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Executive summary
Cloudflare Inc. (NET, Financial) is an internet services company that addresses three spend categories within enterprise and government customers. The company's original offering was content acceleration in the manner of competitors Akamai (AKAM, Financial) and Fastly (FSLY, Financial); later the business added distributed application development and hosting; and most recently it has expanded its capabilities to include zero-trust networking, becoming number two in that market to Zscaler (ZS, Financial).
The stock was an early beneficiary of the tech stock boom in the wake of the Covid lows; rising from $14 per share to $222 per share in less than two years, Cloudflare peaked at the end of 2021 and promptly shed more than 80% of that increase in the course of the following year. This kind of volatility is not uncommon amongst high-beta, high growth technology stocks.
Cloudflare has trended sideways in a range since May 2022 – around 18 months now – and we believe this has been the result of gradual institutional accumulation. We believe the stock is primed to move up and out of that range. We continue to rate the stock at accumulate, but note that it is near the top of our defined "accumulation" range.
Financial fundamentals
Source: Company SEC Filings, YCharts.com and Cestrian Analysis
A few notes on the numbers.
- Revenue growth at the company held up well during the 2022 rate-hike cycle. It has slowed a little of late, from a peak of up 54% in the March 2022 quarter down to a gain of 32% in the June 2023 quarter. We believe the rate of growth is bottoming out and we anticipate acceleration in growth come fiscal 2024.
- Gross margins have held up well in the mid-70% range.
- The company is clearly managed to its Ebitda margins – you can see steady stepwise progression in trailing 12-month margins going back several years – now standing at 14%.
Let's now look at Ebitda down to net debt, deferred revenue and remaining performance obligations.
Source: Company SEC Filings, YCharts.com and Cestrian Analysis
The company utilizes a lot of capital expenditure relative to its revenue – this is endemic to the business model, which involves installing physical server hardware in third-party datacenters close to the network edge. This depresses cashflow relative to Ebitda. Further, only recently has the company started to introduce significant upfront billing; this means that working capital outflows have been meaningful. As the company continues to grow,we would expect modest efficiencies to apply to the capex sales ratio and a gradual improvement in the working capital performance. Neither are likely to transform overnight. This means that despite the 14% trailing 12-month Ebitda margin, the company delivers a -5% trailing 12-month unlevered pretax free cashflow margin. This is fine in the context of the balance sheet, which is unstressed, but we believe that reaching trailing 12-month unlevered free cash flow breakeven or better can support the stock.
The company does have a large order book (“remaining performance obligation”), worth around two-thirds of trailing 12-month revenue. This provides at least some insulation against large earnings shocks due to missed revenue. If the company delivers on its intent to bill more upfront, we ought to see that deferred revenue number tick up on both an absolute and as a percent of trailing 12-month revenue basis – which would also support the stock we believe.
Fundamental valuation multiples
Cloudflare trades at large multiples of everything, and always has. It is easy to stay away from tech stocks valued like this, and no one could be criticized for that logic. But since the dawn of time, tech stocks do trade at outsized multiples and rejecting them on that alone is a recipe to incur a lot of opportunity cost from successful investments that could have been had.
Stock chart
You can open a full page version of this chart by clicking here.
The gray bars on the right-hand side of this chart show the volume times price profile, i.e. shows the volume traded at each particular price zone. Sideways action for 18 months plus high volume – in the context of a company which is an increasingly critical supplier to large enterprises and Federal government departments alike – is characteristic of institutional accumulation, and that is what we believe to be afoot here.
We believe the stock has plentiful upside - $100 should not be too challenging with a fair wind, and all-time highs are not out of the question within say two to three years – and we believe a stop can be placed below that recent low – in the $30 to $35 range – as a protective measure. That may be a wide stop versus the current price of $63, but the upside potential justifies that kind of downside risk in our view.
We rate the stock at accumulate.
Cestrian Capital Research, Inc - 18 October 2023.
