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Cloudflare: When can the company return to high growth momentum?
This is an article about the investment merits and demerits of Cloudflare, Inc. (NYSE:NET) shares. As an analyst, I look, for the most part, at individual companies. But as an investor, I have to acknowledge that much of the price change or the change in valuation is more a function of market trends than it is the performance of individual companies. That is more so now than ever with the rise of algorithmic trading, and the step back from the market of many individual investors.
I think I can say without fear of much contradiction that Cloudflare shares will not outperform the market during a risk-off environment, and the reverse is almost certainly the case. And I am not going to suggest that I have second sight with regards to changes in sentiment. The bear market in high-growth IT names has been going on now for more than a year. Is it over? Honestly, if I had the ability to get that right, I wouldn’t need to play Powerball – hey, you never know.
Some of my friends who do technical analysis suggest that the bear market for high growth IT shares is at an end. I do think inflation is receding, economic activity is contracting, and the first signs of a turn in the labor market are appearing. All of that means that the cycle of Fed tightening is closer to an end; but again, I am not trying to forecast Fed pivots; if I were a Fed Governor, I would have voted to stop demand destruction some time ago.
The economy is entering a recession. Most IT companies, and that includes Cloudflare, will face demand headwinds. It doesn’t mean that their long-term growth story has been impacted. Most IT vendors have seen impacts from the appreciation of the dollar. That, too, has and will constrain Cloudflare’s revenue growth, but it is not a long-term phenomenon in terms of a growth headwind. The company’s strategies and technology and competitive positioning haven’t really changed and are unlikely to do so in the foreseeable future. The company will continue to expand its total addressable market (“TAM”) through both acquisitions and internal development. The company’s business model and its ability to generate cash are improving.
Overall, because a considerable focus of this company’s offering is cyber-security, it should have less cyclical impact than many other IT companies. That said, less doesn’t mean none. While CrowdStrike Holdings (CRWD) and Cloudflare are not direct competitors, the macro headwinds reported by the former suggest that even cyber security is not immune to demand cyclicality – perhaps somewhat surprisingly. But obviously, the forecast for 8% sequential growth in what will be fiscal Q4 for Cloudflare – 41% revenue growth year on year – compares to 12% sequential growth last year going from Q3 to Q4. My view is that 8% sequential growth represents a glass lots more than half full, given the environment, but other analysts have taken a different stance.
Investors are probably going to have to look through 2-3 quarters in which Cloudflare growth is noticeably below its long-term potential. I believe the company will return to 50% growth – the question is more when than whether. Bear markets typically end when investors do just that – look through a quarter that doesn’t tick all of the positive boxes, but presents some signs of hope and stabilization. Buying Cloudflare shares is a bet that the recovery will come, and that the company will resume robust growth. I think that is a pretty high probability bet and it is why I am writing this article at this point.
Many brokerage analysts and other observers, and some readers as well, are unwilling to look across valleys. It can be a difficult undertaking to recommend shares when not expecting a discrete positive catalyst in the next couple of quarters. In the case of Cloudflare, the catalyst is going to be a return to a risk-on attitude rather than some company specific development – or at least that is how I see it at this point. In other words, I expect sentiment will change prior to the company reporting some kind of dramatic upside quarter.
I think almost every investor in Cloudflare is well aware that a recession is impending, and that a recession is going to constrain growth in 2023. But markets are most often forward looking, and I expect that will be the case in this cycle as well. IT stocks have been falling for 12 months now, and started falling well before the business impact of the Fed’s demand destruction policy became visible. Cloudflare’s peak valuation was in the middle of November 2021, and was followed by several strong quarters. While the valuation at the time of the spike was hard to justify – at least for this writer – I do think there can be some decent recovery in the shares long before the company returns to the level of hyper-growth that has characterized its performance for many years.
