Sometimes the market loves a company's results so much that it dramatically reprices the stock. That's what it did when Cloudflare (NET 1.44%) reported earnings on Feb. 8; the stock jumped up nearly 20% the following trading day.
Clearly, there's something in this report that made investors reconsider their valuation of Cloudflare. But was it overdone, or is the stock still a buy here?
Cloudflare's core business is doing quite well
Cloudflare is all about hosting workloads on the cloud. Primarily, it has been used to host websites on its data center network, which spans 310 cities across the globe. By being closer to a data center, anyone trying to access the information should see greater speeds, whether on a website or an enterprise network.
Cloudflare also offers cybersecurity protection for any workloads hosted on its servers. Additionally, with Cloudflare having multiple data center locations, it's less vulnerable to attacks like distributed denial of service (DDoS), which essentially overloads a server with access requests. This can be a problem if a website is hosted at a single location within a company's server room. But if the company uses Cloudflare, it can outsource this work and have increased security as well.
One area in which Cloudflare doesn't have a lot of business is artificial intelligence (AI), but management sees the demand coming. Matthew Prince, co-founder and CEO, had this to say about AI:
"AI is not yet contributing materially to revenue, but it has contributed materially to developer excitement over the platform. And we're seeing more and more large deals, more and more interesting applications coming in using the Workers platform."
The Workers platform is Cloudflare's AI solution and is a network dedicated to running AI tasks. It only launched in September 2023, and by December, the number of daily requests had increased by 9 times.
Clearly, there's a lot of interest, but Cloudflare's base business is also doing quite well.
Cloudflare's stock has some aggressive assumptions priced into it
In Q4, Cloudflare's revenue rose 32% year over year to $362.5 million, exceeding the $352.5 million guidance management gave in Q3. Management also gave strong guidance for 2024, with revenue expected to come in around $1.65 billion, indicating 27% growth.
With Cloudflare being a growth story, that's the primary focus, as it doesn't produce any profits -- although its getting closer to profitability.
Cloudflare's operating loss margin was 12% for the quarter, but this is still an improvement over previous results.
NET Operating Margin (Quarterly) data by YCharts
The key here is that operating expenses grew slower than revenue, which means if Cloudflare continues this trajectory, it should break even eventually. But with the massive opportunity Cloudflare sees ahead (it estimates its total addressable market will expand from $164 billion in 2024 to $204 billion by 2026), investors should get comfortable with Cloudflare's losses, as it won't stop reinvesting in the business until it sees its market opportunity fulfilled.
But all this optimism comes at a price, as Cloudflare's stock is richly valued.
Thanks to its recent jump, Cloudflare's stock is the most expensive it has been in some time.
NET PS Ratio data by YCharts
A price-to-sales ratio of 27 is incredibly expensive, and if Cloudflare can achieve its long-term operating model of 20% or greater operating margin, that would price the stock 169 times earnings if it had a 20% tax rate. If the company grew at a 30% pace over the next five years, that would bring its hypothetical valuation down to 45 times earnings -- still more expensive than many mature tech stocks.
That's a lot of expectations baked into the stock, and while Cloudflare may succeed as a business, that kind of expectation is hard to live up to from a stock perspective. As a result, I've sold some of my Cloudflare stock, but I would be willing to purchase more if the valuation drops to a cheaper level (like what was seen earlier this year).
