Cloudflare (NET -2.16%) is a leading provider of edge computing services that help speed up the rate at which information can be sent and accessed throughout the internet. It's also a lead provider of other services, including protections against distributed denial-of-service (DDoS) attacks that aim to take web destinations offline through a deluge of spoofed server requests.
Cloudflare is one of today's most important internet infrastructure companies and generally posts strong business results, but its stock has seen some turbulent trading over the last couple of years. On the heels of sell-offs that followed the company's first-quarter earnings release, Cloudlare's share price is down roughly 78% from its high.
Is now the right time to be buying the stock? Read on for a look at one green flag and one red flag that you should consider before adding shares to your portfolio.
Green flag: Cloudflare is adding customers and expanding client relationships
At the end of 2019, Cloudflare had 17 customers generating more than $1 million in annual sales. But the company ended 2022 with 85 customers in the cohort, good for a 71% compound annual growth rate across the stretch.
Once companies join Cloudflare's ecosystem, they tend to increase spending as their businesses scale and their needs expand. Last quarter, the web services specialist notched a dollar-based net revenue-retention rate (NRR) of 117%, which means that existing customers still using its services increased their spending at an average rate of 17% year over year.
The net revenue-retention rate has been a major contributor to Cloudflare's strong revenue growth, but management anticipates there's actually significant room for improvement. The company anticipates that increased adoption of its identity verification services, data storage technologies, and other offerings could eventually push its NRR above 130%.
Even as macroeconomic headwinds are making its customers more cautious about spending, Cloudflare got off to a solid start in 2023. The company's revenue climbed 37% year over year to reach $290.2 million in the first quarter, and free cash flow swung to $13.9 million from a loss of $64.4 million in the prior-year period.
Red flag: Headwinds threaten growth-dependent valuation
The company's net revenue-retention rate of 117% in Q1 wasn't bad but was down from 122% in Q4. Macroeconomic pressures aren't causing customers to leave Cloudflare, but they are resulting in slower rates of service expansion.
Cloudflare's most recent forecast calls for revenue of $305.5 million in the current quarter and $1.28 million for the year. Hitting these targets would mean sales of 30% and 31.5%, respectively. Notably, the company had previously guided for annual revenue growth to come in between 36% and 38% this year.
On the heels of 49% annual sales growth in 2022, it's clear that a pretty substantial deceleration is at hand. It's not surprising that the web services specialist's stock tumbled following the downward-guidance revision.
NET PE Ratio (Forward) data by YCharts.
Even after some big sell-offs, Cloudflare is valued at more than 12 times this year's expected sales and 139 times expected non-GAAP (adjusted) earnings. The company may also be years away from shifting into profitability on an unadjusted basis. While the company's GAAP loss narrowed from the $41.4 million it posted in the prior-year period, it still posted a loss of $38.1 million in the quarter.
Heading into a potential economic downturn, Cloudflare's valuation profile is undoubtedly risky.
Is Cloudflare stock a buy right now?
With many economists now forecasting that the U.S. will slip into recession this year or next, there's a good chance that Cloudflare's growth opportunities will be narrowed in the near term. Given that the company's valuation is so heavily growth-dependent, investors without high levels of risk tolerance should probably steer clear of the stock due to macroeconomic pressures and uncertainty on the horizon.
On the other hand, the company has leading positions in its corner of the web services space, and the long-term demand outlook for its technologies remains favorable. Risk-tolerant investors who aren't deterred by the prospect of valuation volatility in the short term may find a lot to like about the stock. I think that Cloudflare has what it takes to deliver strong results for patient shareholders, but the next couple of years could be rocky.
For those who see promise in the company and its opportunities to continue expanding with the growth of the broader internet, this is a case where dollar-cost averaging would probably be a smart approach.