One consideration worth noting with regards to Cloudflare and its valuation is its substantial number of users. The company has 156k customers, most of them quite small, who run their web sites on the company’s infrastructure. Many of these customers are exceptionally loyal Cloudflare users, and in turn, many of them have become Cloudflare shareholders. In the past, these kinds of customers were willing to pay a premium valuation for Cloudflare shares. In some ways, again in the past, this is analogous to how both Unity Software (U) and Atlassian (TEAM) reached their valuation levels. This isn’t a universal phenomenon, to be sure, but I think it does explain a bit of what I have seen in the past as to the overvaluation of the shares.
As an analyst, I really can’t try to value businesses based on who might own the shares and why. But I think the phenomenon is worth noting. I have no idea if the desire on the part of the numerous Cloudflare customers to own the shares might recrudesce, and to what extent and when that might happen. But there is a supply/demand calculus in valuation, and Cloudflare does have an enthusiastic user base.
Cloudflare has a relatively moderate short interest ratio which was 6.5% of the float when last reported on 11/15. The short interest had risen 2 million shares over the prior month, perhaps a bit surprising given the 22% share price implosion after the company reported its results.
While no analysts changed their rating on the shares in the wake of its latest earnings, about half of the analysts who cover the shares rate it as a hold. Sometimes ratings aren’t totally logical or consistent, as the average price target for Cloudflare shares is at $69, or a bit less than 50% higher than its current price. Most of those with hold ratings indicate that their issue is one of valuation rather than questions about the company’s longer-term business trajectory.
Despite its valuation implosion, Cloudflare is still not valued at some bargain basement level. It’s forward EV/S ratio is around 11.5X, quite a bit above average, even for a company with a 3 year estimated CAGR of 50%. It scores a little better when considering the combination of growth and free cash flow margin. That said, many subscribers to Ticker Target are looking for recovery candidates. There are many competitors for such a recommendation amongst the host of busted stocks which have seen their valuation shrivel. I think Cloudflare easily makes the cut and is a company that should rank highly on a list of recovery candidates.
Cloudflare has a rather extensive platform of solutions, and of course not all of them address zero trust or the cyber-security market as a whole. But its closest analog company is Zscaler (ZS). When considering valuation, the fact is that ZS is also seemingly “expensive” although it is further along on its path to strong free cash flow margins. The EV/S ratio for both companies is equivalent and when adjusted for free cash flow margins, their overall valuation is not far different. I will review the competitive battle in the space between ZS, Palo Alto Networks (PANW), and NET later in the article, but they all have somewhat elevated valuations because they are less cyclical and have better visibility than most other enterprise software companies.
Cloudflare and the recession; considering the last quarter in context
As many readers are aware, Cloudflare shares fell 22% in the wake of the company’s earnings release, although they did bounce by more than 40% in the furious rally on 11/10-11 in the wake of the unexpectedly benign CPI print. Subsequently, the shares have lost about half of the appreciation of the bounce. (prices as of 11/29/22). Suffice to say that Cloudflare shares have been and most likely will remain highly volatile. They are not for the faint of heart, and they will reflect risk issues in the overall market as much or more than the specific performance of the company. But eventually, I believe, that, too, will change, and the performance of Cloudflare will reflect in the share price.
Overall, the shares have fallen by 75% from in the first 11 months of 2022 and by 82% from their high. Basically, the quarter recently reported was not much of a beat, and the increase to the forecast was judged to be inadequate for the company’s valuation. Yes, Cloudflare is a mortal company, and there is a cyclical component to its demand. The company had been discussing its vulnerabilities to the macro environment over the course of the last two calls; finally those vulnerabilities showed up in the numbers. That said, it is easy to exaggerate just how disappointing the actual numbers and forecast were.
Revenue last quarter was $254 million, just a little more than 1% above the company forecast of $251 million. Typically, Cloudflare has beaten its revenue guidance by about 3%. Non-GAAP operating earnings were $46 million, or 18% of revenues; the forecast for this metric had been breakeven. So, revenues were marginally above expectations and bore the impact of some FX headwinds, as this company, while it prices in USD around the world, has given pricing concessions to make up for dollar strength. In the prior quarter, revenues beat the forecast by $7 million or a bit more than 3% and the company raised annual guidance by $13 million. So, revenue growth and the forecast of revenue growth is slowing, but the reaction of the shares is far greater than the actual trajectory of the growth slowdown.
