Cloud technology company Cloudflare (NET 3.77%) is trading near 52-week lows after its most recent earnings report didn't meet Wall Street's expectations. The stock had been resilient through much of the bear market over these past couple of years.
But with cracks showing in a rocky economic climate, investors may finally have the opportunity they've been waiting for to own the stock at a reasonable valuation.
Here is why investors should grab some shares and not put too much weight into the stock's recent dip.
A critical piece of the digital economy
Cloudflare's roots are as a content distribution network (CDN). It operates computer servers worldwide, caching (storing) its customers' website data. When you visit a website, it will pull the cached info from the closest CDN server instead of the original. This means information travels shorter distances resulting in faster response and loading times.
Approximately 80% of website traffic using CDNs touches a Cloudflare server. The company has steadily built cloud-based products on top of its CDN network, turning itself into a one-stop shop, offering CDN, networking, and security tools to its 168,000 paying customers.
NET Revenue (TTM) data by YCharts.
Cloudflare has generated steady 50% to 55% revenue growth since going public and recently turned cash flow positive -- a sign that revenue is growing faster than its expenses (operating leverage). But its most recent quarter saw a notable slowdown in which revenue growth slowed to 36% year over year, explaining the falling share price.
A much more reasonable valuation
For a long time since the initial COVID-19 market crash in March 2020, investors have willingly paid a handsome premium to own shares. The stock's price-to-sales ratio was as high as 113 but has fallen to 13 today, near its lowest as a public company.
Cloudflare's current valuation doesn't necessarily reflect a poor outlook for the company. Bank failures, recession worries, and other factors have put fear into the market, and investors are avoiding growth stocks and other more speculative assets. You probably shouldn't expect Cloudflare's valuation to approach 2021 levels anytime soon, a time when low rates and market euphoria stretched valuations to extremes.
NET P/S Ratio data by YCharts.
The good news is that investors now have a margin of safety. Hypothetically, suppose Cloudflare's valuation doesn't go any higher in the future when optimism eventually returns to Wall Street. Investors still have a shot at great investment returns because Cloudflare should continue growing over the coming years.
For some stocks, buying undervalued shares is critical because there isn't enough growth to generate satisfactory returns unless the valuation increases too. But Cloudflare shouldn't have that problem -- it's growing enough to create double-digit investment returns without any input from the stock's valuation. Just buy the stock at a reasonable price and let growth compound.
The long-term outlook is bright
Cloudflare is priced at its lowest valuation since the pandemic, but its outlook has plenty of reasons for optimism. Analysts believe the company's revenue will grow by at least 30% annually over the next several years. Management believes that continued product innovation will keep increasing its addressable market to $135 billion by next year. Remember that Cloudflare is doing about $1 billion in annual revenue, so there is plenty of room to grow.
The business is also getting stronger financially, generating $38 million in free cash flow over the past year. Cash flow is a significant milestone on the way to bottom-line profit. As revenue keeps growing, look for generally accepted accounting principles (GAAP) earnings per share first to turn positive, then outgrow revenue as Cloudflare realizes operating leverage.
Cloudflare's steep decline after earnings may have shaken investor confidence, but the stock is now better positioned as an investment than it's been for several years. The company's financials should continue improving, making the stock a long-term buy in today's shaky market.
