Insights

Cloudflare Is Still On A 50% Growth Hot Streak — Is It Time to Buy the Stock?

Cloudflare (NYSE: NET) just reported yet another quarter of over 50% year-over-year revenue growth — specifically, 54% growth during the second quarter of 2022. When it went public in 2019, Cloudflare reported annual growth of 49%. It’s been increasing more than 50% every year since then and is on pace to come near that percentage increase again in 2022.

And yet Cloudflare stock is down some 70% from its all-time high reached in late 2021. Shares have experienced a painful sell-off as the bear market this year has brought down sky-high valuations on high-growth but not-yet-profitable companies. Is it time to start buying this tech stock again?  

Rapid revenue growth offset by stock-based compensation

Cloudflare’s sales were $234.5 million in Q2 2022. Operating cash flow was $38.3 million last quarter, although free cash flow (which subtracts expenditures on property and equipment from operating cash flow) was negative $4.4 million. Cash and investments on balance were $1.64 billion, offset by convertible debt of $1.43 billion as of the end of June.  

The company is in great shape to continue spending to promote expansion (on things like sales and marketing, research and development). Cloudflare’s cumulative efforts in building tools for developers and small businesses are paying off as it now moves up-market. It signed on a record 212 new “large customers” in Q2, and there’s still room for expansion. Reportedly, only 29% of the Fortune 1,000 (the top American companies ranked by revenue) are paying Cloudflare customers.

The global economy is tapping the brakes, though, and large organizations are slimming down on expenses as a result. However, projects with a quick payoff are being prioritized. Cloudflare co-founder and CEO Matthew Prince said this environment has been benefiting the company as bigger businesses are “leaning forward to hear how Cloudflare can save them money and reduce IT complexity.” In light of this, full-year 2022 revenue guidance was raised to $968 million-$972 million (it had been $955 million to $959 million). This now implies a 48% year-over-year increase in revenue over 2021 at the midpoint of guidance.

All of this growth comes at a cost to shareholders, though. As is often the case with tech companies, employee stock-based compensation is high at Cloudflare. In fact, stock-based compensation was over 22% of revenue the first half of 2022, compared to just over 16% of revenue the same period last year. The timing of payouts can be highly variable from one quarter to the next, but it’s a metric worth keeping an eye on since a higher share count dilutes ownership for existing investors.  

Nevertheless, with the top line continuing to expand at a rapid pace, Cloudflare is still delivering in spite of high stock-based compensation. Average revenue per share was $0.72 last quarter, compared to just $0.29 at the end of 2019. That’s a nearly 150% increase in revenue per share in less than three years. Not too shabby, Cloudflare.

Is Cloudflare stock a buy now?

Rapid expansion doesn’t mean this tech stock is a buy for everyone, though. Cloudflare has put up fast-and-steady sales growth for years now, but the share price will be anything but consistent. The cadence of revenue growth, how many shares are issued, Cloudflare’s progress toward profitability, and a myriad of other factors will create some wild swings in the stock. There’s also the matter of valuation. Shares currently trade at over 23 times current-year expected sales (after the stock made a big 20%-plus jump on the earnings news). If high-risk, potentially high-reward investing isn’t your game, take a pass on this one.

But for the right investor, there’s still a lot to like about Cloudflare even though the market has turned against loss-generating companies as of late. Internet infrastructure is rapidly evolving, hastened by cloud computing and all of the trends it supports (like work-from-home, more online video content, and AI). Cloudflare is helping organizations roll with these changes, bringing simplified IT infrastructure, internet security, and cost savings to its users. These end-markets will be in high-growth mode for the foreseeable future, and Cloudflare is investing heavily to maximize its potential. 

So who might consider buying Cloudflare? Here’s a checklist:

If you don’t mind some hair-raising price swings — both up and down.
You have years to wait (the more the better), since Cloudflare has stated it doesn’t intend to focus on maximizing profit as long as it can generate big revenue gains.
You have the ability to add to a small position over time, perhaps buying quarterly, to take advantage of dips and to help offset dilution from stock-based compensation.

The second-quarter 2022 update reaffirms Cloudflare’s hot streak isn’t over. Investors should exercise caution before buying here, but this tech company is still early on in its growth story. If Cloudflare can sustain its momentum and reach profitability over time, this could be a big winner for patient investors. Now looks like a good time to start nibbling again.

Nicholas Rossolillo and his clients have positions in Cloudflare, Inc. The Motley Fool has positions in and recommends Cloudflare, Inc. The Motley Fool has a disclosure policy.

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