The company is now forecasting revenues of $975 million for the full year; essentially this forecast which is $3 million above the prior expectation, incorporates the Q3 beat and does not increase the forecast for Q4. As mentioned, the specifics of the Q4 forecast call for 8% sequential growth, considerably less than 12% sequential growth the company had recorded in Q4 of the prior fiscal year. Just how much of the forecast is the result of the equivalent of FX headwinds was not discussed by the CFO. The company is now forecasting that non-GAAP operating income for the year will be $32 million, or about 3% of revenues. That is more than $20 million above the prior forecast. The current quarter is expected to achieve a non-GAAP margin of 5%. The level of opex growth required for the forecast is quite a bit greater than implied by the CFO’s comments about moderating hiring and the growth in opex in this more constrained environment so the likelihood is that earnings, at least, will show favorable performance compared to guidance when the company next reports in February 2023.
Last quarter, the company’s operating cash flow was $42 million, compared to a $6 million cash burn in the prior quarter. The deferred revenue balance continued to grow, the GAAP net loss declined, and stock based comp increased. The company’s free cash flow was marginally positive for the quarter with capex rising to $42 million, compared to $29 million in the year earlier quarter. As the company grows it needs to invest in points of presence in order to maintain the performance of sites using its network. The CFO reiterated expectations that the company would be free cash flow positive in the 2nd half of the year; that implies a substantial slowdown in the cadence of capex increases.
The company’s RPO balance rose by 8% sequentially and by 32% year over year. While RPO balance is the best metric that encapsulates a view of bookings, in the current environment, some businesses have held back from making multi-year commitments. Thus, the growth in bookings may not be as representative currently, as it has been in the past, with the actual growth attainment of Cloudflare, or for that matter other enterprise IT vendors.
Finally, the company’s dollar based expansion ratio ticked down from 126% to 124%. The company has a long term goal of 130% or higher, and obviously the disappointing level of the expansion ratio was a step back from that goal. During the conference call, the company indicated that some of its smaller users had gone from the company’s paid tier to its free tier, one factor that pressured the DBE ratio. That said, the company maintained that it hadn’t seen any increase in churn; what it has seen is elongating sales cycles amongst its largest customers who have been reluctant to increase their Cloudflare commitments at the same cadence as in the recent past.
Many observers, including this writer, had hoped that cyber security would see less in the way of cyclical headwinds than some current period results might suggest. While this company said that it had seen some strength in its security portfolio, obviously the leading end-point security company, CRWD, has seen the same paradigm of extended sales cycles and greater scrutiny leading to a lower growth cadence that has been common across the IT space.
The quarterly numbers and the company outlook are broadly consistent with the trends most other enterprise software companies are seeing. Cloudflare doesn’t exist outside the rest of the economy and in a recession its growth is going to be lower than would otherwise be the case. The only other time I wrote about the company was the last time their valuation imploded, at the start of the Covid-19 panic. But after falling by 80%, I think a reasonable case can be made that risk/rewards now tilt in favor of investors.
Cloudflare: The growth of their product portfolio and its resonance in the market
Cloudflare has two basic solution offerings. One of those is Cloudflare One, software that provides users with secure access at the service edge. The company has a variety of offerings within its security portfolio. Some of these include Zero Trust, a very popular concept in cybersecurity these days which is all about reducing risks, increasing visibility and eliminating complexity. The company recently acquired Area 1, a provider of email security. Another significant part of the Cloudflare security offering is what is called CASB, the cloud access security broker which provides users with visibility and control over SaaS apps. This is a critical part of many compliance paradigms and prevents data leaks. Cloudflare also offers a replacement for VPNs.
