Summary
- Cloudflare is a pure-play on the growth of the internet.
- The stock has jumped nearly 100% over the last 6 months alone.
- Cloudflare continues to generate strong growth numbers with gains on the bottom line.
- I explain why the current stock price is full of danger even using very aggressive forward estimates.
Cloudflare (NET) has emerged as a very popular tech stock, as it truly is a play on the growth of the internet. In spite of already trading at what I viewed to be a very rich valuation, the stock continues to rise rapidly. I fear that this is a situation commonly seen in today’s market: investors are buying stocks of high growth companies at any price. If the story is appealing, and the stock price keeps going up, it is easy to convince oneself to keep buying even if the valuation no longer makes sense. The current stock price is setting up new shareholders for a high likelihood of downside surprise.
NET Stock Price
Just 6 months ago, I initiated coverage on NET and pointed out a rich valuation that still allowed for 9% annual returns over the next decade. I also mentioned that investors might want to consider selling a covered call in order to improve the near term returns. My outlook proved too conservative, as the stock proceeded to return 93% from that day:
Why Is NET Stock Up?
This kind of stock price performance is phenomenal. But what drove the strong returns? One might first consider the influence of upside surprises, but NET’s recent quarterly beats were small in comparison with those in the past:
What’s more, the stock was actually mixed following the most recent quarter. Revenues grew rapidly at 53% year over year:
This was driven by 31.7% YOY customer growth as well as 124% dollar-based net retention rate:
NET’s growth appears easy to understand as it has direct exposure to the growth of the internet. The more images, logos, files and videos are uploaded to the internet on NET’s platform, the more NET’s revenues grow.
NET was able to derive some operating leverage as its non-GAAP operating loss declined to 3%:
But what really drove the stunning price performance in NET? NET was trading at 47x trailing sales when I covered the name in March. Since then, revenues have grown 20.6% sequentially over 2 quarters. It appears that most of the upside has been driven by multiple expansion, as NET is now trading at a blistering 76x trailing revenues.
Is Cloudflare Stock A Buy, Sell, or Hold?
When stock price performance is driven by multiple expansion, one mustn’t ignore the fact that this is inherently unsustainable, as the stock should not continue getting more and more expensive. One could make the argument that multiple expansion is reasonable when the stock trades cheaply, but I’m hard pressed to call NET cheap even prior to this 93% run up. NET is now trading at 63.6x forward sales:
I note that Wall Street consensus estimates for 2021 appear to already reflect NET’s new guidance of $632 million in full-year revenues. Is NET attractively valued at 63.6x forward sales and a 33.7% expected 2022 growth rate? No, and let me explain why. NET is modeling 20% long term non-GAAP operating margins:
If we instead assume 20% GAAP net margins, then NET is trading at 185x “adjusted 2023 earnings” - equating to a price to earnings growth ratio (‘PEG’) of around 6.4x. That is in far excess of the 2x that is typically considered reasonable nowadays, and I emphasize that this is using today’s stock price.
But perhaps one makes the argument that NET should continue 20% compounded annual growth for 5 years after 2023, and that it will achieve 40% net margins. In this case, NET is trading at 14.9x 2028 revenues and at a 37x “adjusted earnings multiple.” This earnings multiple looks reasonable based on 20% growth, but unfortunately this is assuming that NET stock does absolutely nothing over the next 7 years. I think I’ve made my point, but just to make sure that I have accounted for those who think my estimates are still too conservative, let’s assume 25% compounded annual growth for 5 years after 2023. NET would be trading at 12x 2028 revenues and at 30x adjusted earnings. One could make the argument that NET should trade at 50x adjusted earnings given the 25% growth rate - equating to 66% upside. But 66% upside over 7 years represents only 7.5% annual returns, and that is after using profitability estimates that are double of management’s own guidance and growth assumptions that are arguably far too aggressive. While I can appreciate the investment thesis of NET being a pure-play on the growth of the internet, the current stock price is pricing in significant downside potential. I wouldn’t be surprised if the stock experiences extreme volatility over the coming quarters as investors realize that growth will not accelerate as much as expected. I am not bearish the stock because the long term growth will likely allow for positive returns eventually, but my neutral rating should be interpreted as aggressively recommending to allocate capital elsewhere.
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