When an investment trend as hot as artificial intelligence (AI) comes along, almost every company will try to tell investors how it is deploying or investing in it. Sometimes, they're just buzzwords from management to generate hype for its product. Other times, a company is legitimately using it or serving customers with it.
Cloudflare's (NET 1.44%) product isn't rooted in AI but provides its customers with the tools they need to make AI work for them. The company also recently reported some great news regarding AI, but does that make the stock a buy? Read on to find out.
AI is just a part of Cloudflare's offering
Cloudflare provides the services necessary for the next age of the internet. Instead of an individual or business hosting a website on premises, Cloudflare allows its customers to host on the cloud. With this method, clients also get other improvements like faster speeds, enhanced cybersecurity, and increased network capacity.
These are huge benefits that are often out of reach of smaller entities. And larger clients would have to spend a lot to do the job of Cloudflare, making it a no-brainer choice. That's why the company has more than 174,000 paying customers, with a revenue stream that is 47% outside of the U.S.
So what does AI have to do with any of that?
Cloudflare also has tools to build AI apps on its network. This allows its customers to create assistant and generative AI tools with pre-trained or custom models. It also allows creators to seamlessly deploy a ChatGPT plug-in or similar ones like SiteGPT, character.ai, or Leonardo.AI.
While AI isn't at the forefront of the Cloudflare investing thesis, it shows management is agile enough to quickly offer products that its clientele demands. CEO Matthew Prince said, "In the second quarter alone, we shared 10 major announcements and features to extend Cloudflare Workers as the preeminent development platform built for the age of AI."
That shows its commitment to AI on its platform. But what else was in that second-quarter earnings report?
Cloudflare's expectations are sky-high
In the second quarter, Cloudflare's revenue rose 32% year over year, much slower than last year's 54%. Many companies are slowing their cloud expansion to reduce expenses during uncertain times, and this slowdown shouldn't surprise many investors. Third-quarter revenue is expected to grow by 30%, about the same as in the second quarter, so this headwind isn't subsiding anytime soon.
With Cloudflare nowhere near profitable, it lost $94.5 million from operations. This revenue slowdown is slightly concerning because the company must continue to grow rapidly for its valuation to make sense. Over the past year, the stock's price-to-sales (P/S) ratio has remained relatively steady at around 20 times sales.
NET PS Ratio data by YCharts.
But with that P/S multiple comes great expectations. Cloudflare believes it can deliver 20% operating margins over the long term, capping its maximum profit margin at about 16% once taxes are accounted for. If Cloudflare could snap its fingers and reach that profitability level, it would trade at 125 times hypothetical earnings.
Few companies consistently trade at this level and survive, so it's a bit concerning. If Cloudflare maintained its 30% growth rate for five years, it would still be valued at 34 times forward earnings, which is probably reasonable for a company with those profit margins. The kicker with that assessment is that its stock price cannot increase during that time frame.
That's just an idea of the level of growth 20 times sales represents. But is there something else missing? Currently, Cloudflare's total addressable market is $146 billion. By 2026, it expects that figure to rise to $204 billion. Furthermore, its customer count is still growing relatively quickly, showing that there are still a lot of potential clients out there.
Because of that, I'm still bullish on Cloudflare. However, I think investors need to purchase at the right time. I'm unsure if right now is the best time to buy it, but I know there will be better entry points along the way.
