Cloud services company Cloudflare (NET -6.10%) might have tested your patience. Those holding out for a solid deal on the stock have waited several years.
Its decline in this bear market has finally pushed the valuation to within shouting distance of its lows as a public company, last seen just before the pandemic.
But does that mean Cloudflare is a buy today? What are investors getting for their capital? I’ll dive into why Cloudflare stock has been so stubbornly expensive, whether the fundamentals justify the valuation, and whether it is a smart buy today.
Exploring Cloudflare’s secret sauce
Cloudflare started as a content delivery network (CDN). It operates servers scattered worldwide; when a customer uploads something to one of Cloudflare’s servers, it’s cached on the network. When someone accesses the content, the server closest to the access point will deliver the content, resulting in faster load times.
On its own, a CDN isn’t necessarily unique; Cloudflare has competitors like Fastly and Akamai Technologies. But Cloudflare has steadily integrated internet, security, and computing services into its network, elevating its product beyond a simple CDN.
Back in the day, you would buy individual products and services for each function of operating online. But as you can see below, Cloudflare wants to integrate everything into its network and rent out an all-in-one package to customers.
Offering more services within its product will not only pack more value for customers (and provide a competitive moat) but will also give Cloudflare more growth opportunities through cross-selling. In 2018, Cloudflare estimated its total addressable market at about $32 billion. But that could grow to $135 billion by 2024.
Considering trailing-12-month revenue is just $894 million, there’s a potential greenfield of growth ahead.
Can the fundamentals justify a hefty price tag?
Wall Street loves a good growth story, and the frothy market of 2021 pushed Cloudflare’s stock to some silly valuations. The price-to-sales (P/S) ratio topped out at 113, among the highest of any technology stock. You can see below that it has come back to Earth, down to a P/S of 19.
Cloudflare looks like a bargain today compared to where the stock previously traded. But it’s still expensive compared to other technology companies. For example, cloud-based cybersecurity company CrowdStrike Holdings trades at a P/S of just 12, yet it has a slightly higher revenue growth rate and generates tons of cash profits, while Cloudflare is still burning cash.
I might not push back if someone argued that CrowdStrike is a better buy today. They’re not direct competitors, but there is enough similarity between the companies that the valuations being so far apart could raise an eyebrow or two.
Should you buy Cloudflare today?
Judging by Cloudflare’s lofty valuation since going public, it seems clear that Wall Street holds the stock in high regard. The company’s growth and cash burn almost seem to be controlled, given how steady they have been over the past several years. Revenue growth has hovered around a 50% rate, and free cash flow is roughly the same as in 2022 despite being a much larger company today.
Buying the stock today boils down to a simple question: Do you think Cloudflare will continue growing at this pace? Even if you accept that the stock isn’t cheap, 50% growth will quickly burn off the excess valuation, making it a potentially good buy for an investor with a multi-year time horizon.
And the cash burn must improve eventually, but the company has $201 million in net cash, enough to cover another couple of years at this rate.
The risk in the stock is if Cloudflare shows operating weakness, causing that premium valuation to dissipate. But if you believe in management and the company’s track record thus far, it’s hard to ignore the stock when it’s near its lowest valuation in years.
Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Cloudflare, CrowdStrike, and Fastly. The Motley Fool has a disclosure policy.