3 2022 revenue was $254 million. Cloudflare keeps adding new customers large and small at a rapid pace as they build on their library of internet security and app development tools. Dollar-based net retention was 124%, implying that existing customers spent 24% more with Cloudflare than they did a year ago.
So why the gloomy mood surrounding this stock? It's more of the same focus on profitability that has hammered Cloudflare all year. This is not a profitable company using unadjusted metrics. The net loss last quarter was $42.5 million. That compares with a much steeper net loss of $107 million in Q3 2021, but still, the market wants to see robust profitability right now in this rising interest rate environment.
On an adjusted basis, Cloudflare did report a net profit of $19.1 million. However, the adjustments that generated that positive figure involved excluding $55.9 million in stock-based compensation paid to Cloudflare executives and employees. Using stock-based comp helps a company conserve cash. For a company like Cloudflare that is investing its cash and while revenue growth rates are approaching 50%, stock-based comp can be a useful way to maximize expansion, as well as a way to keep talented employees from leaving to work somewhere else.
Nevertheless, it's important to keep an eye on stock-based compensation since it also dilutes the value of existing shares. Cloudflare has paid out $155 million in stock-based compensation through the first nine months of 2022.
Keep an eye on this important growth measure
Sooner than later, I expect Cloudflare to start homing in on unadjusted break-even, and reducing stock-based compensation will be an important step in achieving this. However, while it is concerning to see the level of stock-based compensation paid out this year, bear in mind it hasn't totally destroyed potential value creation for shareholders.
The average number of shares outstanding in 2022 to date was reported at just under 325.5 million at the end of Q3. That's about a 5% increase from the number of shares outstanding in the same period last year. When dividing these share counts by revenue generated, we can see that Cloudflare is still indeed generating lots of potential value for investors down the road -- if the company can eventually turn the corner on the bottom line. Revenue on a per-share basis is up over 200% since the IPO.
Data by YCharts.
In other words, Cloudflare's financial figures are far from perfect. But if the company can continue expanding at a rapid pace and gradually get itself profitable (the company's long-term target is in line with a typical software business, with an operating margin goal of at least 20%), Cloudflare doesn't need to be perfect right now.
Unfortunately, that means there will continue to be plenty of volatile swings in stock prices. Such is life as an investor in small, disruptive tech stocks. If you plan to buy (or buy more), I'd continue to preach caution. I add a few shares every so often to slowly build up my position over time, and I keep a diversified portfolio with a few dozen individual stocks in it. But as poorly as the last report was received by the market, I still see enough good stuff to keep me excited about where Cloudflare is headed in the next decade.
