Cloudflare (NET -1.02%) is a tricky stock to understand. The business checks several boxes I like to see in an investment and the company has strong financials. However, the stock is richly valued, presenting an internal conflict for investors.
With the stock down 64% this year, has it finally reached a buying point? Let's find out.
The future of the internet
Cloudflare's mission is simple: "to help build a better internet." It does this by hosting websites in its data centers across the world. Instead of distant users accessing a website from a single point, Cloudflare's solution is much faster because a user is routed to the nearest data center.
Cybersecurity is another aspect of Cloudflare's offering, strengthening the company's value proposition. Not only do customers save on IT teams, but they also avoid expensive security software, not to mention the potential savings from thwarting a cyberattack that may have been successful with second-rate protection.
Leading Cloudflare is one of its co-founders, Matthew Prince, who has a 90% approval rating, according to Glassdoor.
A company led by its founder that attacks a large addressable market with success is a great place to look when searching for investible companies. Of course, having solid financials is also a must-have.
Extreme growth at the cost of profitability
In its life as a public company, Cloudflare's revenue growth has stayed steady at around 50% each quarter.
It's rare to find a company that grows at that level and even rarer to find one that does it consistently. For the fourth quarter, Cloudflare expects revenue growth of 42%, but management consistently undershoots its guidance historically. I'll be curious to see what 2023's guidance looks like, but if Cloudflare can keep this growth pace up, it will become a huge company quickly.
While Cloudflare reported $4.6 million in free cash outflows in Q3, management believes it will return to a free-cash-flow state in Q4. However, Cloudflare does have a hefty stock-based compensation bill to factor in.
In Q3, Cloudflare paid $55.9 million in stock-based compensation -- 22% of revenue. That's a significant expense that shareholders shouldn't overlook, as it caused the share count to jump nearly 4% year over year (YOY). Flooding the market with more shares effectively makes each share less valuable as it increases the number of pie slices.
Still, Cloudflare is a relatively young company. While profits are important, establishing its brand and capturing a large chunk of what it believes will be a $135 billion opportunity by 2024 is critical. If it increases its share count and is marginally profitable for some time but beats the competition, it will be worth it in the end.
But even the most outstanding company in the world must be bought at a reasonable price.
Is the stock too expensive?
Fortunately for investors, Cloudflare's valuation has significantly declined over the past year.
This decline happened for two reasons. First, the stock price has fallen drastically. Second, Cloudflare's sales have risen, driving the valuation down even further. But is 17.5 times sales too expensive?
Analysts project Cloudflare will grow by 35% in 2023. So let's say its growth declines by 5% each year until 2026. Cloudflare's revenues would look like this:
|Annual Revenue (billions)
That would value Cloudflare's stock at 6.2 times 2026's hypothetical sales. Compared to more mature companies, like Microsoft (8.9 times sales) and Adobe (9.3 times sales), 6.2 times 2026 sales seems relatively close. But if you value Cloudflare's stock at the midpoint, 9.1 times sales, Cloudflare's stock would need to have a 10% compounded annual growth rate from today's price to reach that valuation with the growth projected above.
Now 10% returns are pretty much the market average. But it all depends on Cloudflare's growth rate. If the company grows faster than the projections above, it can produce a much higher rate of return (especially if it maintains its near-50% growth rate). On the other hand, if it grows more slowly, the stock could lose to the market.
I think the above projections are conservative, indicating the stock could handily beat the market in the coming years. However, the key is to hold on to the stock over the next three to five years. Without the long-term holding period, the effects of compounding growth are lost. Despite looking expensive now, Cloudflare's stock remains cheap from a long-term perspective.