When bear markets strike, it feels like they will never end, but investors that focus on buying stocks of companies that continue to post strong revenue growth will be poised to realize sizable gains in the next bull market.
One area to hunt for promising winners is cloud computing. Spending on cloud infrastructure has remained very resilient in 2022, up 30% year over year in the third quarter. Earlier this year, Amazon Web Services CEO Adam Selipsky mentioned that cloud computing is still in the early innings of adoption.
While the big cloud service providers like Amazon have a bright future, there are even faster-growing companies addressing specific cloud needs that could lead the market higher over the next decade. Here are two of my favorites.
Snowflake
Snowflake (SNOW -1.99%) is seeing tremendous growth by offering companies a single platform for uploading and analyzing massive amounts of data using artificial intelligence. Over the last five years, annual revenue has increased fourfold to nearly $2 billion, and management believes the business can sustain an average annual growth rate of 30% for several more years.
Snowflake has emerged as the leading data management solution. It integrates with all the major cloud service providers, such as Amazon Web Services and Microsoft Azure. Other cloud companies also offer data analysis tools, but one metric indicates Snowflake is doing it better. For several quarters, Snowflake has maintained a very high net dollar retention rate of over 170%. This means customers spend significantly more with Snowflake after their first year on the platform -- a key indicator of its value proposition.
There is a risk that large cloud service providers with greater financial resources than Snowflake could acquire or partner with other data management services to grab a bigger piece of the market, but that's unlikely for a few reasons. Snowflake already has relationships with many Fortune 500 companies. Most importantly, Snowflake is expanding its competitive lead the more it grows. A key advantage is its data marketplace that allows customers to share and exchange data. This creates a strong incentive for clients to stick with Snowflake.
Long-term, management sees revenue reaching $10 billion by fiscal 2029. The stock currently trades at 18 times management's projected free cash flow of about $2.5 billion in seven years. That doesn't look like a bargain, but if the company continues to maintain its lead, the stock can deliver a good return on investment from these levels. It's a good sign that Warren Buffett's Berkshire Hathaway continues to hold a small stake in the company.
Cloudflare
As businesses migrate their data systems to the cloud, it is creating security vulnerabilities and data congestion that slows down networks. Cloudflare (NET -3.01%) is a leader in helping companies speed up network traffic and shore up internet security. It offers must-have features on a single cloud-based platform, including virtual private network (VPN), routing, traffic optimization, and other services. Cloudflare's network is estimated to serve 94% of the internet population globally.
After posting revenue growth of 52% in 2021, Cloudflare continued to maintain steady growth this year, clocking in at a healthy 47% in the third quarter. The company just surpassed $1 billion in annual revenue, but it's just getting started. Cloudflare has not even penetrated 1% of its addressable market opportunity with its existing products. This is a multibillion-dollar business in the making, and patient investors have the chance to get in on the ground floor.
However, it won't be a smooth ride. The company reported seeing more customers trade down to the free service tier last quarter. The uncertainty in the economy in the near term has weighed on the stock, but the key is that Cloudflare is still signing up its share of new customers while maintaining a dollar-based net retention rate above 120%.
Management expects to increase revenue to $5 billion within five years, which would represent an annualized growth rate of 38%. If Cloudflare can earn a free cash flow margin of 20% on revenue, like other software companies, that would put the stock's current price-to-free-cash-flow multiple at 15.
Like Snowflake, investors must pay a steep price for future growth, but I believe now is the best time to buy these stocks as the market becomes more pessimistic about the future, providing investors better value. The current quote could look like a bargain down the road as Cloudflare signs up more customers, releases new products, and executes against its long-term financial goals.
