Cloudflare (NET 0.07%) stock has been on fire so far in 2023. Shares of the internet infrastructure company are up some 35%, propelled higher after a solid fourth-quarter 2022 earnings update and a fantastic outlook for 2023. Best of all, as management has been promising, Cloudflare also turned free-cash-flow-positive in the final months of 2022.
It's all great news for shareholders, but Cloudflare remains a very expensive stock. Is it time to buy after getting some info on what's in store for 2023?
Resilient growth despite economic headwinds
2022 was a tough year for tech. With inflation running hot, the U.S. Federal Reserve aggressively hiked interest rates to try to cool the economy off. It took some months, but big tech has begun feeling the pinch. Employees have been losing jobs as growth came to a screeching halt in the final months of the year.
Cloudflare slowed down, too, but it was relative. Revenue in Q4 2022 increased 42% year over year to $275 million, narrowly beating guidance provided a few months ago. For full year 2022, revenue increased a whopping 49% to $975 million.
For reference, this is how Cloudflare revenue has expanded since the initial public offering in 2019, including its guidance for 2023:
| Year | Revenue (millions) | Change (YOY) |
|---|---|---|
| 2019 | $287 | 49% |
| 2020 | $431 | 50% |
| 2021 | $656 | 52% |
| 2022 | $975 | 49% |
| 2023 | $1,336 (guidance) | 36% |
Data collected from Cloudflare's quarterly reports. YOY = year over year.
Clearly, Cloudflare is expecting some headwinds to its expansion in the year ahead as the global economy slows. But even as it stands right now, Cloudflare will do just fine in the coming year -- whether recession fears come to pass or not. It's worth noting that the company tends to sandbag a bit and has consistently underpromised and overdelivered during its time as a publicly traded company, so perhaps guidance will be raised as 2023 progresses and if the economy improves.
A key profit metric emerges from the red
In the bear market of the last year-plus, investors have turned a magnifying glass onto profitability, and many upstart computing tech companies have failed the test. However, Cloudflare CEO Matthew Prince has long said that as long as the company can reinvest any profit and generate the kind of growth it's been getting, profitability won't be much of a priority. On the other hand, though, Prince has also been saying that Cloudflare would turn profitable in one key area: free cash flow.
Data by YCharts.
Promises were fulfilled in Q4 2022. Free cash flow was $33.7 million, a 12% free-cash-flow profit margin. On the earnings call, Prince explained that while investing for growth remains the priority (which will create some quarter-to-quarter variability in free cash flow), Cloudflare expects "to be free-cash-flow-positive in 2023 and the years after that."
Basically, free cash flow could temporarily return to negative territory at some points, but for full year 2023 and beyond, Cloudflare will be a profitable enterprise based on this metric. This bodes well for a healthy balance sheet, which can enable a company to stay aggressive as it tries to expand and eat market share from larger peers. Cloudflare ended 2022 with $1.65 billion in cash and short-term investments and $1.44 billion in convertible debt.
Is Cloudflare stock a buy?
The final report card of 2022 and outlook for the new year was excellent. However, even as a happy shareholder since the IPO, I (still) believe investors should remain prudent with Cloudflare. Employee stock-based compensation is still high -- $218 million in 2022. That's only a little over 1% of the current total market cap, so the dilution (when existing shareholders' ownership is reduced because new stock is being issued to employees) isn't a total killer. But it is nonetheless lowering Cloudflare's progress on a revenue-per-share basis.
Data by YCharts.
Granted, more than 200% revenue-per-share growth over the last four years is no joke. And as Cloudflare begins to more consistently generate free cash flow in the coming years, even stock-based compensation may not do much to throttle the company's returns to shareholders on a free-cash-flow-per-share basis as it goes from negative to robustly positive.
Remain vigilant, though, because the market has caught on to Cloudflare's fast-growing internet infrastructure, developer tools, and cybersecurity offerings. At some 15 times expected 2023 revenue, this is no cheap stock. Investors fully expect the rapid expansion to continue for a long time, which means this will be a very volatile stock at best. If you buy, I feel most investors should do so in small chunks -- perhaps using a dollar-cost averaging plan to gradually build up a larger position over time, and if the positive vibes keep coming from Prince and company. And above all, remember to properly diversify so your financial future doesn't rely on the success of one single company.
Nevertheless, there is still plenty to like about this company. Despite economic challenges, Cloudflare continues to deliver on its lofty goals as it develops its next-gen internet services platform.
Editor's note: An earlier version of this article omitted the data source for Cloudflare's annual revenues.
