Cloudflare's (NET -0.23%) stock price plunged 21% on April 28 after the cloud-based content delivery network (CDN) and cybersecurity services provider posted its first-quarter earnings report. Its revenue rose 37% year over year to $290 million, missing analysts' estimates by less than $1 million, and its adjusted net income surged 677% to $27.2 million, or $0.08 per share, and beat the consensus forecast by a nickel.
Cloudflare's growth rates were decent, but its guidance rattled investors. It expects its revenue to rise 30% year over year in the second quarter and 31% to 32% for the full year. It had previously guided for 36% to 38% revenue growth for the full year.
Image source: Getty Images.
That reduced guidance was disappointing, yet it wasn't that surprising in light of the recent macroeconomic headwinds. In addition, Cloudflare's stock has already been cut in half over the past 12 months, which suggests a lot of pessimism is already baked into its price. So could it bounce back over the following year?
The key facts and figures
Cloudflare's CDN platform accelerates the delivery of digital content for websites. It accomplishes this by storing cached copies of photos, videos, and other media on "edge" servers that are physically located closer to a website's visitors than the original "origin" servers. It also shields websites from bot-based attacks with cybersecurity services.
The market's demand for Cloudflare's services has been booming. Between 2019 and 2022, its revenue grew at a compound annual growth rate (CAGR) of 50%. It now serves data from 285 cities across over 100 countries, and it processes an average of 46 million HTTP requests every second. It's still unprofitable on a generally accepted accounting principles (GAAP) basis, but it turned profitable on a non-GAAP basis in 2022.
That growth trajectory is promising. But some cracks start to appear if we track Cloudflare's four main metrics over the past five quarters. Those metrics are:
- Revenue growth
- Growth in large customers (who pay more than $100,000 annually)
- Dollar-based net retention (which gauges its year-over-year revenue growth per existing customer)
- Non-GAAP gross margin
|
Metric |
Q1 2022 |
Q2 2022 |
Q3 2022 |
Q4 2022 |
Q1 2023 |
|---|---|---|---|---|---|
|
Revenue growth (YOY) |
54% |
54% |
47% |
42% |
37% |
|
Large customer growth (YOY) |
53% |
61% |
51% |
44% |
40% |
|
Dollar-based net retention |
127% |
126% |
124% |
122% |
117% |
|
Non-GAAP gross margin |
78.7% |
78.9% |
78.1% |
77.4% |
77.8% |
Data source: Cloudflare. YOY = Year over year.
Cloudflare's growth in large customers and revenue has gradually decelerated, and its dollar-based net retention rate and gross margins are slipping. During the conference call, CFO Thomas Seifert blamed that slowdown on the persistent "elongation" of sales cycles in a tough macro environment and admitted the company faced "unprecedented" headwinds in the first quarter that had "surpassed" its own cautious expectations. Seifert said that while "elongated sale cycles are temporary in nature," he expected the headwinds to "persist through the end of the fiscal year."
Another troubling issue is that Cloudflare's smaller competitor Fastly (FSLY -0.47%), which is growing at a slower rate with lower gross margins, actually grew its trailing-12-month net retention rate by a percentage point sequentially to 119% in the fourth quarter of 2022. That expansion, which coincides with Cloudflare's declining retention rates, suggests the competitive pressure could continue to compress Cloudflare's gross margins.
On the bright side, Cloudflare expects to remain profitable on a non-GAAP basis for the foreseeable future, and it expects its non-GAAP EPS to jump 162% to 169% for the full year. That robust profit growth, along with its improving free cash flow (FCF) -- which came in at positive $14 million in the first quarter compared to negative $64 million a year earlier -- suggests it can easily weather the near-term macro headwinds and emerge as a stronger company.
But valuation is an issue
Cloudflare's slowdown seems mild, but its stock is still pricey. With an enterprise value of $20 billion, it's still valued at 15 times this year's sales. That's why any sign of weakness -- which appeared in its latest guidance -- will attract the bears.
For reference, analysts expect Fastly's revenue to rise only 16% this year, but it looks more reasonably valued at 5 times that forecast. Their mutual competitor Akamai (AKAM 0.42%), which is expected to generate just 3% sales growth this year, trades at 4 times that estimate. In other words, there's a risk that Cloudflare's stock could be cut in half again (or more) before contrarian investors consider it to be an undervalued growth stock.
Cloudflare's frothy valuation makes it a tough stock to buy right now. It might continue to command a premium valuation over the next 12 months as investors focus on its long-term growth potential, but it won't outperform the market so long as its sales growth, retention rates, and gross margins are all headed in the wrong direction.