Zero trust security is a very large market-the projection linked here says revenues from zero trust security solutions will reach $87 billion by the end of the decade, with a CAGR of about 15%. Of course, Cloudflare is growing at rates far greater than 15%; much of the difference between 15% and Cloudflare’s growth is a function of market share gains,
Cloudflare also has a set of solutions that accelerate the performance of web applications. The company has a content delivery network (CDN) that uses edge technologies to improve performance. Within this space are a number of specific services such as load balancing, smart routing, video stream deliver, analytics and a 3rd party tool manager. Overall, the CDN market has been forecast to grow at a CAGR of 12% over the coming years. Cloudflare’s growth over the years has been a function of major market share gains in the CDN space which will be outlined more fully below. At this point, over the last few years, Cloudflare has gone from a start-up to the vendor with the greatest number-although not the greatest amount of traffic-in the CDN space.
A couple of years ago, Cloudflare released a service called Workers. Workers provides developers with a serverless execution environment that allows developers to create new applications without the need to configure infrastructure. Applications developed using Workers allows for performance improvement and scalability because of the use of the Cloudflare network and the technologies of edge computing. Edge computing is one of the more rapidly growing segments of the IT market space with a projection of 39% growth through the end of the decade. Edge computing is still in an early stage of development, although the study linked here says the edge computing revenues have reached a run rate of $11 billion.
Cloudflare Workers has achieved some noticeable success, although the company hasn’t really broken out any specific financial numbers. Recently, the company announced that its R2 service, which is a storage product that is used with the Workers solution. The company is going to be releasing D1, a database service for use with Workers. It would appear at this point that Workers is winning the battle for primacy as an edge computing solution. Edge computing is probably the single fastest growing market in which Cloudflare has offerings. According to the 3rd party analysis linked above, the market for edge computing is growing at a CAGR of just less than 40% and will reach $150 billion by the end of the decade. There are, to be sure, many companies chasing the edge rainbow, but I think Cloudflare has a strong offering, at least according to 3rd party commentators, and this is going to be a significant demand driver for the company over the next several years.
Zero trust security, web performance acceleration and edge computing constitute an impressive portfolio in the software world by any measure. Cloudflare has strong positions in three of the most rapidly growing parts of the software business and that will be just as true after the recession ends as it was over the past several years.
Cloudflare’s competitive position
While many commentators view Cloudflare as a major competitor in the CDN space-and of course it is that-much of focus and competition Cloudflare faces is in the cyber security area. In particular, Zscaler’s internet access solution (ZIA) and Palo Alto’s Wildfire are the most prominent competitors who offer zero-trust solutions. There really isn’t all that much to distinguish between the two offerings, or between Cloudflare and Palo Alto’s Wildfire. The claims and counterclaims in the space go on ad infinitum.
Zscaler is larger and is security-only. It is growing at a similar rate to the growth of Cloudflare. The Palo Alto offering is showing higher percentage growth from a lower base. While cyber security is not nearly as cyclically sensitive as some other IT segments, macro headwinds have apparently led to elongating deal cycles and more deal scrutiny for all vendors, including Cloudflare. That said, on the last conference call, the company talked about its security offering holding up well and seeing some growth acceleration in a few cases.
Cloudflare and Zscaler have been competing for years, and have been growing for years. There really is nothing that can be found in 3rd party competitive evaluations that might suggest that this competitive balance will change any time soon. Palo Alto is the largest cyber security vendor and its zero trust offering has gained lots of market share, but again, those market share gains haven’t changed the growth trajectory of Cloudflare. In assessing the investment risks and opportunities of Cloudflare, its competitive position in cyber security is basically not a factor; it is one of the 3 leaders and will remain so for the foreseeable future. Choosing between Cloudflare and Zscaler as investments is a bit of a toss-up. Essentially, Cloudflare with a much broader offering, including CDN/edge computing will appeal to soma, and Zscaler with a total focus on security will appeal to others.
Cloudflare has many CDN competitors. The link here provides a list of some of the more prominent CDN alternatives. To cut to the chase here, the evaluation from a 3rd party source called Serverguy is that “for basic needs, Cloudflare is still the best.” The best known CDN competitor to Cloudflare is Akamai (AKAM), a vendor that has been around for a long time and which is entrenched at many major businesses. Akamai currently serves 19 of the 20 top ecommerce sites in the U.S. and 10 of the 10 top U.S. banks. Akamai Technologies also offers a Cloudflare alternative, as is Google (GOOG, [[GOOGL[[). Overall, Akamai is handling between 15% and 30% of total web traffic.
