NET

Cloudflare, Inc.

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38.96 221.64
52 weeks
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Cloudflare: A Buying Opportunity

Summary Cloudflare posted another impressive quarter, with revenue up more than 50% for the 7th consecutive quarter. Analysts talked of a slowdown, but if you know the company well, there will be no slowdown any time soon. Reasons why the stock plunged so much after the earnings and look through the financial data. Cloudflare now successfully competes with companies like Palo Alto Networks and Zscaler. AWS even sent a customer to Cloudflare. We look at the competitive advantages that Cloudflare has. I do much more than just articles at Potential Multibaggers: Members get access to model portfolios, regular updates, a chat room, and more. Learn More » With all the earnings releases and the very volatile behavior of this market, time goes by fast. It's already about 10 days ago Cloudflare (NYSE:NET) reported its Q1 2022 earnings and it has been a rough week. On Wednesday, the stock was down 30% before bouncing back on Thursday and Friday and then plunging again on Monday and Tuesday. The stock is now down 51% over the last month. Did it have anything to do with the earnings? Nope. Just the general market sentiment and the rich valuation that Cloudflare still has. The numbers Cloudflare's revenue came in at $212.2M, up 53.7% YoY, beating the estimates by $6.54M. EPS came in at $0.01, one cent above the $0.00 consensus. The consistency of Cloudflare's revenue growth is impressive: The dollar-based net retention rate ('DBNNR') was 127%. DBNRR means that you compare the dollar amount that companies a customer 1 year ago brought in, including churn. As you can see in my chart, the DBNNR came in at the highest rate ever and it keeps growing. Great to see this. On the conference call, founder and CEO Matthew Prince explains why the DBNRR keeps going up: New products and an increased interest in consolidating behind a single trusted vendor for network services has been the key As always, Cloudflare beats the estimates again: Like clockwork, Cloudflare also made higher guidance than the consensus, both for the next quarter and the whole year. For Q2, the company now guides for $227M at the midpoint versus the consensus of $217.76M. It guides for $955M to $959M for the full year, raising its guidance from $929M and the consensus of $932.44M. Last year, Q2's revenue was $152.43M. So, at the higher end of the range, the Q2 guidance numbers would mean 49% YoY growth. But still, we saw this title on this beloved platform: This was also included in the article: This is what the analyst wrote: Piper Sandler slashed the target from $125 to $83, with analyst James Fish suggesting that "the +50% topline growth is not enough as it's the smallest upside since the IPO. Analyst Brent Thill noted that the "impressive" but cautious sales guidance suggests a material deceleration compared to the 1Q growth. Sign of growth slowdown? Where? I call that explaniorism. You see the stock price drop and you have to come up with some form of explanation, it doesn't matter if it makes sense or not. If these people had pointed out the rich valuation Cloudflare still has, I would understand that in this context. Of course. But growth slowdown? I think they don't know the company that well if they point at guidance. For Cloudflare, you don't take the low side of the yearly guidance (which is 'only' about 46% growth). You should know that it will beat the upper limit of guidance and then probably raise guidance again. Cloudflare has never guided for 50% revenue growth. But it has delivered that for 7 quarters in a row now. I'm confident that they will be growing by more than 50% for both the next quarter and the full year. You don't have to believe me on my word, though. RPO (remaining performance obligation) grew faster than revenue, 57% and that is a great window into the future. RPO is money that is already under contract but that cannot be recognized as revenue yet. The current RPO (which will be recognized in the next 12 months) was 76% of the total RPO. Matthew Prince summarized the results pretty succinctly on the conference call when it comes to customers. Why would I do it myself if we have the CEO, right? We had a terrific quarter. In Q1, we achieved revenue of $212 million, up 54% year-over-year. We added a quarterly record of more than 14,000 new paying customers, up 10% quarter-over-quarter, bringing our total paying customer count to over 154,000. We add 121 new large customers, those that pay us over $100,000 per year, up 53% year-over-year to a total of 1,537. Today, 58% of our revenue comes from those large customers. Our largest customers continue to get larger and larger. Those spending over $500,000 a year, growing 68% year-over-year, and those spending over $1 million a year, growing 72% year-over-year. We now have 12 customers and partners spending over $5 million per year with us. And yet, we remain highly diversified, with no customer representing more than 5% of revenue. This is the first time that Cloudflare mentions customers spending more than $5M a year and it sends out a message. It shows that big enterprises see the value of Cloudflare and are willing to spend their money. Why was the stock down so much? The stock tanked after the earnings. The reason why the stock was down so much is not very clear if you just look at the numbers. Was it the valuation? A general distaste for growth stocks? The headlines that I mentioned before? We don't know. Probably a combination. Or maybe algorithms read this: Free cash flow was negative $64.4 million or 30% of revenue compared to negative $2.2 million or 2% of revenue in the same period last year. Operating