The world's demand for content delivery networks (CDNs) continues to grow rapidly. The growth of e-commerce, streaming services, and just about all the most visited websites, including Meta Platform's Facebook and Netflix, use a CDN to improve internet speed and security, and Cloudflare (NET -0.23%) is one of the largest CDN providers in the market.
Cloudflare recently reported earnings results that beat analysts' estimates. Revenue grew 42% year over year in the fourth quarter. The company is obviously delivering enough growth to warrant interest by long-term investors, but the stock's 50% jump year to date has made the stock very expensive from a valuation perspective.
Let's look at the company's performance and what management had to say about near-term demand trends to help determine if the stock is worth paying up for.
Large corporations are choosing Cloudflare
There's a lot to like about Cloudflare as a long-term investment. Not only is it growing revenue quite fast in a challenging economic environment, but it offers its service as a pay-as-you-go subscription plan, where customers can even sign up through Cloudflare's website using a credit card. It also offers a free plan, which widens its potential market opportunity to businesses of all sizes.
The company is also seeing improving profitability. Adjusted (non-GAAP) operating margin was over 6% in the fourth quarter, and the company's free cash flow has been improving, too, although it is still below breakeven.
NET Free Cash Flow data by YCharts
Cloudflare is widely used, with about 18% of all web traffic handled by its network based on data from W3Techs. Revenue from large customers grew 56% year over year last quarter and now represents 63% of Cloudflare's total revenue.
Because the company continues to add more advanced technology and services to its network platform, including Zero Trust and other security services, its addressable market continues to expand, now estimated at $135 billion.
The problem is most of these opportunities may already be priced into the stock's current valuation. Here's why investors might want to be cautious about buying the shares right now.
Corporate spending is slowing down
Management cautioned investors about the near-term economic uncertainty, and the impact this is having on the business. During the earnings call, Chief Financial Officer Thomas Seifert said, "Economic uncertainty resulted in businesses being more cautious with their spending, leading to longer decision-making processes and ultimately longer sales cycles during the quarter, pressuring revenue growth across the technology industry, including Cloudflare."
The uncertainty in the economy is reflected in Cloudflare's numbers. Revenue growth was very stable through the first half of 2022, but then it quickly started to decelerate in the third quarter, dropping from a 54% year-over-year increase to 42% in the fourth quarter.
| Metric | Q4 2021 | Q1 2022 | Q2 2022 | Q3 2022 | Q4 2022 |
|---|---|---|---|---|---|
| Revenue growth (YOY) | 54% | 54% | 54% | 47% | 42% |
Data source: Cloudflare. YOY = Year over year.
Even Cloudflare's existing customers are pulling back on purchasing additional services. The dollar-based net retention rate, ticked down to 122% in the fourth quarter, meaning customers spent an average of 22% more in the most recent quarter than a year ago. The fourth-quarter retention rate was down from 127% in the first quarter of 2022.
While most analysts still rate the stock a buy, there was one notable call from Goldman Sachs after the company's recent earnings report. Analyst Gabriela Borges initiated coverage of the stock with a sell rating, citing several factors, but most importantly, a lack of catalysts in the near term due to the slowing pace of digital transformation in the economy, which could hurt demand for Cloudflare's platform.
The analyst sees slowing revenue growth as not providing enough free cash flow to support the stock's valuation. Because of these obstacles, Borges expects there to be some speedbumps in the company's path to reaching management's five-year target of $5 billion in annualized revenue.
The stock's valuation is, indeed, a bit stretched after the post-earnings surge. At a price-to-sales multiple of about 23, Cloudflare is one of the most expensive software-as-a-service (SaaS) stocks.
Data by YCharts
Valuation can have a big impact on future returns. It's always a good idea to shop around to see if you can find another company with a similar growth profile trading at a cheaper valuation. There are other software stocks that are growing just as fast as Cloudflare but are trading at lower P/S multiples.
Because of its premium valuation, I would wait for a better price before buying shares of Cloudflare right now.
