Cloudflare Is Not An AI Winner

seekingalpha05-01

Cloudflare is no longer on track to be the 4th public cloud.The emergence of generative AI has led to a change to Cloudflare's business strategy.But Cloudflare still has some opportunities in the AI ...

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What Does Cloudflare Actually Do?When Amazon introduced and commercialized Cloud computing, the premise was that it can help all companies with IT infrastructure of storage and other software services and save developers a lot of time. As a simple example, rather than IT professionals and developers building servers to store the company's data on, they could just rent storage from Amazon. A race then ensued to build the most storage and offer the most comprehensive software services to enterprises. Amazon was the clear leader, Microsoft was trying to catch up, with Google and others also entering the market. This is a profitable business, and also has high barriers to entry given the amount of capital required. Meanwhile, Cloudflare was simply focusing on protecting websites, initially by focusing on blocking spammers. 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Sundry Photography My thesis on Cloudflare, Inc. (NYSE:NET) was that it had a good chance of leveraging its network to ultimately become the fourth public cloud. The introduction of generative AI, however, is having a monumental effect on Cloudflare's business strategy and that thesis no longer holds. This article will discuss the nature of that change, how the company is adapting and what it means for the stock. How AI Changes Everything for Cloudflare Cloudflare's management had some harsh words for analysts like me. In a recent interview, CEO Matthew Prince said: I think at various times, people have said, \"Oh, Cloudflare is the fourth public cloud,\" which actually I think is kind of insulting to the folks at Oracle and IBM and Alibaba and Tencent. But it never quite struck us as exactly right. I initially argued that Cloudflare can offer a host of services at a cost advantage as a result of having a large network all over the world. I thought the company's offerings could be so large it would in essence be the fourth public cloud, and that this was an opportunity worth investing in, especially that Cloudflare was trading at 1% the market cap of hyperscalers like Amazon.com, Inc. (AMZN) and Microsoft Corporation (MSFT) at the time. While Cloudflare management disagrees with that premise, my thesis was based on the strategy they articulated to investors, from Business Insider in Sep. 2021: Indeed, Cloudflare's ambitions are bigger than just enticing customers away from AWS — the company aims to \"be the fourth major public cloud,\" Prince said, with R2 being \"one of the tools that is helping complete that vision.\" So why is Cloudflare pursuing a change in strategy now? The answer is ChatGPT. What Does Cloudflare Actually Do? When Amazon introduced and commercialized Cloud computing, the premise was that it can help all companies with IT infrastructure of storage and other software services and save developers a lot of time. As a simple example, rather than IT professionals and developers building servers to store the company's data on, they could just rent storage from Amazon. A race then ensued to build the most storage and offer the most comprehensive software services to enterprises. Amazon was the clear leader, Microsoft was trying to catch up, with Google and others also entering the market. This is a profitable business, and also has high barriers to entry given the amount of capital required. Meanwhile, Cloudflare was simply focusing on protecting websites, initially by focusing on blocking spammers. There were concerns that the company's initial offering would make its customers' websites slower, and so Cloudflare started working on latency issues, ultimately building a network of servers that span 300 cities worldwide. The company could then start to offer more software services, and they ended up in a similar place to hyperscalers, just arriving to it differently. While Amazon and Microsoft can use the data centers to offer more software solutions, Cloudflare could use its network to offer dozens of software solutions as well, including storage. All that changed when ChatGPT took the world by storm. Now the focus is on training AI model, and Cloudflare simply can't compete in that space due to the nature of its servers. I've brushed on the matter in my article on Nvidia's bull case: The introduction of ChatGPT is sparking a move from a world where software applications relied on the computing power of the device, to one where they rely on the computing power of servers in data centers. For that, companies need: 1) Processing chips that can do things faster 2) Connect as many chips together as possible to increase the computing power further and deliver spectacular software applications like ChatGPT, Midjourney and the like. 3) Support in building these new AI applications. Cloudflare doesn't have a chance to be a hyperscaler in the AI world because the latter is all about accumulating state-of-the-art chips, compared to Cloudflare's network that was built on commodity hardware. Going out now to buy thousands of h100 chips is simply unfeasible for Cloudflare. The second thing is, as discussed in the paragraph above, training an AI model is all about chips and