cash flow was negative at $35.5 million in the first quarter or 70% of revenue, compared to $23.5 million or 17% of revenue in the same period last year. In an environment that focuses much more on profitability, this looks really ugly, right? But it's not as bad as it looks if you consider the context. The decrease in cash flow was primarily related to a unique withholding tax payment of approximately $30 million. As mentioned last quarter, we expected to see some cash flow variability in the first half of 2022, but we continue to expect to return to positive free cash flow in the second half of this year. So, nothing that looks really ugly if you know that context. There was a tax payment. The company also has a bit more Capex now because it invests in its infrastructure. The negative FCF could help explain some of the price action as well. Another reason might be the slowdown in RPO. While it still grew faster than revenue (57% vs. 53%) it slowed down from the previous quarters, which came in very strong at 63% YoY growth, 60% in Q3 2021, even up 77% YoY in Q2 2021 and even 88% YoY in Q1 2021. Despite the slowdown, we have not seen any effect in revenue growth so far, though. More financial information The gross margin came in at 77.8%, down slightly from 78.1% in Q4 2021. This is not really a surprise, as Cloudflare is investing in its infrastructure with more POPs (points of presence) but especially its Cloudflare for Offices, which means that you get edge computing power in your office building (if you have an office in one of the mega towers, that is). So, I wouldn't worry about this too much, as this will also bring additional revenue. Operating margins were negative 18.9% and net margins 19.5% on a GAAP basis. On a non-GAAP basis, though, the operating margin improved by 7.7% and came in at $4.9M. The difference is because of stock-based compensation and other non-cash items. Outstanding shares went up by 11% YoY. That's substantial, definitely, but not excessively high for a tech company. When it comes to operating margins, this is what Matthew Prince said on the conference call: So I think that we've been very consistent at saying that we are going to hold as close to breakeven on our operating margin as we can. I said on a previous call that if we showed massively positive earnings per share, that would mean that we did something wrong because if we can continue to grow at the rates that we're guiding towards, there's nowhere else we should be putting that money other than back into the business to grow the business as quickly as possible. I definitely agree with Prince here. Yes, Cloudflare could become profitable quickly, but it wouldn't be right, not even in this environment. The non-GAAP operating margin came in at 2.3%, almost double the last quarter's (1.2%). In Q1 2021, that was still -5%. Over the long term, Cloudflare aims for operating margins of more than 20%. Management always shows their long-term goals and compares them to the current situation, which I really like. The rest of the numbers showed operating leverage. Sales and marketing went from as a percentage of revenue. This is on a GAAP basis (from right to left). In Cloudflare's first quarter as a public company, it still had 96% of its revenue going to SG&A, now just 63%, down from 70% last year. If you exclude G&A (general & administrative), sales and marketing as a percentage of revenue decreased 2% QoQ and decreased to 42% from 46% in the same quarter last year. G&A also went down, by 1% QoQ, 2% YoY, from 17% to 15%. So, you see that extra revenue growth means lower costs as a percentage of revenue. That's operating leverage. Cloudflare is competing more and more with companies like Palo Alto Networks (PANW) and Zscaler (ZS). Matthew Prince on the conference call: A large Indian media platform chose Cloudflare over Zscaler and Palo Alto Networks for their zero trust network. They signed a $150,000 deal for 5,000 seats. They appreciated how much more tightly integrated our solutions were than the competition. We are going head-to-head with Zscaler and Palo Alto Networks more and more, and we like our win rates when we do. Cloudflare is also close to receiving the FedRamp certificate. It has passed the review and is waiting. Matthew Prince: And any day now, hopefully, the FedRAMP DMV will call our number, and we'll be able to announce that. That process is formally behind us. This could mean another big market for Cloudflare. With FedRamp approval, it can be used in all kinds of government-related institutions and it gives trust to their other potential customers as well. Matthew Prince was very positive about Area 1, the e-mail security company Cloudflare has bought. We closed our largest acquisition ever in the quarter, buying Area 1 Security for $162 million. We have a very high hurdle rate for acquisitions being strongly biased towards internal development but Area 1 technology and team are special. We started out as a customer. I remember shortly after we implemented their solution, writing to our Chief Security Officer to ask if something was wrong, I hadn't seen any phishing reports in a few weeks, where usually our team would report double digits per day. It turned out Area 1 and their incredible e-mail security tech was the answer. By the way, if you're still seeing phishing messages in your own box, tell your IT team to call us. We now have a great solution. Over the last few years, the customer of Area 1, we got to know their team. At Cloudflare, we're a bunch of geeks. We're good at snipping out when tech is real and when it's BS. The Area 1 team shares the same spirit, so they were fun to work with, and their tech definitely isn't BS. We talked to them briefly about a partnership, but it became quickly clear