Cloudflare (NET 1.44%) is a leader in helping organizations secure their internet connections, but it hasn't been smooth sailing over the last few years. The stock is down 67% off its previous peak as companies have tightened their spending on cloud services. Cloudflare's revenue growth has also cooled off, although it's still growing at high rates.
The stock found a second wind in early November after the company reported its third-quarter financial results. The item that seemed to get the most attention on Wall Street was the company's opportunity to serve the booming market for artificial intelligence (AI) workflows.
With the stock making a big move recently, it's a good time to take a second look at this beaten-down growth play. Here are three things about Cloudflare that smart investors know.
1. Cloudflare's competitive advantage is driving growth
Companies are still cautious about spending in the near term, but Cloudflare surprised investors with stable growth last quarter. The number of paying customers increased by 17% year over year, while existing customers continued to spend on additional services. This drove a 32% year-over-year increase in revenue, consistent with the previous quarter.
Solid growth can be traced back to competitive pricing and industry-leading networking and security services. "We were selected over first-generation Zero Trust competitors due to our ability to consolidate numerous products across both application security and Zero Trust onto a single platform," CEO Matthew Prince said on the Q3 earnings call.
Price mentioned that within its Zero Trust security service, the company could add all the traffic served by its competitors to the Cloudflare network without adding to its cost of goods sold. This low-cost advantage will be important over time to keep prices down and add more customers.
2. AI is emerging as a lucrative opportunity
Cloudflare is ready for the growing demand for AI workloads across its networks. It is working with several leading companies that are tackling the AI market, including Databricks, Nvidia, Hugging Face, Meta Platforms, and Microsoft. Following announcements with these companies in September, Cloudflare added new AI capabilities to its global network.
While it's still early, management reported excellent results so far. "We have a pipeline of customers interested in putting hundreds of billions of inference tasks on our infrastructure each month," Prince said. The inferencing that Prince is referring to is where an AI-trained computer model learns to make predictions from new data, which will become the most important stage of AI development over time. Cloudflare is clearly maneuvering itself to serve AI companies over the long haul, not just the initial ramp of AI training.
There are three ways Cloudflare hopes to grow this into a lucrative opportunity. It could offer security solutions to AI developers, storage of AI training models, and a charge for extra computing capacity. The possibilities to monetize the exploding volumes of data traveling across its network has Wall Street changing its tune about the stock's near- and long-term prospects.
3. Cloudflare stock is a long-term buy-and-hold
One headwind that has hurt growth stocks like Cloudflare over the last few years is rising interest rates. Rates are still trending higher, and are weighing on highly valued stocks. Investors are currently paying a price-to-sales multiple of 20 for Cloudflare stock, which is expensive.
However, Cloudflare's ability to invest in its network infrastructure without meaningfully increasing costs is driving record free cash flow for the business and could outweigh the negative effect of rising rates on the company's valuation.
NET Free Cash Flow data by YCharts
Despite management's guidance for slightly lower revenue growth in the fourth quarter, the company's improvement on the bottom line makes the stock worth more to investors. That said, management's Q4 revenue guidance for year-over-year growth between 28% and 29% reflects headwinds in the economy that may limit the stock's upside next year. But over the next several years, a recovery across the tech sector would benefit Cloudflare's business and could send the stock much higher.
