Cloudflare (NET 1.86%) is an internet-infrastructure company with a solid competitive position in edge computing, internet security, and storage for artificial intelligence (AI) training data sets -- excellent areas to invest in for the next ten years. And with many economic experts believing at the beginning of the year that the Federal Reserve could avoid a recession, growth investors saw the first quarter as an ideal time to start buying the stock, thinking they were catching a bottom from its steep drop from 2021's all-time highs. As a result, investors bid the stock price up 36% -- a fantastic performance.
Unfortunately, with the failure of SVB Financial and Signature Bank, the second- and third-largest U.S. bank failures of all time, many now believe the U.S. economy will instead dive into a recession within a year, not a healthy environment for Cloudflare's business in the short term. So balancing the risks of a significant stock-price downdraft over the next few quarters versus its high revenue and earnings-growth potential over the next ten years, should you buy this stock?
Let's look more closely at that question.
There's a lot to like about the company
Growth investors have loved this company since it first came public in September 2019. It has produced more than 40% year-over-year revenue growth since its initial public offering, and with only 0.8% penetration of a $125 billion total addressable market in 2023, it has plenty of room to continue growing.
Image source: Cloudflare.
All the use cases in the image above support many high-growth secular trends, attracting customers in droves. The customer account increased by 16% over the previous year's comparable period to 162,086. More importantly, large enterprise customers rose to 2,042 in the fourth quarter of 2022, up 44% over last year's comparable quarter. Since larger customers have more cash to spend on more products, robust enterprise-customer growth can often foreshadow a considerable revenue boost over time as those clients buy more products through Cloudflare's upselling and cross-selling activities.
Image source: Cloudflare.
Another thing investors drool over is the company's consistently high gross margin, which means the direct costs to produce its service, like labor and material costs, are low. And it means that Cloudflare has a far easier path to create bottom-line profits and free cash flow while reinvesting back into the business to produce additional revenue growth than companies with low gross-profit margins.
Image source: Cloudflare.
The company's gross margins have consistently stayed above 75% over the last five quarters, which is excellent for a subscription business and a great reason to buy.
However, there are reasons to be cautious
Cloudflare's main issue in today's economy is that despite its $19.4 billion market cap, it is still a relatively early stage business in its many competitive markets and has yet to scale up to profitability and generate free cash flow (FCF).
It produced Q4 2022 GAAP (generally accepted accounting principles) operating margins of negative 20.6%, a GAAP net loss of $193.4 million, and FCF of negative $39.8 million.
NET Operating Margin (TTM) data by YCharts.
Since high inflation, rising interest rates, and a stalling economy have historically resulted in decelerating revenue, higher financing costs, and fewer profits dropping to the bottom line for individual companies, the value of all businesses has deteriorated for investors in today's economic environment. And the most significant drop-off in value has occurred with unprofitable and negative FCF businesses. Thus, many Cloudflare shareholders started running for the hills in late 2021 as they anticipated today's economic environment.
The risk investors take by investing in Cloudflare today is prematurely assuming that the worst of this slowdown is over and finding out things could indeed worsen. The Federal Reserve has yet to end its interest rate hike campaign; most Federal Reserve officials have predicted at least one more hike; and a few expect even more. Moreover, most economists think there will be a recession, and while many believe the recession will be mild, in truth, no one knows the severity or length of a possible recession. Meanwhile, its valuation is very high compared to other cloud-infrastructure peers.
CrowdStrike and ZScaler are growing revenue faster than Cloudflare yet have lower valuations.
NET Revenue (Quarterly YoY Growth) data by YCharts.
Suppose the economy continues to deteriorate more than many expect. Cloudflare's revenue could decelerate faster and further than bullish investors were banking on and miss on analysts' quarterly revenue estimates. Then, the stock price would fall off a cliff from the current valuation.
Should you buy it?
Although it has its finger in the pie of many high-growth secular trends, it faces significant competition in those areas. From companies like Zscaler in Zero Trust Security to companies that compete in edge computing like Fastly to the big boys like Amazon, Alphabet, and Microsoft, all have very competitive products to Cloudflare's offerings. So, there is no guarantee that the company can scale up its business to reach sustainable profitability facing such stiff competition, especially in a tech sector notorious for companies introducing disruptive new products unexpectedly.
Suppose you invest in Cloudflare at current prices. Not only are your hard-earned dollars at significant risk from the poor macroeconomy in the short term, but the gamble on the company's long-term potential may also fail to pay off, resulting in either meager returns or permanent losses.
All but the most extreme risk-takers would be better off giving this stock a hard pass at its current valuation.
