Cloudflare: Risk/Reward Skew Warrants A Hold Ahead Of Q3 Earnings

Investment thesis

I wanted to take a look at Cloudflare (NYSE:NET) before it reports its Q3 earnings on the 2nd of November to see if the company is a good long-term investment. Upon further analysis of its financials, from a value perspective, the company is too risky and unpredictable, with stock-based compensation eating away at its profitability annually while exhibiting very strong revenue growth. To make this valuation somewhat useful, I excluded SBC from my valuation model and found that the company is still a little expensive, therefore, I assign a hold rating until, the company stops relying so much on SBC and finally reports GAAP-positive numbers.

The company

Cloudflare is, as the name suggests, a cloud service provider that provides a range of different services including DDoS mitigation, content delivery network or CDN, security, and domain name server services or DNS. What I find sets the company apart from its competitors like Akamai Technologies (AKAM), Fastly (FSLY), and Zscaler (ZS), is its comprehensive suite of services that offer security and other performance services in a single platform, which is very enticing for many customers and gives the company an advantage over the competition.

Financials

As of Q2 '23, the company had around $1.6B in cash and marketable securities, against ~1.3B in long-term debt. It's important to note that $1.4B of liquidity is investments that yield interest income. So, how dangerous is this debt for the company? Well, the company isn't making any operating profit if we look at the GAAP numbers, however, its interest expense is around $7m annually, while it receives around $60m in interest income from the mentioned marketable securities. The company has turned positive in non-GAAP metrics as operating profit ended up being around $20m in the 2nd quarter, up from an operating loss of around $1m in the same quarter a year ago. So, it's not great when the company is still unprofitable, however, the amount of liquidity it has can cover those annual expenses on debt, so I think the company is at no risk of insolvency right now.

The company's current ratio has been very strong over the last few years. I wouldn't mind it coming down slightly to a range of 1.5-2.0 as I view this to be more efficient. This range tells me that the company is not holding on too much to its cash pile and is being proactive in expanding its footprint and furthering the growth of the company. On the other hand, a ratio of around 4 means the company can easily pay off its short-term obligations and have plenty of liquidity for growth initiatives.

In terms of efficiency and profitability, we can see that these are negative because the company is not profitable yet. The big reason the company is not profitable yet and heavily relies on non-GAAP estimates is because of its overreliance on stock-based compensation or SBC. Many companies that are still relatively new in operations, I believe NET IPO'ed at the end of 2019, so to attract top talent when you don't have the money, offer them shares. The problem I have with this is that I don't think the company will stop relying on SBC for a lot longer and will continue to dilute its shareholders via share issuing. The website I use for financials can gather the company's info back to 2018, which shows massive dilution. The good thing about the company's share price is that it is much higher than when it went public (around 310% higher), which means even with such dilution, the shareholders are better off still. Can this continue is another question.

In terms of revenues, I can see why the company would be trading at such a high multiple. The company managed to attain phenomenal CAGR over the last few years. The company is truly a growth company and to continue to justify such multiple, it needs to continue to grow at such elevated growth for much longer, which doesn't look like it is going to happen as analysts are estimating around 30% CAGR for the next three years, which is still respectable, however, nowhere near the past growth numbers of around 50% CAGR.

In terms of margins, the company can achieve stable high levels of gross margins, which is commendable. In terms of GAAP figures, operating and net margins are being affected by the high amounts of SBC as mentioned earlier. If we strip this out, the company's operating profit margin for Q2 '23 was 6.6%, which is up 700bps or 7% y/y according to the transcript. These are substantial improvements, and I will be paying attention to how these margins have developed when the company issues its third-quarter results. I would like to see an acceleration in efficiency and profitability, which may indicate the company will rely less on SBC. We can see from the below image that GAAP margins have also seen a substantial improvement since '18, which is a very positive sign.

Overall, the company is a growth company with lots of unknowns about how it is going to perform going forward. The company is very stable financially, with lots of liquidity on hand, the debt is not worrisome at the minute, and GAAP margins seem to be going in the right direction, however, shareholder dilution and slowing revenue growth may be a problem in the near future.

Comments on outlook

So, the company's been doing quite well in the last couple of years and is benefiting from being in a very in-demand sector, which is the cloud. This helped the company grow tremendously, and when the pandemic hit in '20, the company more than 10x in two years, as many enterprises scrambled to update their infrastructure to accommodate the new way of working, the hybrid working, which right now has become the new standard for many.

On top of these partnerships, the company is positioned well to benefit from the overall strong demand for digitization across the board, with around 17% CAGR projected through '25, and 14% through '30. These are substantial growth numbers and I'm sure a company like Cloudflare is going to be able to capture much higher growth than what is projected on the global scale, due to it being much smaller in size.

The company recently expanded its operations in the Mexican market. This is a good way of expanding its footprint in Latin American countries as these are some of the "largest digital populations in the world". These countries are growing very rapidly when it comes to digitization and any further investment into the region will be beneficial in the long run. The same goes for other regions like India where the company managed to 10x their customer base in two years.

So, there are plenty of opportunities to expand its global footprint and grow at a substantial pace, however, does this mean it can retain that 50% CAGR over the next decade? I am having a hard time believing that and as we saw analysts aren't predicting such growth going forward either, so I have to be on the conservative end when it comes to my valuation below.

Valuation

For revenue growth, I decided to stick with around 26% CAGR for my base case for the next decade. That still feels like a stretch, however, not impossible to achieve. I also have some assumptions for a conservative and an optimistic case. Below are those assumptions.

For margins and EPS, I went with the below assumptions. These assumptions take out the effects of SBC as with them the model will always show the company being unprofitable and that is not a goal for any company to continue to operate in such a way. I assume that in the future the company's reliance on SBC and non-GAAP figures will come down and these figures will be very close to the GAAP metrics.

For the DCF model, I used a 10% discount rate and a 2.5% terminal growth rate. I usually use the company weighted average cost of capital as my discount rate, however, it stood at around 9%, which I think doesn't provide enough margin of safety, therefore I chose 10%.

On top of these estimates, I also decided to play it safer and added another 25% margin of safety just because the company's so young, which means there may be a lot of volatility in the near future until it becomes profitable. With that said, Cloudflare's intrinsic value and what I would be comfortable paying for the company is around $43 a share.

Closing comments

The company's past performance of 50% CAGR definitely deserved a high multiple, however, a FW PE ratio of 153 according to my calculations is rather outlandish if the company isn't going to achieve such numbers going forward. The company is still growing quite rapidly; however, the current PE multiple is not reflecting that yet.

I would like to see the company's margins improve substantially and I want to see the management relying less on non-GAAP figures. The company is a better deal than it was back in November '21, however, if growth initiatives don't show similar growth as before, I would like to see a pullback before jumping in because even at the current price, the risk/reward is not enticing for me.