NET - Cloudflare's AI-Powered Solutions In Demand But Expectations Are High (Upgrade)

2023-09-25 10:16:57 ET

Summary

• This is the bull case based on Cloudflare, Inc.'s integration of AI into its solutions.
• Cloudflare's near-term prospects show promise but are accompanied by uncertainty.
• Concerns about Cloudflare's valuation persist, with questions about high investor expectations and the stock's multiple compared to established peers like Akamai Technologies.

Investment Thesis

Cloudflare, Inc.'s ( NET ) platform provides a suite of integrated products that improve the security, performance, and reliability of businesses' digital operations, optimizing web applications and network connectivity across diverse environments that include hybrid and cloud-first businesses.

The business is extremely well placed for the digital revolution, with strong secular AI opportunities leading to a rapidly expanding total addressable market. Given this consideration, I do not believe it makes sense to have a sell rating on this stock anymore. Consequently, I'm now more neutral on this name.

That being said, I find it challenging to regard paying more than 100x next year's EPS as an enticing entry point.

Cloudflare's Near-Term Prospects

Cloudflare is a cloud services provider that enhances the performance and reliability of businesses' digital operations. That, in a nutshell, is what Cloudflare does.

Their network interconnects with thousands of networks, including major ISPs. This infrastructure allows for performance optimization, and network connectivity, across on-premises, hybrid, cloud, and SaaS applications.

Cloudflare's "serverless" architecture allows them to deploy standard hardware while managing the execution of customer and developer code, resulting in improved performance and more scalability.

Cloudflare seeks to facilitate a better Internet experience for all. They empower businesses to secure their external-facing infrastructure, accelerate web and mobile performance, and simplify network management while eliminating the need for on-premises hardware. The one advantage that Cloudflare has compared with some of its peers is Cloudflare's comprehensive offering, more on this soon.

Recent developments point to Cloudflare's expanding AI sector, thereby highlighting its competitive position and potential for future growth.

Cloudflare is actively capitalizing on the potential of AI across various aspects of its business. By integrating AI into its security solutions, the company can proactively detect and counteract threats, making its services even more robust. Additionally, AI plays a crucial role in optimizing performance and ensuring faster load times for websites and applications.

Cloudflare's emphasis on Zero Trust security architecture, powered by AI, enhances security while maintaining flexibility. Its serverless computing platform, Cloudflare Workers, has seen substantial growth, with AI applications benefiting from edge computing's real-time processing capabilities. Moreover, Cloudflare's positioning in the AI inference market and its recognition of AI's strategic importance solidify its role as a leader in providing comprehensive AI-driven solutions to customers.

Cloudflare's commitment to innovation is evident in the solid growth of its developer platform, Cloudflare Workers, plus services for email security, Zero Trust, and network edge security-as-a-service. In fact, as noted earlier, Cloudflare's broad product suits allow them to take market share from the likes of Akamai Technologies, Inc. ( AKAM ).

Note, Akamai is well-suited for businesses looking to accelerate web content delivery and enhance web performance, while Cloudflare is ideal for organizations seeking a holistic approach to security and performance optimization.

Incidentally, it appears that over the past year, Akamai has been significantly less volatile and a better performer than Cloudflare. That being said, past performance is not indicative of future returns.

Next, let's analyze Cloudflare's financials.

Revenue Growth Rates Are Still Impressive

First, let's discuss the good news. The good news is that Cloudflare is still delivering very strong growth. Also, the fact that its comparables with the prior year are starting to ease up, which means that there's a very strong likelihood that Cloudflare can continue to grow into 2024 at 30% CAGR.

Also, Cloudflare has a long history of beating analyst's revenue consensus figures.

The bad news is that more recently, Cloudflare has missed one quarterly revenue estimate, back in Q1 of this year. Furthermore, the size of Cloudflare's revenue beats is becoming smaller.

And then, we have to consider the following customer adoption curve.

The table above is illustrative of a company that's starting to mature. Case in point, in the past 4 quarters Cloudflare's paying customers are growing at less than 20% CAGR.

All these aspects in and of themselves are not such a big deal, every company slows down at some point. The problem has more to do with investors expectations for when the business will slow down.

NET Stock Valuation -- Still Carrying a Premium

There's no doubt that Cloudflare's multiple is a lot cheaper than it was in the past. Looking back, at its peak, Cloudflare was once priced at 90x forward sales (data not shown).

But does the fact that today Cloudflare is priced at 15x forward sales make it cheaply valued? I'm not convinced that this stock is all that enticing.

While I recognize that growth stocks always are expensive, I'm still not compelled to pay approximately 150x forward earnings per share. Is this valuation warranted?

I know that Akamai Technologies is much further along its business cycle and is growing at a much slower clip, with its EPS figures barely growing at 10%, while Cloudflare's EPS is still growing at more than 180% y/y. But the problem here is that expectations for Cloudflare are extremely high. Again, as a comparison, Akamai is priced at around 10% of the valuation that Cloudflare is priced at.

I'm not going to openly declare that Cloudflare is overvalued. I'm simply stating that I'm on the fence when it comes to appraising this opportunity.

The Bottom Line

Cloudflare's near-term prospects appear promising, yet uncertain. The company's strategic focus on AI presents significant growth opportunities, particularly in enhancing security and performance. By integrating AI into its solutions, Cloudflare can proactively detect threats, ensuring robust security. Additionally, AI plays a pivotal role in optimizing performance, leading to faster load times for websites and applications.

When it boils down to it, my uncertainty surrounds the stock's valuation, with concerns about paying over 100x next year's EPS and high investor expectations.

While Cloudflare's growth rates remain impressive, the question of whether its current valuation is justified remains uncertain, especially when compared to more established peers like Akamai, which is valued at a significantly lower multiple. This uncertainty leaves too much room for doubt, hence I'm staying on the fence.

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