data centers being in close proximity, which is the exact opposite of what Cloudflare has in servers located far apart all over the world. How Cloudflare is Adapting to the AI Trend The introduction of AI basically rules out the possibility of Cloudflare becoming a hyperscaler one day, and in my opinion there are two trends that will determine the viability of Cloudflare as an investment going forward. Cloudflare Could Be the Switzerland of the Hybrid Cloud Cloudflare, as a network, is now more about the movement of data rather than the housing of data as would be the case pre-ChatGPT. The more the need for the movement of data grows, the better off Cloudflare's business. Cloudflare is currently in a good place, given the popularity of hybrid and multi-cloud strategy among corporate IT departments, and that would require lots of movement of data. Funnily enough, Cloudflare is in a similar position to Roku. I recently discussed how Roku's advertising business was all about the streaming wars, with a huge chunk of ad revenue coming from entertainment companies promoting their streaming services. As those companies entered the streaming space, Roku thrived thanks to the increased promotional spend. But once entertainment companies rationalized and some sought consolidation, Roku's business suffered. Cloudflare will experience a similar dynamic; increased competition between hyperscalers and the popularity of the hybrid cloud model will be good for business. On the other hand, some sort of consolidation or a move away from hybrid clouds will hurt business. Prince again:  At Wells, you guys use Microsoft, but you also use Google. And the question is, like if you are using these two things and both of them are trying to say, we want all of your data to be held captive in that. It turns out customers don't want that. They want to be able to take advantage of each of those different bits. But if you're going to do that, you need some level of a control plane, which is consistent across it. And what does that control plane need to do. It's got to have security, absolutely. It's got to be able to be performant, to make it so that you don't suffer some sort of performance penalty when we're using both Microsoft and Google...And so oftentimes, when someone will sign up with Cloudflare, will be able to reduce the cost and the spend that they have on their hyperscale public clouds. And that's oftentimes where the dollars that we capture are.  This does sound like a value proposition for large corporations, so investors should focus on Cloudflare's large customer wins. Cloudflare's large enterprise penetration is small but could grow significantly (regulatory filings) Cloudflare's number of customers paying more than $100,000 a year is still rather small. For comparison, ServiceNow has basically the same number of customers paying $1 million a year. It is also smaller than direct competitor Zscaler, Inc. (ZS), which has more than 2,800 customers paying more $100,000. Cloudflare is growing its customer base faster, however, at 34% YoY compared to almost 20% at Zscaler. Cloudflare's total number of paying customers at 182,027 however dwarfs many enterprise companies, it also has millions of free customers. ServiceNow for example has slightly more than 8,000 customers in total. Management highlights the importance of free customers to their business, which doesn't necessarily apply to other SaaS businesses, so investors shouldn't dismiss its value. Here is COO Michelle Zatlyn explaining: It turns out the attackers often start, say, targeting a blog in Malaysia, and the blog in Malaysia needs Cloudflare’s basic service to super charge their site, and we get the early detection, so that 18 months later when those attackers might be doing a larger attack, maybe an airport, we know about them, and can stop them automatically. It’s almost like an immune system for the internet. We get value from our free customers. It’s really cool. It’s a symbiotic business model. Data Sovereignty Could Be a Big Opportunity for Cloudflare Another opportunity for Cloudflare could come once the focus shifts from training AI models to using them. Prince again from the same interview: some models are going to be too big to be able to work on the actual device. And so I have no doubt that in 10 years, you're going to have ChatGPT-level quality on your phone effectively GPT-4 on your device. But by that time, we'll be up to GPT-20, and that's going to be too big to run on your device itself, and it's going to be better in some various ways, do something the thing on your phone can't do. And so the next best place is to have that influence run as close as possible to where you are. And that's better than going all the way back to Ashburn, Virginia, for two reasons. The first that everyone thinks about it is just faster. Speed of light is only so fast and having to send your data all the way across the world and all the way back is inefficient, slow. So being able to answer that query as close as possible is actually better. Cloudflare as an investment, in essence, will be an arbitrage on the gap in hardware capabilities of data centers (that have the best chips connected to each other) compared to end-user devices. Prince also mentioned a second advantage: And then the second reason, which is actually more important is, around the world, we're seeing all of this regulation around AI. And