Cloudflare's (NET 0.81%) big downgrade on 2023 growth expectations is now long forgotten, replaced with excitement about the company's "act three" driven by... artificial intelligence (AI). Shares have rallied some 50% this year.  

Of course, there are lots of reasons to be bullish on the business as it continues to win over lots of new customers. However, the stock price still fetches a very high premium. Is it too late to buy? 

Does anyone remember the 2023 downgrade?

Cloudflare had a solid performance in the second quarter of 2023, with revenue of $308.5 million and adjusted net income of $20.3 million topping its own guidance provided three months ago. CEO Matthew Prince and the top team even slightly boosted full-year 2023 financial guidance as a result.  

However, before jumping into the buy-or-sell fray, let's remember Cloudflare is in the midst of a tough period. After growing close to or above 50% since its 2019 IPO (including 49% growth in 2022 during the bear market), management delivered a stunner to shareholders earlier this year when it backtracked its already pedestrian (by Cloudflare standards) guidance for 2023.  

Date

Full-Year 2023 Revenue Guidance

Implied Growth Over 2022

Feb. 9, 2023

$1.33 billion to $1.342 billion

36% to 38%

April 27, 2023

$1.28 billion to $1.284 billion

31% to 32%

Aug. 3, 2023

$1.283 billion to $1.287 billion

31% to 32%

Data source: Cloudflare.

The good news is that Prince commented on the last earnings call that customer concerns over the economy and resulting purchase behavior seem to be stabilizing. But Cloudflare's growth trajectory matters a lot. The stock trades for nearly 18 times expected 2023 revenue -- a hefty premium considering the low-30% outlook for sales expansion. And free cash flow of just $63 million over the last 12-month period isn't high enough to be a meaningful gauge of valuation. Cloudflare is still young, and generating cash hasn't been a high priority until recently.

Will AI save the investment thesis?

Given the current price tag on the stock, the market clearly expects an acceleration in growth to kick in sooner or later (maybe 2024), or at least for Cloudflare to sustain this new pace of expansion for many more years. Is that a reasonable expectation?

The company initially built its business as a content delivery network (CDN), the basic internet infrastructure that allows businesses to deliver data and apps securely to user devices. The company has built next-gen cybersecurity products atop that base and is increasingly competing against security software leaders like Palo Alto Networks and Zscaler. And now, as JMP Securities analyst Trevor Walsh phrased it on the last earnings call, Cloudflare is in the midst of an "act three" surrounding software developer services -- and especially for AI-powered apps.

This is embodied by the Cloudflare Workers developer platform, and especially the "R2 Storage" service that provides an alternative for software developers looking for a place to store massive amounts of unstructured data (often needed for AI algorithm training). Prince said on the earnings call that R2 Storage "continues to grow and now stores over 13 petabytes of customer data, up 85% quarter over quarter."

As I wrote a few months ago, the average investor is glossing over Cloudflare's 2023 cool-off due to AI and Cloudflare touting its global network infrastructure featuring Nvidia hardware. AI-related revenue could begin to kick in for 2024, though, perhaps providing a bump-up in growth trajectory. But it's simply too soon to tell. 

I'm a happy Cloudflare shareholder, and I have no plans of selling. This company has landed many victories in its short history as a publicly traded concern, and it has lots of potential. But the valuation simply looks too optimistic right now, so I'm not buying any more.

For investors excited about owning a piece of this company for the very long term, consider using a dollar-cost averaging plan to build a larger position over time, as this stock is going to be highly volatile given the premium price tag.