Cloudflare (NYSE:NET) is a leading cloud service provider that is well positioned to transform the IT infrastructure and security industry. From 2019 to 2021, revenue grew from just 287 million to 656 million at an impressive 51% CAGR. In the first quarter of 2022, the company again delivered blowout results with top-line growth of 53.7% YoY and guided 2022 revenue of $957 million at midpoint (+46% YoY). Despite all the good news, Cloudflare is one expensive stock at 26x/19x 2022/23 sales. Given the business is unlikely to turn a profit any time soon, I believe investors should avoid the stock along with other high-flying cloud names.
1Q22 results show cloud migration is structural vs. temporary due to Covid.
From a top-line standpoint, there’s literally nothing to dislike about Cloudflare as the company has been able to grow at a fast clip even in a post-pandemic world, proving that cloud migration is structural vs. Covid-driven. Q1 revenue of $212 million (+54% YoY) beat $206 million consensus, with Russia being a <1% impact. On the bottom-line, Cloudflare delivered a 2% adj. operating margin (vs. -5% in 1Q21) and net loss of 40 million for EPS of -$0.13 (inline with 2021).
Dollar-based net retention rates (DBNR) came in at a highly respectable 127% vs. 123% in 1Q21. On the customer front, Cloudflare’s paying customers increased 29% YoY to 154K, while customers with >$100K ACV increased 63% from 945 to 1,537.
On 4/1, Cloudflare closed its acquisition of Area 1 Security for $162 million to enhance its zero trust offerings in email security. Per management, customer reception of Area 1 has been strong. It’s also interesting that Cloudflare started out as a customer of Area 1 Security and decided to integrate Area 1’s technology after seeing a solid improvement in the prevention of email phishing. That said, Cloudflare expects Area 1 to contribute <1% of revenue.
Outlook suggests enviable growth despite high 2021 comps.
Cloudflare’s 2Q22 guidance of $227 million at midpoint (+49% YoY / >$218 million consensus) is highly enviable amongst the vast majority of tech companies that are struggling with slower growth post-Covid. While most tech names are cutting guidance, Cloudflare actually raised full year 2022 guidance from $927-931M (+41%-42% YoY) to $955-959M (+45%-46% YoY). Given 1Q22 revenue growth of 54%, 2022 revenue target seems achievable despite suggesting a “deceleration” from 52% growth in 2021.
On the bottom line, Cloudflare expects non-GAAP operating income of $10 to $14 million (1.3% operating margin at midpoint) and non-GAAP EPS of $0.03 to $0.04 vs. $0.03 consensus.
Overall, the business appears very healthy in terms of top-line growth as corporations across the world continue their transition from legacy on-premise solutions to cloud. Following the stock’s 9% drop post-earnings, however, it’s clear that investors are looking for profits today vs. at some point in the future.
Where does Cloudflare’s stock go from here?
Cloudflare is not a Covid stock, but quite a durable growth stock except with a luxurious, Hermes-like valuation that simply doesn’t work under the current interest rate regime. While 2022 top-line growth is highly respectable at 46% YoY, markets have more than captured the company’s fundamental upside by awarding the stock with P/S multiples as high as >100x back in November 2021. This implies that if the company’s profits equaled its revenue, it’d take just a century for investors to breakeven.
Per famous VC capitalist Bill Gurley, companies selling for over 10x revenue should be treated with skepticism, as not all revenues are created equal. Despite fast top-line growth, Cloudflare has not been able to turn a profit, with consistently negative free cash flow over the last few years. Couple this observation with a tightening monetary policy where a lot of money will be pulled out of the financial system, I’d expect further multiple compression for the stock. Unless the Fed suddenly takes a 180-degree turn to cut interest rates back down to 0, there’s no reason why Cloudflare’s valuation multiple cannot reach the 10x rule of thumb or $36 based on 2023 revenue.
Maybe I’m exaggerating (I hope I am), as the highly volatile market today could see a sudden rally given tech stocks have been very oversold. However, the risk/reward is simply not there for high-flying stocks considering how unsupportive the monetary environment is. Besides Cloudflare, I’d also avoid other similarly vulnerable names like Datadog (DDOG) and Snowflake (SNOW), because at the end of the day, valuation does matter.