Cloudflare (NET -0.23%) had been on my watchlist for quite some time. I've watched as shares of the global cloud services provider have tumbled nearly 60% from their peak over the past year. During that time, the company's financial results have steadily improved. That recently led me to step off the sidelines and add a few shares of the beaten-down growth stock to my portfolio.
Here's why I think the sell-off looks like a good buying opportunity for long-term investors.
The numbers are all trending in the right direction
Cloudflare recently reported its fourth-quarter and full-year results, which were impressive. Revenue surged 42% in the quarter to $274.7 million while jumping 49% for the year to $975.2 million. It also reported $35.7 million of non-GAAP (adjusted) income from operations last year, an improvement from a net loss of $7 million in 2021.
Meanwhile, free cash flow was positive in the fourth quarter at $33.7 million, or 12% of its total revenue. That allowed the company to end the year with a solid balance sheet, with nearly $1.7 billion of cash, equivalents, and securities against $1.4 billion of convertible senior notes.
The company's growing scale is helping drive its operating margin higher.
Image source: Cloudflare Investor Relations Presentation.
Cloudflare expects its operating margin to continue expanding as it scales. Its long-term model has sales and marketing (S&M) costs falling to 27%-29% of revenue while general and administrative expenses (G&A) decline to 8%-10%. That should ultimately enable the company to expand its operating margin above 20%, potentially enabling it to deliver significant earnings and free-cash-flow growth in the coming years.
A vast market opportunity
A big factor driving the company's long-term operating model is its belief that it can continue to scale the business. It sees an enormous and growing total addressable market (TAM) opportunity.
Image source: Cloudflare Investor Relations Presentation.
As that slide showcases, the company's current product offering positions it to capitalize on a $125 billion cloud market opportunity. That's up from $32 billion in 2018, driven by organic market growth and the company's product innovation. Meanwhile, its TAM should continue expanding, driven by organic growth and continued innovation, to tap new potential growth areas.
The company has multiple ways to tap that large opportunity, including:
- Acquire new customers: The company grew its customer count by 16% last year to over 162,000 paying customers.
- Expand relationships with existing customers: The company's dollar-based net retention rate has averaged more than 120% over the past year, showcasing its ability to retain customers and expand those relationships. Meanwhile, it's quickly growing its large customer groups ($100,000+) as it continues expanding those relationships.
- Develop new products: Cloudflare continues to invest in innovation to expand its opportunity set.
- Extend its serverless platform strategy: The company's unique network increases retention and opens new market opportunities.
Despite the uncertain macroeconomic environment, the company expects to continue growing briskly in 2023. It sees total revenue rising to between $1.33 billion and $1.342 billion, a 37% increase from last year at the midpoint. While higher costs will keep its operating margin at bay this year, earnings will still grow at a healthy clip. Meanwhile, the investments in its network and research and development (R&D) position the company to continue growing rapidly.
A lower entry point
Cloudflare's stock has lost a lot of altitude over the past year, selling off along with most growth stocks. However, its financial results continue to get better. While it's not cheap by any means, the company's growing scale should allow it to grow into its valuation as it capitalizes on the massive opportunity it sees ahead in the cloud services market. Thus, it's a much more compelling investment opportunity these days.
