Edge computing leader Cloudflare (NET 1.44%) reported solid second-quarter results on Thursday, with enough good news to send the stock flying. Revenue rose 32% year over year to $308.5 million, and the company reported positive adjusted operating income and free cash flow. Cloudflare struggled with sales force execution issues earlier this year, and while those problems aren't completely solved, the company has made good progress.
While Cloudflare is getting better at navigating the uncertain economic environment, the stock is priced for something close to perfection. Cloudflare is a great company with incredible long-term growth potential, but investors need to be careful with this frothy stock.
Making progress
The big problem Cloudflare faced to start 2023 was a sales organization suffering from lackluster productivity. With the economic picture darkening, potential and existing customers started to need more convincing to adopt Cloudflare's products. The sales team also had to contend with selling a platform that has become increasingly complex. Cloudflare relentlessly launches new products, which is a gift and a curse.
The company has been working to revamp its sales teams, and that effort is starting to pay off. Average account executive productivity has improved meaningfully, and sales cycles have shortened. The average sales cycle is still longer than it's been historically, but the metric is moving in the right direction. Pipeline close rates are also improving.
During the second quarter, Cloudflare added 196 large customers, defined as those spending at least $100,000 annually. The company also had one of its best quarters ever in terms of adding customers spending more than $1 million annually. Cloudflare has nearly 175,000 paying customers overall, but these large customers are critical. More than 60% of revenue comes from large customers, and these big spenders use Cloudflare's services so broadly that they're unlikely to seek alternatives.
Cloudflare is now free-cash-flow positive, which is a positive step toward profitability. Free cash flow was $20 million during the quarter, although it should be noted that it would have been deeply negative if stock-based compensation had been added back in. The company reported a positive adjusted operating profit as well, but it remains unprofitable on a generally accepted accounting principles (GAAP) basis. GAAP net income was a loss of $94.5 million, worse than its loss of $63.5 million in the prior-year period.
Hard to justify
The lack of real profits and a growth rate that's no longer all that impressive makes Cloudflare's valuation tough to get behind. Cloudflare is valued at roughly $24.5 billion following the post-earnings rally, putting the price-to-sales ratio based on 2023 guidance at about 19.
Cloudflare does have an enormous total addressable market that grows each time the company expands its platform. Cloudflare expects its market opportunity to reach $204 billion by 2026, with a big chunk of that coming from its serverless computing and object storage products. AI could expand the opportunity further. Cloudflare sees an opening to become a leader in AI inference workloads.
Even so, Cloudflare's valuation multiple could come crashing down if growth slows further or if real profitability remains elusive. While Cloudflare is seeing signs that the IT spending environment is stabilizing, the trajectory of the global economy remains highly uncertain. If anything goes wrong for Cloudflare, the stock could be in for a harsh correction.
