Shares of Cloudflare (NET 0.73%) initially rocketed more than 10% following its strong fiscal fourth-quarter and full-year report. However, that rally fizzled out as investors focused more on the cloud company's near-term headwinds than its long-term growth potential.
That tepid response to the cloud security, performance, and reliability company's exceptional earnings looks like a great buying opportunity for long-term investors seeking high-upside growth potential.
Starting to cash in
Cloudflare's revenue rocketed 42% year over year in the fourth quarter to $274.7 million. While the company posted a GAAP loss of $45.9 million, it improved from a $77.5 million loss in the year-ago period. Meanwhile, the cloud company delivered non-GAAP earnings of $21.6 million, a big jump from $0.1 million in last year's fourth quarter.
One metric that really stood out was free cash flow. The company produced $33.7 million of free cash flow in the quarter, or 12% of its revenue. While Cloudflare wasn't free-cash-flow positive for the full year -- it was a negative $39.8 million, or 4% of revenue -- it's heading toward producing sustainable free cash flow.
That's crucial, given the current market environment. With stock prices down and interest rates up, capital has become much more expensive to access. Because of that, companies that can self-fund their growth and produce free cash flow have a competitive advantage. While Cloudflare doesn't need outside capital right now thanks to its cash-rich balance sheet -- it ended the year with $1.65 billion of cash, equivalents, and marketable securities against $1.4 billion of convertible senior notes -- its improving cash flow will further enhance its financial flexibility.
Lots more growth ahead
Cloudflare expects to continue growing briskly this year, albeit at a slower rate due partly to a more challenging macroeconomic environment. The company sees its revenue rising to a range of $1.33 billion to $1.342 billion, up 36.4% to 37.6% from last year's level.
However, the company is only scratching the surface of its market potential:
Image source: Cloudflare Investor Relations Presentation.
As that slide shows, Cloudflare's investments in innovation have significantly expanded its total addressable market (TAM). However, at around $1 billion of annual revenue, it has only captured a small slice of that massive and growing opportunity.
The company has four growth drivers:
- Acquiring new customers: It has multiple ways to grow its paying customer base; that's currently over 162,000. Millions of businesses could become paying Cloudflare customers in the future.
- Expanding relationships with existing customers: The company's dollar-based net retention rate has averaged over 120% in the past year as it retains customers and grows those relationships. Cloudflare has grown its large customer count (those with over $100,000 of annualized revenue) at a 57% compound annual rate. With only about 2,000 customers qualifying as large, it has a long growth runway within its existing customer base.
- Developing new products: Continued investment in innovation should enable the company to keep expanding its TAM.
- Extend its serverless platform strategy: This approach will enhance retention and open new market opportunities.
Cloudflare believes its ability to continue growing rapidly will increase its scale, improving margins and earnings. The company's long-term target is to expand its non-GAAP operating margin to more than 20% -- up from 6% during the fourth quarter. That would be a significant profitability and cash-flow booster.
Massive growth potential
After failing to launch following its fourth-quarter report, shares of Cloudflare remain more than 50% below their 52-week high. While the company's still not cheap at more than 14 times its projected 2023 revenue, it has tremendous expansion potential that could see it grow into a more comfortable valuation over time. That revenue growth should drive margin expansion, potentially powering robust earnings and cash-flow growth. Those factors make Cloudflare look like an exceptionally compelling opportunity for investors looking for a potentially high-upside growth stock.