Probably the largest single problem that users have when considering the Cloudflare CDN offering is the requirement to enter a captcha at each Cloudflare-supported site they access. But overall, it is much easier to setup and install Cloudflare, and it offers an official WordPress plugin. In addition, Akamai is quite a generally more expensive and requires a 1-year commitment from users. For all of these factors as well as others, Cloudflare has been growing much faster than Akamai and has been gaining users rapidly. According to the study linked above, Cloudflare has the largest number of users, but obviously its network doesn’t carry the largest share of Internet traffic. That said, Cloudflare is now used by 29% of the top 100k websites in the world.
As mentioned previously, Cloudflare’s growth in recent years has been significantly enabled by its pivot to larger users. Cloudflare has announced some high profile wins over the years. It has some very high profile ecommerce users, including Etsy, Walmart, Best Buy, Dell, Nike and H&M. In most cases, these sites also use Akamai and other CDNs.
Part of the investment case for Cloudflare is that it continues to gain share in the CDN space. According to one third-party analysis linked here, that is because it has both some functional advantages, and a strong sales execution capability. Its market share gains are likely to continue for the foreseeable future.
While edge computing is really one of the features often considered as part of a CDN, I think the success of Cloudflare’s Workers platform is probably significant in evaluating the overall competitive position of the company. Edge computing is one of the major trends of the future. Workers is an important offering in the space. Of course all of the Web service providers offer an edge computing service. Workers is not the same as the edge computing services such as Amazon’s EC2. It is a set of tools that developers use to build serverless applications that run on Cloudflare’s network. I have linked here to a list of some of the competitors to Workers.
Cloudflare’s business model – a work in progress
Before discussing Cloudflare’s business model, it should be noted that the company uses a significant level of stock-based compensation (“SBC”). Last quarter, SBC expense was recorded at $56 million, just about double the level of the year earlier period, and about 22% of revenue. SBC expense was flat sequentially. A 22% SBC expense ratio is about average for a high growth IT companies but will doubtless not find favor with some readers/potential investors. The company has moderated the cadence of its hiring, and the overall market for hiring IT professionals is far less competitive these days than in the recent past. I expect, therefore, to see the SBC expense ratio start to decline in future quarters. I account for SBC by looking at the growth in outstanding shares; the outstanding share count rose by 1.5 million shares sequentially, or a 2% annual rate, which I use in calculating valuation metrics.
The company’s non-GAAP gross margin fell to 78% last quarter compared to 80% in the year earlier period. Most of the change in the gross margin ratio is a function of mix and in particular the pivot to much larger customers who get better pricing. The company’s overall customer count rose by 18% with some churn in the very lowest tier of the base while large customers rose 51% year on year. It is this pivot that has accounted for the decline in gross margins, although gross margins are still greater than the company’s target model.
The company has always spent heavily on sales and marketing, and that remains the case. Last quarter, non-GAAP sales and marketing expense was 40.5% of revenues, compared to 45% the previous year, and to 45% the previous quarter. Sales and marketing expense growth was essentially flat last quarter; it actually ticked down marginally on a non-GAAP basis. Basically, the company has slowed hiring, and the reduced cadence of hiring has started to show up in a slowing growth of operating expenses. The slowdown in opex growth, even beyond what the company had foreshadowed in its prior earnings call, was the principal reason why EPS beat prior forecasts by such a significant amount. While it is still a couple of months before the current quarter finishes, I think the expense discipline that the company is showing will probably provide an upside to earnings in the current quarter.
The company’s non-GAAP research and development expense ratio was 18% last quarter compared to 19% in the year earlier period, and compared to 20% in the prior sequential quarter. Overall, non-GAAP research and development expense was flat sequentially, part of the company’s hiring slowdown that had been indicated during the Q2 conference call. Actually, even GAAP research and development expense was flat on a GAAP basis, suggesting that Cloudflare is already constraining expenses just about across the board.
