Will Cloudflare Stock Recover?

Content delivery network Cloudflare (NYSE:NET) has been among the worst-performing major tech stocks of 2024. While many stocks are up by double-digit percentages, NET has lost about 19% of its value so far this year.

Can Cloudflare bounce back, and why is the market being so hard on what was once an extremely popular technology company?

Why Did Cloudflare Fall?

Fundamentally, Cloudflare’s selloff appears to have been a response to a combination of overvaluation and contracting revenue growth. Even with shares off so much from the beginning of the year, NET is valued at 16.4x its trailing 12-month sales. At its highest level, that ratio reached over 60x sales.

In order to command this pricing, the company needed to continue delivering exceptionally high rates of revenue growth. However, that pace has been gradually fallen over the past year, causing the market to reprice the stock.

The situation wasn’t helped by management’s decision not to raise guidance in the most recent earnings report. The previously stated guidance that still stands implies revenue growth of about 27% over the coming year.

For most companies, this would be an exceptional outlook. Cloudflare, however, was reporting revenue growth rates of over 40% as recently as the end of 2022.

The next year’s guidance therefore represents a significant slowing of revenue growth compared to what investors have become accustomed to from Cloudflare.

This contraction in revenue growth might not be such a problem if Cloudflare was already profitable. However, the company has lost $184.0 million over the last 12 months and delivered a net margin of -13.1%.

With revenue growth running out of steam, investors are understandably concerned that Cloudflare will either continue losing money or fail to eventually generate enough earnings to justify its high price tag.

The Silver Linings

Things may seem bleak for Cloudflare on the surface, but the company still has quite a few positives. To begin with, Cloudflare serves about 19% of all websites worldwide.

Though far from a majority, a fifth of all the websites on the internet is a large enough share to give Cloudflare a rudimentary competitive moat. Among the company’s customers are massive names like Shopify and OpenAI.

Because of its widespread use, Cloudflare also has the potential to generate growth by offering new products and services.

In April, for instance, the company announced that it would acquire cloud observability company Baseline. The rollout of observability services to customers means Cloudlfare can go head-to-head with Datadog for a serious share of the observability market.

Cloudflare continues to gain new and valuable customers. According to management, Q1 saw the number of new customers contributing $100,000 or more in annual revenue rise to a record high.

New initiatives are promising, such as the partnership with the Treasury Department to provide advanced cybersecurity threat detection for major financial institutions.

Finally, Cloudflare still has the potential to one day become a very profitable company. Gross margin as of Q1 stood at 77.5%, and free cash flow was 9% of revenue.

Even though Cloudflare is still losing money on a GAAP basis, these results suggest that the company’s basic business model has the potential to generate very respectable profits.

Is Cloudflare Still Overpriced?

To determine whether Cloudflare can rebound from its selloff, it’s important to determine whether it’s been sold off indiscriminately by the market.

Based on the price-to-sales ratio, there’s a good chance that the stock is still priced above a reasonable level. This conclusion is further supported by NET’s price-to-cash-flow ratio of about 252.

These multiples would be justified if Cloudflare was still growing as it was in 2021 or 2022. However, analysts expect the company’s growth to continue leveling off. 

They predict revenue growth of 29.3% in the coming year, a bit above management’s own projections but still far short of what would be necessary to propel NET shares significantly higher at the moment.

Has AI Hype Run Its Course?

Another possible pitfall for Cloudflare is the fact that the stock was to some extent inflated by hype surrounding AI.

Certainly, the company is investing in using the technology to improve its content delivery network. However, it’s not yet clear when or to what extent Cloudflare’s work in the AI field will turn into real revenues.

Since the stock was bought up on investor hunger for stocks in the AI field, it’s also reasonable to assume that the souring of investor sentiment on Cloudflare will result in a continued selloff.

Will Cloudflare Stock Recover?

Until Cloudflare can either regain its revenue growth footing or begin making serious progress toward GAAP profitability, the stock is unlikely to recover well.

While NET shares may get a bit of a boost if revenues beat management’s guidance as expected by analysts, a significant recovery doesn’t appear to be on the horizon.

Another headwind to Cloudflare’s recovery is the interest rate environment. At this point, the Federal Reserve appears unlikely to cut rates until next year. With high interest rates remaining in place, growth stocks like NET become less appealing for investors.

A final point that’s worth considering is that Wall Street’s smart money seems to be losing faith in Cloudflare. In May, Goldman Sachs, Citigroup and JPMorgan Chase all lowered their target prices for NET.

Though institutional ownership of Cloudflare still sits at over 80%, it seems that major institutional investors are beginning to see less upside in Cloudflare than was previously assumed.

Despite its decent moat and double-digit revenue growth, Cloudflare appears to still suffer from a lofty valuation problem.

The stock may not be a sell, but it also seems to be too expensive and too volatile to buy at the moment. Investors who already own NET may want to hold to take advantage of future growth and the potential for a slight rebound in share prices, but those who don’t can likely find better values in other stocks.

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