Cloudflare (NET 1.44%) stock took a hit following its Q1 2023 earnings report, largely on news that the content delivery network and cybersecurity service lowered guidance for the rest of the year due to economic headwinds. Sure, annual revenue growth of 31% to 32% isn't bad at all, but this is a premium-priced stock. The market was anticipating expansion much closer to 40% or higher for the year.
But in 2023, there seems to be a quick fix for companies experiencing a flagging share price: Just mention AI. After a handful of announcements about its work in AI, Cloudflare stock quickly reclaimed much of the ground it lost post-Q1 earnings.
The lessons something like this teaches abound for investors.
Cloudflare taps the AI hype cycle
After reporting its last quarter, Cloudflare released a couple of news items discussing its work in generative AI -- the type of service OpenAI's ChatGPT provides that got this whole media cycle brewing in the first place.
First, Cloudflare made note of the fact that its internet security suite has tools that AI companies can use to make sure their data is secure. Given that much of the generative AI work being done today takes place in the cloud (data and AI algorithms hosted in a remote data center, accessed remotely via an internet connection), safety tools like those that Cloudflare has in place are an important part of an AI start-up's toolset.
And second, Cloudflare announced that a number of generative AI app start-ups -- including Character.ai, Leonardo.ai, Lexica.art, and SiteGPT.ai -- are using Cloudflare's R2 Storage in managing the massive datasets they need to train their algorithms. Cloudflare also announced a number of AI infrastructure start-ups have partnered up to provide Cloudflare's R2 Storage as part of their AI training platforms.
Suffice it to say the market was excited by these two press releases after Cloudflare's disappointing downgrade on 2023 revenue guidance.
Data by YCharts.
I'm not knocking what Cloudflare did. Sometimes investors need a reminder that a business is doing just fine and that long-term growth prospects remain intact. Is the market punishing a stock? Just say "AI," and investors will respond accordingly. However, this sequence of events illustrates where we are at in the current hype cycle surrounding AI.
Don't buy just because it says "AI"
The problem I have with the market's response to Cloudflare's AI news is that this isn't exactly new news at all. Two years ago -- April 2021, to be more precise -- Cloudflare announced a partnership with Nvidia (NVDA 6.18%) in which it would fill up its global internet infrastructure network with GPUs and Nvidia software models to enable AI.
Yes, that Nvidia, the one that the market suddenly woke up to this year and decided was a giant in AI computing.
The point is, for those early followers and shareholders of Cloudflare (myself included), it was already more than implied that Cloudflare was providing services to this nascent generative AI movement, with some help from Nvidia chips and software. Cloudflare's series of news items is exciting, but not exactly a set of game-changing revelations that should inform an investment decision.
This is happening all over the place right now, thanks to the early viral success of ChatGPT. Indeed, generative AI could be a game changer for many businesses in the coming years. But a company simply invoking the power of the word "AI" is not the same as delivering financial results. A stock should not simply be rewarded because the business says it's working on AI. Investors that chase these hot stocks of the moment are playing a dangerous game.
The real reason to buy a stock
As for Cloudflare stock and whether it's a buy, I'd say pass right now. I'm still very optimistic about the company's long-term prospects, but the sell-off following Q1 2023 earnings was completely justified. Remember, management forecasted full-year 2023 revenue to be as much as $1.34 billion just a few months ago. Now the outlook has been lowered to about $1.28 billion.
Generative AI or not, Cloudflare is dealing with some macroeconomic speedbumps this year. Shares now trade for nearly 15 times expected 2023 sales, and the business is still reporting variable free cash flow from one quarter to the next.
Data by YCharts.
If you like Cloudflare's business, I'd wait for some of the AI hype to cool off before nibbling. And if you do, remember to nibble. As in times past, I still think buying shares of a company like this one in small batches and building to a bigger position over time makes the most sense. This stock is going to be a very bumpy ride for years to come.