and made far more sense for them to join Cloudflare and fully integrate with our zero trust suite. There are good acquisitions and bad acquisitions, and I would be surprised if this one turns out to be a bad one. Competitive strengths Cloudflare continues to thrive, even after the pandemic, while sector peers like Akamai (AKAM) and Fastly (FSLY) saw slower traffic growth, Cloudflare did not see that. Analyst Joel Fishbein asked about this and Matthew Prince gave a great answer full of insight, like the whole conference call, actually. I'm citing the whole conversation here. Joel Fishbein Matthew, a couple of other companies that are cloud-centric have reported that Internet traffic has been trending down over the past several months. I'd love to just get your take on what's happening and how Cloudflare is positioned and how your Internet traffic has been flowing. Matthew Prince We haven't seen that. I think it has been continued growth. First of all, to answer your question, just straight up, we saw year-over-year traffic growth across our network of 75.8%, quarter-over-quarter growth of 15.9%, and that's in line with the quarter-over-quarter growth that we've seen for the last period. It's worth remembering that we don't bill primarily based on usage. We bill in a much more predictable way. And so I think that, that is a good indication that we are taking share from the rest of the industry. But even in the post-COVID times, the traffic across our network continues to grow. And we do that while still maintaining above what our target gross margins are. I think the other thing which you didn't ask about, but I think it's interesting to compare, is how much usage has grown across our network. And where bandwidth has grown 75.8% year-over-year, CPU usage has actually grown 89.1%. And over the quarter, it's 15.9% for bandwidth and 21.8% growth for CPU usage. What I think is -- why that's interesting and that's important, because I think that that's actually showing where people are not just using Cloudflare for moving bits around, but they're using Cloudflare in order to do intelligent processing of those bits, and that intelligence, which is really driven by like our Workers' edge computing product, as well as some of our security products, that's actually growing faster than bandwidth. And I think that, that delta shows why we're able to continue to grow revenue at the 54% that we did in the quarter. Does that answer your question? That answers the question very well indeed and points to one of Cloudflare's main competitive advantages over its competitors. It is not just a CDN ('moving around bits') but a platform where CDN is just the basis for all its other services, most of which are in edge computing and security. Another competitive advantage is Cloudflare's efficiency. Matthew Prince explains where it comes from and why Cloudflare is more efficient. I think efficiency is just at our core. And so our network has always been designed in such a way to be able to get to be as efficient as possible. And so that has allowed us to deliver the services that we do. I think we sometimes get compared with some of the more traditional CDN-type vendors, and that's just never how we have seen ourselves, and it's not business that we have chased. And so I think that where, if you're selling just bit delivery, it turns out that being a little bit faster -- really the returns are incredibly diminishing. Whereas if you're selling security, if you're selling intelligence, which is built into the network, if you're selling the ability to drive that, that has a very compelling use case. I think from the beginning, we also always said that Cloudflare, one of the first tenants of Cloudflare was never lose on price. And I think that forced us to be efficient from the beginning. And so customers, I think, in this time where everyone is looking for ways to figure out how they can save money on their IT budgets and where many other vendors are trying to figure out how they can either hold or raise prices, I think we can continue to be pushing forward and taking share and especially taking that high-margin share from both existing hardware vendors who are having a hard time even delivering their products, as well as other cloud vendors that, again, I think are not as efficient as we've been. In short: we are much more efficient, allowing us to undercut competitors. A lot of Cloudflare's competitors lease their data centers and cloud capacity. That will make them less efficient, as their gross margins will be lower. As a reference, Akamai has gross margins of 63%, and Fastly, which was clearly referred to by Matthew Prince in this quote, has a gross margin of only 50%. Another competitive advantage is Cloudflare's hiring. While you hear from many companies that they have trouble attracting top talent, Cloudflare doesn't have that problem at all. A lot of people working in the business are very excited about Cloudflare. As a result, Cloudflare hired 42% more employees than in Q1 2021 and 12.7% more than in Q4 2021. That's fast growth. But the most staggering number is this. Cloudflare added 310 employees, in the quarter, but it received a staggering 133,000 job applications. That means that only 0.23% are hired. I think that you can say without a doubt that you can attract the cream of the crop with such impressive numbers. On top of that, attrition went down, which is against almost all comments you hear in the industry about resignations. And how about this incredible statement? I think this shows truly how incredibly strong Cloudflare's offering is. A Fortune 1000 gaming company signed a $3.3 million, 3-year contract. I love this story. They were using AWS, but found their security couldn't prevent the attacks they were seeing. After