When edge computing leader Cloudflare (NET -0.23%) reported its first-quarter results last week, the market wasn't happy. Shares of Cloudflare plunged more than 20% on Friday, undoing the gains of the past few months.
A combination of slowing growth and a sky-high valuation helped produce the big post-earnings decline. Cloudflare is still growing at a healthy pace, but its outlook for the year came in well below expectations. While it can be tempting to buy the stock on the dip, investors need to understand that the valuation is still high and investing in Cloudflare is going to require patience.
A major slowdown
Cloudflare offers a wide array of products and services, but its core offerings tackle security and content delivery. It's a popular choice among developers and businesses of all sizes, and its generous free plan creates a nice pipeline of potential customers.
The company gained nearly 20,000 new paying customers over the past year, bringing the total to just over 168,000. Included in that customer base are 2,156 customers spending at least $100,000 annually. That large customer count has jumped by about 600 since the first quarter of 2022.
The problem for Cloudflare is that its customers are starting to act a little more cautiously. The company's dollar-based net retention rate, which measures how quickly existing customers are expanding spending, slumped to 117% in the first quarter. The metric has been trending downward over the past year, and it's down a full 10 percentage points since the first quarter of 2022.
Cloudflare's revenue grew by 37% year over year in the first quarter. That already represents a significant slowdown, but the company expects the situation to get worse.
For the full year, Cloudflare is predicting revenue growth of 31% to 32%. For the second quarter, growth should come in at 30%. By comparison, Cloudflare's revenue grew by 49% in 2022.
An out-of-sync valuation
Revenue growth of 30% is nothing to sneeze at, especially given the backdrop of economic uncertainty. But relative to Cloudflare's lofty valuation, this growth rate isn't enough. Even after the post-earnings drop, the company sports a market capitalization of about $15.6 billion. With guidance calling for revenue of $1.282 billion in 2023, Cloudflare stock trades for more than 12 times forward sales.
In 2021, when investors were willing to pay ludicrous prices for the fastest-growing stocks, a low-teens price-to-sales ratio would have seemed like a bargain. That's not the case anymore. It's now common for formerly high-flying software-as-a-service and cloud stocks to be trading at single-digit multiples of sales.
Cloudflare isn't profitable on a GAAP basis, producing a net loss of $38.1 million in the first quarter on $290.2 million in revenue. The company is profitable on an adjusted basis and on a free-cash-flow basis, but in both cases, a substantial amount of stock-based compensation is backed out. With the market punishing unprofitable growth stocks over the past year, the days of no one caring about real profits appear to be over.
Cloudflare requires patience
Cloudflare is a great company, and its edge network grants it plenty of optionality as it looks to expand its market opportunity over time. Today, the company estimates its total addressable market at $125 billion, driven partly by newer businesses like Zero Trust security and serverless computing. As the company finds more ways to leverage its network, this addressable market will grow over time.
But Cloudflare, the stock, is problematic. Given the slowing rate of growth and no sign that the growth rate will bottom out anytime soon, paying more than 12 times sales is tough to justify. To buy the stock today, you need to be a long-term investor willing to accept the risk of valuation multiples contracting further.
Cloudflare could be a cloud giant in the making, but it's going to be a rough ride for investors.
