Is Cloudflare Stock a Buy Now?

Cloudflare's (NET 1.44%) stock price dropped 6% during after-hours trading on Nov. 2 following its third-quarter report. The cloud-based content delivery network (CDN) and cybersecurity service provider's revenue rose 32% year over year to $336 million and exceeded analysts' estimates by $5 million. Its adjusted net income surged 189% to $55 million, or $0.16 per share, and beat the consensus forecast by $0.06 per share.

Cloudflare's growth rates looked healthy, but its cautious fourth-quarter guidance sunk its stock. Let's see if the market overreacted and created a good buying opportunity for long-term investors.

Image source: Getty Images.

A solid quarter with stabilizing growth

Cloudflare's CDN accelerates the delivery of digital photos, videos, and other media for websites. It accomplishes that by storing cached copies of the digital content on edge servers that are physically located closer to a website's visitors. It also shields those websites from bot-based attacks by forcing visitors to prove they're human.

Cloudflare's revenue rose 50% in 2020, 52% in 2021, and 49% in 2022. Those growth rates suggested the company could achieve its long-term goal of becoming a "water filtration" system for the modern internet.

But over the past year, its growth in total revenue, large customers (those who spend over $100,000 annually), dollar-based net retention rates (its year-over-year revenue growth per existing customer), and gross margins all declined. It blamed that slowdown on macro headwinds that drove many companies to rein in their software spending.

Data source: Cloudflare. YOY = year over year.

Yet that deceleration stopped in the third quarter. Its year-over-year growth in revenue and large customers held steady from Q2, its dollar-based net retention rate rose sequentially, and its adjusted gross margin expanded sequentially and year over year.

But its slowdown hasn't ended yet

Those growth rates suggested Cloudflare's business was finally stabilizing, but the company doused any hopes for a near-term recovery with its downbeat guidance.

For the fourth quarter, Cloudflare expects its revenue to only grow 28%-29% year over year, compared to the consensus forecast for a 30% boost. During the conference call, CFO Thomas Seifert said the company was maintaining a "prudent and cautious" outlook, as the "broadening geopolitical uncertainty and increasingly mixed macroeconomic data points across geographies" made it "challenging to predict" its near-term future.

On the bright side, Cloudflare continues to expand into the artificial intelligence (AI) market through Workers AI, a new platform for developing AI apps like chatbots directly on its CDN, as well as the installation of Nvidia's high-end GPUs into its edge networks to accelerate the delivery of AI applications for websites. But it only recently started testing those services, so they won't meaningfully boost its revenue anytime soon.

For the full year, Cloudflare reiterated its guidance for about 32% revenue growth. Analysts expect its revenue to rise 32% in 2023 and 30% in 2024.

Cloudflare is still expanding, but a lot of its future growth has already been baked into its stock valuation, which currently stands at 11 times next year's sales. By comparison, smaller rival Fastly, which is expected to generate 16% revenue growth in 2024, trades at 4 times that forecast. Cloudflare is growing twice as fast as Fastly, but its price-to-sales ratio is nearly 3 times higher, so its stock might still be overvalued.

Stabilizing its margins as its growth cools off

As Cloudflare's revenue growth cools off, it's reining in its spending to strengthen its operating margins. On a non-GAAP (generally accepted accounting principles) basis, its operating margin more than tripled year over year from 2.7% to 8.8% in the first nine months of 2023, while its GAAP margin rose from negative 21.5% to negative 15.3%.

As a result, it expects its adjusted EPS to double year over year in the fourth quarter and grow about 250% for the full year. Both of those estimates surpassed analysts' expectations. Analysts had forecast its adjusted earnings would jump 185% in 2023 and 22% in 2024, but those estimates will likely be raised to account for its rosier outlook.

Is it the right time to buy Cloudflare?

Cloudflare's stock isn't cheap, but it still has a lot of irons in the fire and should grow more quickly in a more favorable macro environment. It's also growing a lot faster than other CDN providers like Fastly and Akamai. I wouldn't back up the truck on this volatile stock yet, but I'd be willing to nibble on it when it unexpectedly pulls back -- as it did after its latest earnings report -- to gradually accumulate a larger position.