What happened
Shares of Cloudflare (NET -0.23%) rose 13.4% in February following a strong quarterly earnings report. The stock charged 30% higher in the first two weeks of the month, but it surrendered a large chunk of those gains during a marketwide stock sell-off.
So what
Cloudflare reported excellent quarterly results on Feb. 9. Its revenue grew 42%, and it achieved a new all-time high free cash flow of $34 million. The company exceeded analyst expectations for both sales and earnings. Cloudflare also surpassed an important milestone, with over 2,000 customers paying at least $100,000 annually. The company's net dollar retention, which measures its ability to retain and expand customer relationships, remained above 120% despite declining from prior periods. That's a strong metric indicating product quality and customer satisfaction.
Cloudflare also provided an encouraging forecast for investors. The company is expecting 35% revenue growth and 50% expansion in adjusted operating profit, according to guidance. Investors are worried about slowing growth and shrinking margins in the face of macroeconomic trouble. Cloudflare's solid results and positive outlook directly addressed investor concerns, instilling confidence to drive the stock higher.
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That positive momentum couldn't keep the cybersecurity stock out of trouble when broader market forces turned sour toward the end of the month. Economic data and commentary from Federal Reserve officials raised concerns that interest rates would remain higher for longer than anticipated, which generally weighs on stocks. Growth stocks with high valuations were hit the hardest, and Cloudflare got caught up in that turmoil.
Now what
Cloudflare has strong growth catalysts moving forward. The company provides a network that improves the efficiency and security of its customers' websites, and the number of businesses relying on those services just keeps rising. Cloudflare has a relatively small number of large-scale direct competitors. It also benefits from a strong brand and modest switching costs that keep customers engaged.
It's hard to knock Cloudflare's operational success and positive outlook, but the stock is priced aggressively. It has a price-to-sales ratio close to 20, and its price-to-cash-flow is above 150. Expensive stock valuations create lofty expectations for the company's future results, making it vulnerable to stock market volatility and investor fear. Given Cloudflare's growth trajectory, its valuation isn't high enough that long-term investors need to stay away, but it's important to accept and prepare for price fluctuations in the short term.
