Is Cloudflare's AI Business Really a Reason to Buy the Stock?

Another quarterly earnings season in 2023, another AI hype-fueled stock rally. Going on year two of the buzz surrounding generative AI spawned by the success of OpenAI's ChatGPT, make no mistake that the decades-long development of artificial intelligence-powered software has reached an important inflection point where it is actually useful to the mainstream.

But does that mean stocks capitalizing on AI are an automatic buy? Maybe; maybe not. Cloudflare (NET 1.44%) has certainly been one of those companies that has caught a sort of AI-fueled "second wind" this year as investors rally to the stock. But for longtime Cloudflare shareholders, seemingly recent AI developments aren't actually all that new. Here's why you might pause before buying Cloudflare right now.

A stellar quarter of financial execution fueled by AI

Cloudflare reported a solid Q3 2023 with year-over-year revenue growth of 32% to $336 million, beating its own guidance provided a few months prior.

After downgrading its full-year revenue guidance early in 2023, Cloudflare has settled back into its habit of underpromising and overdelivering the last couple of quarters. However, while 32% growth is nothing to complain about, higher interest rates and the slowdown of the global economy have hit Cloudflare like it has everyone else in the software and computing tech sector this year. CEO Matthew Prince and the top team expect results to improve in 2024 due to operational changes, as well as new AI products starting to contribute.

Data source: Cloudflare.

Now, let's talk about those new AI products. At several points this year, Cloudflare has announced new AI services powered by its large global edge computing network of data centers. Throughout the late summer and early autumn, Cloudflare announced new collaborations with the likes of Nvidia and Meta, as well as with AI start-ups like Hugging Face, to bring AI models to the edge so customers can efficiently deploy them to users. This culminated in the announcement of Workers AI in October, an extension to its Workers product for software developers.

It's all impressive stuff, and the sum of these AI tools is helping to clearly differentiate Cloudflare as a leader in this new era of AI software. However, it isn't exactly new. As I pointed out earlier this year, Cloudflare has been making some of these partnerships pretty clear for at least a couple of years (most notably the Nvidia one, originally announced in 2021). It's only just now that the market is catching on and once again running up Cloudflare's stock price as it sniffs out a potential acceleration in growth, perhaps in 2024, as Prince has been hinting at.

At any rate, it was mentioned on the earnings call that Cloudflare's installation of AI hardware throughout its global network of data centers is going according to plan. Prince said:

Right now, there are members of the Cloudflare team traveling the world with suitcases full of GPUs, installing them throughout our network. We have inference-optimized GPUs running in 75 cities worldwide as of the end of October. We are well on our way of hitting a goal of 100 by the end of 2023. By the end of 2024, we expect to have inference-optimized GPUs running in nearly every location where Cloudflare operates worldwide, making us easily the most widely distributed cloud-AI inference platform.

Time to buy the Cloudflare AI story?

Before rushing to hit the buy button on Cloudflare stock, let's back up to the financials again. Growth is showing resilience this year against a less-than-ideal economic backdrop. However, Q3's generally accepted accounting principles (GAAP) net loss was $23.5 million (compared to a GAAP net loss of $42.5 million a year ago). Free cash flow was positive at $34.9 million (compared to negative $4.6 million last year). The discrepancy between GAAP net losses and free cash flow last quarter was primarily due to employee stock-based compensation of $74 million.

Data by YCharts.

The takeaway? Clearly, Cloudflare is still a grow-first, profit-later operation -- and perhaps for good reason. As Prince and company have explained many times in the past, they see a clear runway to sustaining very high growth for many years and will take the opportunity to capture market share before worrying too much about maximizing the bottom line.

Cloudflare is doing a good job of executing on this goal and ramping up free cash flow, but a no-profit business (at least on a GAAP basis) can cause some very wild swings in stock price. Bear this in mind before going all in on the AI optimism.

I still believe Cloudflare is best purchased using a dollar-cost averaging plan, building a larger position over time. This seems prudent if you also fully expect some volatility (big drops in stock price) at some point. Be cautious, but also know that Cloudflare's business has tremendous potential as it continues to build top-notch cloud and edge computing infrastructure for the AI future.