Cloudflare (NYSE:NET) saw its stock tick higher on Friday in spite of generally brutal trading action across the tech sector. The company reported strong results and appears to be a potential winner from the Crowdstrike (CRWD) fiasco. NET maintains a net cash balance sheet and is generating positive free cash flow. The business continues to post remarkable top-line growth rates, but given relative valuations seen at tech peers, I am no longer of the view that the stock presents compelling value. I am downgrading the stock to a neutral rating in light of better opportunities elsewhere.
NET Stock Price
I last covered NET in May where I explained why I was upgrading the stock to a buy amidst the ongoing volatility. The stock has outperformed the broader market by around 17% since then.
That relative outperformance has created an attractive exit opportunity, as the stock was already trading near the high end of my fair value range prior to the rally.
NET Stock Key Metrics
NET is an enterprise tech platform which is best known for its content delivery network, upon which it helps enable a faster and more secure internet.
In the latest quarter, the company generated 30% revenue growth to $401 million, surpassing guidance for up to $394.5 million. Non-GAAP operating income of $57 million crushed guidance for $36 million.
The company has continued posting strong customer growth, which is impressive given the current environment in which most tech peers have struggled with increased IT scrutiny. This is a testament to the notion that NET benefits from being “not just any” tech stock, but one offering services of greater importance.
NET saw its dollar-based net retention rate compress to 112%, indicative of the aforementioned IT scrutiny but still representing a strong rate relative to peers.
NET ended the quarter with $1.76 billion of cash versus $1.3 billion of debt, representing a strong net cash balance sheet. I note that the company’s convertible notes will be maturing over the next one to two years, which may imply an uptick in interest expenses if the company chooses to refinance them (which I find likely).
Looking ahead, management expects the third quarter to see 26% YoY growth to up to $424 million in revenue. Management raised full-year guidance ever-so-slightly to $1.659 billion (up from the prior target of $1.652 billion). In this environment, even maintaining full-year guidance is an achievement.
On the conference call, management credited their strong performance as being due to both their product being a “must-have, not a nice to have” as well as their investments in their sales team. Management noted that they saw “another double-digit year-over-year improvement in sales productivity.” It was only about one year ago in which management undertook efforts to restructure their sales organization – their quick progress is a testament to this management team’s historically high level of execution. Management even noted that “close rates and sales cycles” both improved on a QoQ and YoY basis, a datapoint which suggests the company might not be facing the tough macro in the same way as its tech peers. Management noted that while they do not offer directly competing services as CRWD, that this incident may prove to be a long term tailwind due to customers becoming of the view that they can not be “sole-sourced on any one vendor.” The implication is that whereas in the past it can be difficult to convince customers to “rip and replace,” now they have an easier entrance for the first purchase. It remains to be seen if this reasoning proves to be the case, but NET’s financial results certainly are showing some separation from the pack.
Is NET Stock A Buy, Sell, or Hold?
It may surprise readers to know that in spite of NET’s strong financial results, I am downgrading the stock. This is in large part due to valuation, as the stock recently traded hands at 16.3x this year’s sales estimates.
Management has guided for at least 20% non-GAAP operating margins over the long term, driven largely by improvements to sales & marketing.
The stock looks richly valued even if I assume 30% long term GAAP net margins. 10x sales would imply a 33x earnings multiple based on that assumption and looks like a reasonable valuation assumption as growth matures. If we assume that NET can meet consensus estimates through 2028, the stock is currently trading at around 6x sales. That implies roughly 13% annual upside potential over the next 4 years. I am not of the view that this potential return is sufficient enough to justify the risks of active investing, for starters, consensus estimates look rather aggressive as they factor essentially no deceleration in top-line growth rates. NET has historically managed to sustain elevated growth rates in large part due to its product-driven growth model. The problem is that this kind of playbook inherently has limitations especially in the software space where developing “hit” products is not so trivial (compare this with e-commerce giant Amazon (AMZN) simply building out the same infrastructure). As I stated in my last report (which had a bullish rating), there I saw around 15.5% annual return potential at that time and noted that it was at the “lower end of my targeted hurdle rate for a stock of this risk profile.” With NET not yet GAAP profitable (as well as the just-discussed skepticism of forward estimates), I am not prepared to continue supporting this name with just 13% return potential.
NET Stock Conclusion
NET is seemingly one of the few software names to be showing financial resilience amidst numerous headwinds from higher interest rates, generative AI, and even potential recession. That said, even the highest quality companies can make for unattractive stocks if the valuation is too high. NET stock finds itself trading just a tad higher than the high end of my fair value range, and I am not of the view that it is offering enough return potential to justify the risks. I note that many other software names have been beaten down and many are even trading right around the same levels seen at the depths of the 2022 crash in tech stocks. This is not an environment in which one needs to pay up so generously for slightly higher quality. I am downgrading the stock to a neutral rating.
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