Finally, non-GAAP general and administrative expense was 13% of revenue compared to 14% of revenues in the year earlier period, and compared to 15% of revenues in the prior sequential quarter. Actually, on a GAAP basis general and administrative expense fell by 10% sequentially. I don’t think investors appreciate the extent to which this company has put the brakes on its spending and focused on managing expenses in the midst of macro headwinds.
As mentioned earlier, the company’s operating cash flow margin rose noticeably in Q3; it was 16.5% of revenue, or $42 million, compared to a cash burn of $7 million in the year earlier period. While nice to see the acceleration in free cash flow last quarter, I tend to look at longer periods. For the first 9 months of the year, the company’s operating cashflow rose by about 80%; its operating cash flow margin was 6.5%.
Cloudflare, compared to other software companies, has relatively significant capex requirements to fund the requirements of its growing number of points of presence. This company has to keep investing in larger and new data centers to keep up with the ever increasing traffic load on its network. The company broke even on a free cash flow basis last quarter; it projects that it will be free cash flow positive in the second half of the year. The company’s capex has been at 15% of revenue through the first 9 months of the year, and it is projecting it will come in toward the bottom of a range of 12%-14% of revenue for the full year. That would imply about $30 million of free cash flow in the next quarter, or a free cash flow margin of about 11%. If earnings turn out greater than guidance in Q4, free cash flow will be higher still.
Finally, the company’s RPO balance rose by 9% sequentially, a decent showing in this environment. The company CFO did not discuss duration, so the RPO balance may have been constrained by users signing shorter commitments.
Cloudflare’s valuation-reiterating my buy recommendation
For years now, I have been unwilling to step up to pay the elevated valuation for Cloudflare shares. The company wasn’t generating free cash and it had an EV/S ratio that rivalled anything else in the IT space. In many ways, the results of the company were almost monotonous in terms of beat and raise quarters with execution at high levels in two high growth markets. Valuation is still elevated on a relative basis, but far less so than in the past couple of years. Of importance to me, is that the company is finally generating at least some free cash. Considering the combination of growth + free cash flow margin takes the company’s valuation to just modestly above average for its growth cohort.
Like just about every other IT vendor, Cloudflare is feeling macro headwinds. Its management has been articulating how macro headwinds have caused lengthening sales cycles and inducing some of its smaller users to downgrade from a paid to a free tier for the past several quarters. The quarter it reported last month was the one where those macro headwinds caused it to reset expectations. But that said, the reset was hardly existential. Management is forecasting 8% sequential revenue growth rather than 12%. Some of that is an FX headwind as opposed to a demand slowdown. I think investors have a seminal opportunity to acquire shares in one of the stronger and more innovative companies in the IT space-a market leader in a couple of significant business segments. While the shares are still not “cheap” as many define cheap, at least the share are at a far less elevated valuation than in a long time.
Some investors may want to withhold committing capital to high growth IT shares until a Fed pivot is visible or at least in plain prospect. Other investors may want to delay a commitment until the company actually achieves a quarter showing solidly accelerating growth. The problem with those approaches is that when the pivot happens, or even when 2nd-order derivative sales growth metrics turn back up, shares of Cloudflare, along with many other high growth IT names will appreciate 20%-30% or more in just a few days. Indeed, just a speech by the Fed Chairman that was viewed as less hawkish, caused Cloudflare shares to spike by 10% in a few hours.
If investors are concerned about volatility and draw downs, Cloudflare shares will not provide a comfortable holding. If investors are compiling lists of what investments will work well in a recovery, then Cloudflare ought to be one of 5 or 7 potential investments at the top of a list.
I don’t offer a personal perspective on when investors start to look through negative outlooks and contemplate a return to more normalized growth. I probably would have considered that the level of shredded valuation was sufficient a month or two ago, but that has certainly not been the case. Looking at the trading in CrowdStrike shares in the wake of that company’s earnings release, it is obvious that investors aren’t looking through anything but are intent on finding coal lumps in about every stocking on the mantel.
I have never heretofore owned Cloudflare shares, but I have started to accumulate a small position and will continue to use the current market environment to build a position. I expect I will have to be patient, but I want to board the train, rather than be left waiting at the station.
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