struggling to keep their application online, AWS's team eventually told them, "You should just use Cloudflare." And so they did. AWS was telling their client to go to Cloudflare. Wow! These are not the only competitive advantages that Cloudflare has. The most important one may even be that the company has become a one-stop-shop that brings so many functionalities. Cloudflare can be your CDN provider, it can be your DDoS protector, your DNS provider, it can be your network security provider, your e-mail security provider, your edge computing platform and so on. It's a whole ecosystem that keeps expanding, a platform that can take over more and more work. Cloudflare's ambition of becoming the fourth cloud player can really work out. Not because it will replace the hyperscalers (AWS, Azure, and Google Cloud Platform) but as complementary for specific functions. This was another great quarter from Cloudflare. The company keeps growing at a blistering speed of 50% revenue growth as if it is nothing. And that is what Cloudflare is all about. However, there is no doubt that it's still very expensive. With a market cap of $15.7B and a bit under $1B in revenue expected for this year, Cloudflare's stock still trades at a 15 times forward revenue. I don't know what the stock price will do over the short term. Yes, it's expensive, but I have also seen companies that trade at very fair or low multiples sell off almost as much. I think that Cloudflare is a great stock to own and that also means that I will add money to this position slowly, as I always do. Valuation Valuations are always much more complicated than many people seem to think. There is no such thing as the 'right' multiple. That doesn't mean we can't look at valuations, though, to see where the stock trades. Judging a growth company on a PE ratio makes no sense, as the companies are investing heavily into their future. Let's take another approach. A company like Zscaler has free-cash-flowèè margins of 20%+, CrowdStrike (CRWD) even 35%+ and I think Cloudflare can go into that category if it wanted. If you take a 20% FCF margin and apply that to the current revenue of about $1B, you get $200M in FCF. With a market cap of $15B, that means that Cloudflare trades at a 'possible' FCF multiple of 75 times. That's very expensive. But if it keeps adding 50% growth rates, that goes down fast. It would mean 50 times in 2023, 33 times in 2024, 24 times in 2025, 16 times 2026 and 10 times in 2027 possible FCF. Expensive? Yes, if you want to hold this for the short term, there is definitely risk that the stock continues to drop. That's why I still think it's not a time to go all-in and I will keep following my dollar-cost average plan. The company keeps issuing new products at an incredible speed. The fact that these products can soon compete against the big boys in their field, as the example with AWS and the other one with Zscaler and Palo Alto clearly show, that's even more impressive. Matthew Prince has instilled a decentralized, innovation-minded company culture that pays off. With R2 to be generally launched in Q4 of this year, this will add another significant source of revenue for Cloudflare. That's the company's strength. These are the revenue growth projections of the analysts. I think that this will be much too conservative. I get it, though, analysts can only judge on what they know. R2 could bring in tens of millions of dollars soon but it's not in the numbers yet. And how about all the initiatives announced in the Platform Week, another one of the company's Innovation Weeks? They are not factored in, of course. All in all, Cloudflare will probably launch more than 700 new products and features this year alone. How can you factor that in? The answer is simple: it's impossible. Conclusion Cloudflare posted another great quarter and the thesis is fully intact. We don't know how the market will price this fantastic company over the short term, but I am very happy to keep holding this position for many years to come, adding to it regularly. In the meantime, keep growing! Stocks that go up 10x or more can change your life and that is what Potential Multibaggers focuses on. Potential Multibaggers is not for those who trade in and out of stocks but for long-term investors. Some picks: Shopify ($77), Cloudflare ($39), The Trade Desk ($19.5), etc. That's from just 24 picks. Potential Multibaggers is not just about the stocks but also market psychology, a great community, webinars, a live portfolio and much more. Feel free to start the free trial now! This article was written by I am a 45-year old investor with a long-term perspective and that means I mainly think about the future when I invest. I try to uncover multibaggers early on. And it works: of the 23 picks, 11 are already multibaggers, several others are close. Picks include Shopify ($77), Sea ($54), Okta ($64), The Trade Desk ($19.5), Cloudflare ($39) etc. The strategy is simple but not easy: find disruptors that have a very high quality and hold them for a very long period. I try to identify stocks that have the potential to go up 1,000% and more over the next 10 years. I do deep research for the stocks that I pick to know if the quality is high indeed. I do not care about what my selection of stocks will do next year, but what the result will be over the long term. To paraphrase Warren Buffett: "You should only have stocks that you would feel comfortable having if the stock market closed up for 10 years." I appreciate your comments, because I believe I can learn a lot from your feedback and I believe in the wisdom of crowds. Disclosure: I/we have a beneficial long position in the shares of NET, CRWD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Comment

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