Wall Street Thinks This Stock Could Rise Over 30%

Data has become an important pillar for decision-makers in companies of all sizes. The corporate tech stack typically comprises cybersecurity applications, cloud storage instances, customer relationship management (CRM) and human capital management (HCM) systems, accounting tools, and more.

Many companies compete in cloud storage, data analytics, and network solutions. However, software-as-a-service (SaaS) application Cloudflare (NET 0.81%) is unique because it is a flexible tool that can be layered on top of different technologies. Cloudflare's business absolutely boomed over the last few years. This is not entirely surprising given the tailwinds in demand due to the COVID-19 pandemic. But even as society moves along from the height of the pandemic, Cloudflare is still witnessing a robust inflow of business. Let's dig in.

How are the financial results?

For the year ended Dec. 31, Cloudflare reported total revenue of $975 million, which was a 49% year-over-year increase. Gross margin was slightly lower during the same period, coming in at 76.1% in 2022 compared to 77.6% in 2021. However, despite the nominal deterioration in margin, the company's GAAP net loss improved dramatically. For 2022, the net loss was $193.4 million compared to $260.3 million in 2021.

One important thing to note is that 2021 contained some financial anomalies. Namely, the company experienced a loss on the extinguishment of its debt for roughly $72 million. If we were to back that out, given its nonrecurring nature, a more normalized look at net loss in 2021 would be around $190 million, which is relatively in line with 2022's net loss.

Another important metric to analyze is free cash flow. For 2022, free cash flow was negative $40 million. By comparison, free cash flow in 2021 was negative $43 million. Revenue increased 49% year over year, but net loss and free cash flow burn were essentially the same in both years when we normalize for one-time events. So should investors be worried that Cloudflare's management is not efficient with capital allocation?

Image Source: Getty Images.

A leader in a growing market

Cloudflare is considered a growth stock. Generally speaking, growth companies are expected, to some degree, to reinvest in the business so they can innovate to compete with larger, more mature organizations. Investors need to examine whether these expenses are providing a good return on investment.

For SaaS businesses in particular, we look closely at industry-specific key performance indicators such as annual recurring revenue (ARR), net revenue retention (NRR), and payback period. NRR measures ARR net of churned customers. Simply put, if this ratio is above 100%, it implies that the company is outselling its churn. And payback period is important because it quantifies how long it takes a company to break even on customer acquisition. Ideally, SaaS businesses would like to see this figure decrease over time.

The most basic way to measure these metrics is to look at reported revenue, margin, and cash flow on the financial statements. If revenue is growing faster than expenses, then margins are likely expanding, and cash flow is likely moving in a positive direction.

The table below illustrates Cloudflare's NRR over the last several quarters:

Data source: Cloudflare investor presentation.

Here's what we can unpack: The NRR ratio is consistently over 100%. That's good! But it's beginning to slow down. Should investors panic?

Cloudflare's CEO, Matthew Prince, addressed this head-on during the earnings call:

Our dollar-based net retention ticked down to 122% while our gross renewal rates remain as high as ever. Like others in the industry, we're seeing customers take longer to sign new and expansion deals with us. Procurement departments are definitely in the mode of measure two or three times before cutting one. We still see a clear path to a dollar-based net retention over 130% as we ramp seat-based products like Zero Trust and storage-based products like R2. And we won't be satisfied until we get there.

That degree of confidence and encouragement reminds me of a football coach giving a pep talk going into the fourth quarter when the team is down by three touchdowns. But all kidding aside, Prince gave us some really good information here. He assured investors that renewal rates are at all-time highs. However, like those of its cohorts in tech, Cloudflare's sales cycles are long, and corporate budgets are tight.

While this could be viewed as concerning in the short term, its important to look at the big picture. Factors such as inflation and a potential recession are the drivers behind this short- to intermediate-term cyclical headwind. However, as digital transformation becomes more integral to businesses, investors should be bullish about the long-term secular tailwinds for solution vendors like Cloudflare.

What does valuation imply?

Valuation is tricky in general, and assessing the intrinsic value of a particular stock can be a daunting task. Given that Cloudflare has not yet reached consistent profitability, the price-to-earnings (P/E) ratio is not a reliable measure. We could use the PEG ratio here, but it might also be a poor fit due to its heavy reliance on estimated future earnings.

As of the time of writing, Cloudflare stock trades at roughly 19 times its trailing-12-months sales (P/S). By comparison, the company was trading at 57 times P/S in March 2021.

It's fair to say that the pullback in Cloudflare's stock price has been due to macro factors -- technology stocks across the board have gotten slammed since the beginning of 2023. Interestingly, Cloudflare stock is down nearly 50% over the last 12 months but is actually up 23% year to date.

Yet despite Cloudflare's solid start to the year, Wall Street analysts at Truist Securities, RBC Capital, and KeyBanc all have buy or buy equivalent ratings on the stock and believe it is significantly undervalued. Both Truist and KeyBanc believe the stock can rocket another 50%, while RBC Capital thinks Cloudflare could rise 30% from current levels.

If you are already invested in Cloudflare, now appears to be a fantastic opportunity to lower your cost basis by adding to your position. For those looking for exposure to a growing end-market and industry leader, now could be the time to scoop up some shares.