Cloudflare Q4 Earnings: Can The Share Price Be Justified? (NYSE:NET)

Investment Thesis

Cloudflare (NYSE:NET) is a founder-led, industry-leading, cloud-native CDN (content distribution network) and cybersecurity company, with a mission “to help build a better internet”. The company offers an efficient, scalable, global network that customers can simply ‘plug into’ in order to improve both their security and performance.

Like many something-as-a-service companies, Cloudflare is able to lean on its existing customer base when releasing new products in order to generate additional sales, since it’s a lot easier to integrate new ‘add-ons’ if a business is already using Cloudflare. Combine this with a team that is committed to rolling out new products and services and a rapid clip, and it’s clear to see why Cloudflare’s total addressable market just keeps expanding.

My personal thesis for investing in Cloudflare is the following: it is a leader in multiple growing industries that are transitioning to the cloud, from CDN to cybersecurity, and operates in business-critical areas, making Cloudflare more recession resistant than other companies. It has continually, successfully rolled out new products to existing customers (as evidenced by its high dollar-based net retention rates) and has seen substantial growth thanks to this. The company has an attractive long-term operating model, with operating margins expected to exceed 20%, and it has been growing rapidly over the last few years and should continue to do so in the future.

Unfortunately, it’s not been a fun 18 months for Cloudflare shareholders. The stock has fallen an eye-watering 75% from its peak in a market that has trounced many high-growth tech stocks.

It’s hard to argue too strongly against this falling share price, as Cloudflare had an absolutely insane valuation by pretty much any metric at its peak market capitalisation of $69.9 billion in November 2021: price-to-sales of 102x, price-to-gross-profit of 154x, and any other metrics are basically pointless because both free-cash-flow and operating profit were negative.

With the share price crashing back down to earth, Cloudflare shares are still priced at a premium – and with good reason, as I outlined in my original Cloudflare analysis just how brilliant a business I believe this is.

With the company set to report its Q4 results this week, here is what investors should be watching to see whether Cloudflare remains a premium business that deserves a premium valuation.

Cloudflare’s Q4 Results Expectations

Cloudflare is set to report its Q4’22 results on Thursday, February 9, after the market closes, and there are several key items that investors should keep their eyes on.

Starting with the headline numbers, where analysts are expecting Q4’22 revenue of $274.2m, representing YoY growth of 41.6% and falling within management’s extremely tight guidance range of $273.5-$274.5m. It’s worth noting that Cloudflare usually surpasses management’s guidance with ease, but this has been a tough earnings season so far for cloud giants Microsoft (MSFT) and Amazon (AMZN), so it will be interesting to see how much of this broader pain is being felt by Cloudflare.

Looking ahead to Q1’23, analysts are expecting Cloudflare to deliver revenue of $291m, which would represent 37.2% YoY growth. Whilst this level of growth is outstanding in the current macroeconomic environment, it would still represent a slowdown; Cloudflare has grown revenues at ~50% CAGR over the past few years, so 37% growth would be a substantial deceleration.

Moving onto the bottom line, and analysts are expecting Cloudflare to deliver adjusted EPS of $0.04 in Q4, which is towards the lower end of management’s tight $0.04-$0.05 guidance.

Looking ahead to Q1’23, and analysts are expecting Cloudflare to deliver EPS of $0.03. Whilst these are not particularly meaningful numbers, it’s worth highlighting that Cloudflare’s adjusted EPS has been improving substantially over the past couple of years.

Investing is very much a forward-looking game, and so it’s useful to understand the future expectations that Wall Street has baked into Cloudflare’s share price. Looking ahead to FY23, analysts are expecting full year revenue of $1.31B, representing YoY growth of ~34%.

I am expecting Cloudflare’s management to give full year guidance for FY23 when the company reports on Thursday, and it will be incredibly interesting to see how they view the upcoming year, given all the uncertainty.

Moving onto the bottom line, and analysts are expecting Cloudflare to deliver adjusted EPS of $0.15 for FY23, representing an improvement on FY22’s expected adjusted EPS of $0.11. Again, this number isn’t too meaningful right now, but at least it’s heading in the right direction.

There are plenty of headline numbers for investors to watch, and I’m sure these will dictate any short-term share price movements after Cloudflare reports. But, aside from the obvious headline figures, what else should investors be looking out for?

2 Key Metrics To Watch In Cloudflare’s Q4 Earnings

One of the big stories out of the cloud giants was the cautiousness of larger enterprises when it came to making investments, as all businesses are now focused on cutting and optimising their spend.

That makes me even more eager to see how Cloudflare has performed in Q4 when it comes to the number of large customers it has. As per the below graph, the rate at which Cloudflare has been adding customers into this ‘>$100k in Annualised Revenue’ bracket has been decreasing, but remains very healthy.

