2023-08-21 08:28:35 ET
Summary
- Cloudflare's management appears to have moved past the sales execution issues seen in the prior quarter.
- In its most recent quarter, Cloudflare delivered solid revenue growth of 32% YoY, but saw a dip in its dollar-based net retention rate.
- Cloudflare has a net cash balance sheet and is generating cash.
- Cloudflare is positioned to sustain 30% revenue growth in the years to come as it powers a faster and safer internet.
Cloudflare ( NET ) has long been a tech darling, and remains so to this day. The stock has experienced a large amount of volatility in sentiment, in large part due to the tough macro environment. Previously, management had highlighted issues in execution among its sales team, leading to the disappointment in reported growth. The stock plunged briefly, but has since recovered those losses. As if like magic, management is now reporting strong improvements in sales cycles. Management remains confident that growth will eventually accelerate - and the stock is pricing in that acceleration at current levels. While NET remains one of the most richly valued names in my tech coverage universe, I am upgrading the stock to a buy due to the positive momentum in its business and reasonable valuation.
NET Stock Price
NET shareholders could be forgiven for having heartburn over the past year.
I last covered NET in June, where I explained why I was moving to the sidelines. The stock is down low double-digits since then, but it is primarily management's positive commentary regarding execution that have brought me back to this story.
NET Stock Key Metrics
In its most recent quarter, NET delivered solid 32% YOY revenue growth to $308 million, slightly surpassing guidance for $306 million in revenues.
While 32% growth is a high watermark for the tech sector, it represents a steep deceleration from years past for the company. NET saw solid growth among its largest customers and overall customers, a tough feat given that customer acquisition has become harder in this higher interest rate environment (many firms are reigning in IT budgets). NET saw its dollar-based net retention rate dip yet again to 115%.
On the conference call , management again reiterated that they weren't seeing elevated competition or churn, and instead blamed "slower expansion" from existing customers. In theory, dollar-based net retention should accelerate as the macro environment improves.
On the profitability side, NET delivered $20.3 million in non-GAAP operating income, coming ahead of guidance for $15 million. NET has delivered solid operating leverage over the past several years.
NET ended the quarter with $1.6 billion of cash versus $1.3 billion of convertible notes, representing a comfortable net cash position. NET repurchased some of its 2025 convertible notes in the quarter, paying some premium in the process due to the notes being "in the money."
Looking forward, management has guided for up to 30% YOY growth in the third quarter, and $1.287 billion in revenues for the full year, a slight raise from prior guidance of $1.284 billion. Management also expects operating income to rise to $85 million, up from guidance of $77 million.
On the call, management noted that the guidance does includes "a good portion of caution" as it does "not assume that the macroeconomic environment is improving significantly." In the firsts quarter, management had noted seeing sales cycles increase by 20%, but management notes that "discipline around deals" has helped sales cycles return to levels close to last year. It is hard to verify this but if true, is an impressive achievement given that it was only last quarter in which the company underwent a restructuring among the sales teams. Remaining performance obligations of $1 billion represented 36% YOY growth and implies that the company should be able to sustain elevated revenue growth in the near term at the least.
Is NET Stock A Buy, Sell, or Hold?
NET believes that it is part of the evolving enterprise stack - it notably calls Palo Alto Networks ( PANW ) and Zscaler ( ZS ) as being part of "yesterday's" stack.
My personal view is that it may be too early to determine if NET has truly disrupted the likes of ZS, as both look like capable operators in cybersecurity. To refresh the reader's memory, NET is most well-known for its content delivery network services, which help speed up the internet by bringing data content closer to consumers. NET has added cybersecurity services on top of that core offering.
NET's attractive positioning as a leading vendor in being a mission-critical enabler of a faster internet allows it to constantly add new products and services to its platform to increase its total addressable market.
While NET is not currently gushing cash, management expects the company to eventually generate at least 25% free cash flow margins over the long term. I view such a target as being reasonable given the high 78% gross margin run rate of the business.
NET isn't cheap anymore. At recent prices, NET was trading at around 15x this year's sales.
On the earnings basis, NET does not look cheaply valued until many years later.
It is worth highlighting that consensus estimates have NET generating a 22% net margin by 2032. Based on a 25% long term net margin, 30% top-line growth, and a 1.5x price to earnings growth ratio ('PEG ratio'), I could see the stock sustaining a 11x sales multiple over the medium term. The stock trades in excess of that right now, but grows into that valuation very rapidly assuming the company can sustain solid growth for many years. That valuation implies a price target of $162 per share in 2028, or 20% compounded annual return upside over the next 5.5 years.
What are the key risks? It is possible that the macro environment worsens from here. While management appears to be of the view that the worst is behind them, it is admittedly difficult to predict anything in this macro environment. A more important risk may be that of valuation. NET is trading at a material premium to peers and that is apparently justified by consensus estimates for the name to sustain 30% growth for many years. If NET disappoints on that outlook, then I would not be surprised to see the stock re-rate sharply downwards due to both the lower estimates as well as a loss in confidence.
While NET does not look cheap until several years later, I am upgrading my rating to buy due to my confidence in the company's growth outlook.
For further details see:
Cloudflare: Upgrading To Buy On Strong Execution In Sales Challenges