Cathie Wood's Ark Invest believes companies that deal in disruptive innovation are the ones most likely to see long-term appreciation. In keeping with that philosophy, it manages several thematic funds focused on disruptive technologies like artificial intelligence (AI).
Ark sold shares of Tesla (TSLA -1.11%) and Nvidia (NVDA 6.18%) throughout September. That might puzzle investors because Tesla is generally seen as a leader in autonomous driving technology, and Nvidia's chips are considered the gold standard in AI infrastructure.
There is a simple explanation: Ark trimmed its positions not because it lacks conviction, but to rebalance its portfolio. Tesla stock has doubled year to date, and Nvidia stock has tripled, so Ark decided to resize its positions and redeploy capital elsewhere.
Some of that capital was invested in Cloudflare (NET 1.44%), a cloud computing company often omitted from AI discussions, though it could indeed be a major beneficiary of the growing demand for AI.
Cloudflare is a market leader in several cloud computing verticals
Cloudflare offers a range of application, network, and security services that improve the performance of corporate infrastructure across private data centers and public clouds, while eliminating the cost of on-premises network hardware. The company also provides developer services that help businesses build applications and websites directly on its network.
Cloud computing is a highly competitive space dominated by the likes of Amazon Web Services (AWS) and Microsoft Azure, but Cloudflare has distinguished itself in three important ways.
First, its infrastructure-neutral platform enables a business to manage its entire IT ecosystem (across every major public cloud) from a single interface. Neither Amazon nor Microsoft offers the same interoperability.
Second, Cloudflare runs the fastest global cloud network in the world, an achievement not easily replicated due to the requisite time and money. That has won the company a leadership position in software for content delivery networks and in edge development platforms.
Third, Cloudflare powers about 20% of the web in some capacity, meaning it has a unique ability to gather performance data and threat intelligence across the internet. That data advantage powers a network effect that makes its platform incrementally better and more secure with each added user. This has helped Cloudflare forge a leadership position in email security and zero-trust network access.
Cloudflare should benefit from growing demand for AI
Cloudflare reported stellar financial results in the second quarter in spite of challenging macroeconomic conditions. Its customer count climbed 15% to 174,100, and the average customer spent 15% more.
In turn, revenue increased 32% to $308 million -- topping the sales growth reported by AWS and Azure -- and the company achieved its fourth consecutive quarter of record operating profit.
Investors have good reason to believe that momentum will continue and even accelerate. Cloudflare values its addressable market at $146 billion, but management sees that figure reaching $204 billion by 2025 as businesses lean into digital transformation and cloud migration. That alone forms the foundation of a solid investment thesis, but there is more to the story.
Cloudflare attributes roughly one-third of its market opportunity to developer services, a category that includes its application development platform (called Workers) and various storage products. Forrester Research has already recognized Workers as a leading-edge development platform, but management sees substantial upside in the growing demand for AI. To quote CEO Matthew Prince:
By our estimates, Cloudflare is the most commonly used cloud provider across leading AI start-ups. 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. We believe we're uniquely positioned to become a leader in AI inferencing.
If Prince is right, Cloudflare would be a key player in what promises to become a multitrillion-dollar market.
Cloudflare expects rapid revenue growth in the coming years
Management expects its annual revenue run rate to reach $5 billion by the third quarter of 2027, implying annual revenue growth of 39% over the next four-plus years. That makes its recent valuation of 17 times sales look quite reasonable, and it's certainly a discount to the three-year average of 41 times sales.
There are plenty of ways to invest in AI, including autonomous driving companies like Tesla and chipmakers like Nvidia. To account for the range of opportunities, investors should consider building a basket of AI stocks, and I think cloud providers like Cloudflare (and Amazon) belong in that basket.