It saw 51% YoY growth in Q3’22, or 9.1% QoQ growth. Looking ahead to Q4, I would expect sequential growth to remain in single digits, and the broader macroeconomic environment suggests that Q4 should’ve been a tough quarter for Cloudflare to bring large customers into this bracket.

However, if Cloudflare proves me wrong, and does in-fact see strong growth rates in its large customer numbers, then I will be over the moon. I’d personally be impressed with any QoQ growth rate above the 8.5% seen in Q1’22.

The other core metric for investors to watch is Cloudflare’s dollar-based net retention rate, since this is a key indicator that reflects the company’s ability to upsell its existing customers with new products – a core aspect of my investment thesis.

Like many things investing-related, we see a nice upward trend into 2021, and then a downward trend in 2022. Once again, I would be expecting this figure to fall further in Q4’22 due to the difficult business environment – arbitrarily, I would be happy with anything above 120%, but it’s clear that upselling to enterprises right now is a difficult task.

It’s worth highlighting that Cloudflare has a goal of getting its DBNRR above 130%, but I fear investors may be waiting a year or two for this company to achieve its lofty ambitions.

Quick Take: Cloudflare’s Core Financial Metrics

As Cloudflare’s year draws to a close, now is the perfect time to reflect on the company’s financials. I won’t talk too much about these (the tables are mainly there for you to reference and draw your own conclusions), but there are a couple of important points worth highlighting.

Firstly, can we just appreciate the astounding growth rates that Cloudflare has shown over the past few years; not only have they been rapid, but they have been accelerating! I expect this to reverse course in 2023, but it has been a stellar performer.

Whilst growth has remained strong from 2021 to 2022, margins have not. Although I’m glad to see adjusted EPS improving, I would feel much more comfortable if I could see both EBIT and free cash flow margins improving too; I’m sure management will realise that Mr. Market is focusing on profitability right now, which I hope will encourage them to drive EBIT margins in the right direction.

Looking at the quarterly view, it’s clear to see that stock-based compensation has been going through the roof (as a percentage of Cloudflare’s gross profit). This is not a trend unique to Cloudflare, but I will be looking to management to bring these figures back down to earth in the year that follows.

The impact of excess stock-based compensation is, of course, shareholder dilution. Per the below graphic, shareholders have been diluted by 12% in the 3-or-so years since Cloudflare came public.

Whilst this isn’t great, Cloudflare isn’t the worst offender, and the company has still been able to reward investors over that time period.

NET Stock Valuation

As with all high growth, disruptive companies, valuation is tough. I believe that my approach will give me an idea about whether Cloudflare is insanely overvalued or undervalued, but valuation is the final thing I look at – the quality of the business itself is far more important in the long run.

Once again, the end of a financial year provides a good opportunity for detailed reflection; given this, I’ve made some substantial updates to my previous valuation model for Cloudflare.

Starting with arguably the most substantial change; I have decided to take this model through to 2030 rather than 2026. The primary reason for this is because by 2026 Cloudflare’s free-cash-flow is still too far away from optimisation to be given a reasonable multiple. On the other hand, extending into 2030 enables me to use a much more appropriate EV/FCF multiple of 30x in my base case scenario.

The other substantial change is the use of analysts’ revenue estimates from Seeking Alpha through to 2030 in the base case scenario, rather than my own estimates. Analysts will generally have more tools and insights available to them than I would, so I think it makes sense to use their estimates in my base case scenario and put my own views into the bull and bear case.

I’ve also used the 20% free cash flow multiple for Cloudflare by 2030 based on management’s long-term model of EBIT margins above 20%; I actually believe 20% FCF margins by 2030 to be conservative, as Cloudflare’s free cash flow may well exceed its EBIT margins substantially by then.

My bull case scenario assumes that Cloudflare gains even more traction and continues to grow at a rapid clip, thanks to its ability to produce industry-leading solutions that it can upsell to an ever-growing customer base. My bear case scenario effectively assumes the opposite; that Cloudflare fails to grow as quickly for several potential reasons (macro, competition, etc.).

Putting this all together, I can see shares of Cloudflare achieving a CAGR through to 2030 of (1%), 14%, and 26% based on my respective bear, base, and bull case scenarios.

Bottom Line

Cloudflare is a premium company at a premium share price, with plenty of growth required by this business to justify its lofty valuation. I for one believe that Cloudflare is more than capable of achieving these high expectations, as it continues to be a brilliant founder-led business with plenty of different routes to success.

Looking specifically to its Q4 earnings, I am slightly more pessimistic. This business needs to grow rapidly to satisfy Wall Street, but 2023 is likely to prove much more challenging in this regard.

I still think Cloudflare will be a fantastic long-term investment, but shareholders should be well aware of the challenges that this business (and, well, all businesses) will be facing in the year ahead.