2023-08-22 12:00:00 ET
Summary
- I cautioned investors to be cautious in July as Cloudflare stock looked like topping out. Accordingly, NET formed its top and has underperformed since then.
- Despite posting a solid Q2 earnings release, investors weren't convinced by its expensive valuation. Despite that, Cloudflare's worst days are likely over.
- The company could continue gaining operating leverage and robust free cash flow conversion. As such, Cloudflare is likely to make solid market share gains, given its advantages in AI inferencing.
- I make the case for why NET seems to be bottoming out, supported by its "A+" growth metrics. Investors looking to buy more should capitalize on the recent selloff.
- Comment and let me know whether you think my upgrade is timely.
I urged Cloudflare, Inc. (NET) investors to be wary about adding in July, as I anticipated sellers returning to force a steeper selloff. That thesis had panned out as NET encountered significant resistance at the $76 level before the recent August selloff surprised late buyers.
While NET was caught in the early August volatility engendered by a weaker-than-anticipated performance from Fortinet (FTNT), the selloff intensified last week. Notwithstanding the selloff, Cloudflare reported a solid second-quarter or FQ2 earnings release, demonstrating its operating performance has likely bottomed out.
As such, it corroborated my previous Bullish thesis in late April, urging investors to consider buying more NET shares. Management updated holders that the increased deal scrutiny the company saw in Q1 has improved. As such, the company experienced more robust sales momentum in Q2 that aligned with the previous year. Despite that, deal scrutiny remains elevated, given the uncertain macroeconomic conditions. Therefore, I assessed that there is room for further improvement if these conditions don't worsen further. I'm not in the hard landing camp and believe our global economy will avoid a debilitating hard landing.
Cloudflare also added more color to the remarkable momentum, bolstered by its expertise in generative AI inferencing. Analysts on Cloudflare's earnings call were intrigued by the company's mention of its robust positioning to leverage the AI inferencing trends.
Management alluded to Cloudflare's well-diversified global scale and capacity, allowing its customers to perform low-latency and cost-efficient inferencing for downstream users. Also, Cloudflare isn't limited by the tight supply dynamics affecting the high-end GPUs used for advanced model training. Therefore, I believe Cloudflare's end-to-end offerings, including zero trust and cloud-native network security, are expected to help it gain traction in the enterprise market.
Management highlighted that it saw robust momentum in the large customer adoption, particularly in new customers. While its net retention rate fell to 115%, Cloudflare accentuated that it expects an improvement in the second half. The company also reminded holders that its net retention rate metrics are "backward-looking" and don't provide sufficient forward-looking insights into its enterprise customers' spending. Hence, investors shouldn't be unduly worried about the declining trend when assessing Cloudflare's thesis.
Cloudflare's guidance suggests it's on track for +30% revenue growth for FY23 while improving its operating leverage and free cash flow or FCF conversion. Hence, Cloudflare's business model has demonstrated that as it scales up, it can gain market share against "first generation" zero-trust providers, including Zscaler (ZS) and Palo Alto Networks (PANW). The company highlighted that Microsoft's ( MSFT ) entry into the zero trust space "validates" the importance of the market. Despite that, Cloudflare is confident that it can continue to gain strength with larger customers while Microsoft expands its offering with SMBs.
I assess that NET's FY25 EBITDA multiple of 50x still indicates a steep premium. Seeking Alpha Quant's "F" valuation grade corroborates my observation, although Cloudflare boasts a best-in-class "A+" growth grade.
Therefore, investors are likely assessing whether it's sufficient to justify NET's growth premium, which lies in its ability to significantly outperform its earnings estimates.
Also, are recent buying sentiments robust enough to justify a more constructive rating at the current levels?
Despite the selling pressure, NET buyers attempted to help the stock bottom out last week. However, I haven't gleaned a validated bullish reversal, although the support level looks constructive.
NET must hold the current level, as a further breakdown could open up significant downside volatility toward its May 2023 lows.
Therefore, buyers deciding to add at the current levels must carefully assess NET's buying sentiments. Notwithstanding the caution, I believe the risk/reward levels have improved markedly from NET's July highs, allowing me to be more optimistic about its potential consolidation zone.
Rating: Upgraded to Speculative Buy. Please note that a Buy rating is equivalent to a Bullish or Market Outperform rating.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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Cloudflare: Load Up Before The Northbound Train Leaves