one of the things that governments around the world are insistent on is how with AI do we not make what they see as the same mistakes that we made with the Internet originally, which is today, too much of the Internet is concentrated from the perspective of the global audience is concentrated in the United States. Too much data flows back to the United States. How do we make sure that's not the case, and if Cloudflare isn't successful in this...I talk to leaders in Europe and Asia, all around the world, they're saying, we want to make sure that as our citizens are using these AI models, that they're distributed globally and that the data about our citizens stays as local as possible. And so to that extent, we think that the second best place for an AI model to run is in a network which is as close as possible to that end user. And that's what we've built at Cloudflare. So just as the nature of Cloudflare's network prevents it from competing with hyperscalers as a public cloud in the age of AI, it comes back to give Cloudflare an advantage over them when it comes to the sovereignty over data. Simply put, because Cloudflare's servers are all over the world, developers can move their data to different regions and have the region's regulations applied to that data. They can do it at better speeds than the large cloud players, because the latter have their data centers clustered together, which is perfect for training AI models, but not so in dealing with governments who want certain standards and protections for their citizens' data. You can find a more detailed explanation in Cloudflare's introduction of Durable Objects. But here is a quote I think is useful:  When using Durable Objects, Cloudflare automatically determines the Cloudflare datacenter that each object will live in, and can transparently migrate objects between locations as needed. Traditional databases and stateful infrastructure usually require you to think about geographical \"regions\", so that you can be sure to store data close to where it is used. Thinking about regions can often be an unnatural burden, especially for applications that are not inherently geographical. With Durable Objects, you instead design your storage model to match your application's logical data model. For example, a document editor would have an object for each document, while a chat app would have an object for each chat. There is no problem creating millions or billions of objects, as each object has minimal overhead.  And so NET stock will not just be an arbitrage on the future demand for data transfer, it is also an arbitrage on AI and data regulatory complexity. The more regulation there is over the sovereignty of data and AI models, the more likely it is that the company's fundamentals improve. Valuing Cloudflare Is No Easy Task Cloudflare is GAAP unprofitable and just turned free cash flow positive, making it difficult to value based on those two metrics. The price/sales may be one that investors can at least have a look at. Seeking Alpha's valuation tab gives a nice overview, Cloudflare, however, doesn't measure well.   Cloudflare is overvalued based on Price to Sales compared to peers (Seeking Alpha) One thing to bear in mind is that valuation techniques like price to sales offer a snapshot in time and don't factor things like growth. Cloudflare management said they aim to hit $5 billion in revenue in 5 years. I went ahead and compiled the valuation of major SaaS companies when they hit 5 billion in revenue.   Cloudflare could be decent value if it delivers on growth targets (created by author using Seeking Alpha's financials tab) I focused on companies that were born in the cloud with more than $5 billion in revenue. To determine EV for each of those companies, I used the closing price for the month that saw the earnings announcement when the company reached $5 billion in revenue. One good thing about this method is the three companies hit $5 billion in sales at different times in terms of the interest rate environment to some extent but definitely in terms of investor sentiment. Having said that, I think the average valuation is a bit aggressive, with Salesforce's valuation of 8x more appropriate and with enough margin of safety in my opinion. For Cloudflare, that would amount to an enterprise value of $40 billion in nominal terms by 2027, or $118 a share. I'll let each investor apply their own appropriate discount rate. Cloudflare Is Not on Track to Reach $5 Billion By 2027 Cloudflare's revenue growth have decelerated sharply (Seeking Alpha) Adding to the complexity is that Cloudflare's growth has slowed enough to prevent it from reaching $5 billion by 2027 if it persists. The company needed a YoY sales growth of roughly 37%. That hasn't happened since Q4 of 2022. Operating margins have improved somewhat, but I doubt investors will be looking for companies like Cloudflare for the cost-cutting. Cloudflare Remains a Hold  In conclusion, the introduction of generative AI has altered the thesis that Cloudflare can be the fourth public cloud, limiting the upside for the stock in the process. Having said that, the company still has some opportunities in an AI world, and management are very clear in their efforts to attack those opportunities. The stock remains a hold, however, due to the decelerating sales growth over the past few quarters. 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