CloudFlare, Inc. operates as a cloud services provider that delivers a range of services to businesses worldwide. The company offers an integrated cloud-based security solution to secure a range of combination of platforms, including public cloud, private cloud, on-premise, software-as-a-service applications, and IoT devices. Its security products comprise cloud firewall, bot management, distributed denial of service, IoT, SSL/TLS, secure origin connection, and rate limiting products. The company also offers performance solutions, which include content delivery and intelligent routing, as well as content, mobile, and image optimization solutions. In addition, it provides reliability solutions comprising load balancing, anycast network, virtual backbone, DNS, DNS resolver, online, and virtual waiting room solutions. Further, the company offers Cloudflare internal infrastructure solutions, including on-ramps, which connect users, devices, or locations to its network; and filters, which are the products that protect, inspect, and privilege data. Additionally, it provides developer-based solutions, such as serverless computing/programmable network, website development, domain registration, Cloudflare apps, analytics, and data localization management; Consumer DNS Resolver, a consumer app to browse the Internet; and Consumer VPN for consumers to secure and accelerate traffic on mobile devices. The company serves customers in the technology, healthcare, financial services, consumer and retail, and non-profit industries, as well as government. CloudFlare, Inc. was incorporated in 2009 and is headquartered in San Francisco, California. The company is publicly listed on NYSE under the ticker “NET”.
Our considerations
Cloudflare an IT company uniquely positioned to benefit from the catalyzed growth in the zero trust security market. From a technical perspective, Cloudflare is a content delivery network (CDN), which means that it makes data available at fast speed, while at the same time protecting who can access it. Cloudflare has infrastructure located in over 250 cities across over 100 countries, and without them fast internet wouldn’t be much but a dream. Therefore, as more and more data is uploaded to the internet, this company benefits directly. This factor, in addition to the cult-like following that it developed on Internet during the early 2021, easily explains the insanely high valuation it reached. Indeed, even though it already corrected more than 60%, the company still has a P/S ratio of 55, a P/B ratio of 43 and a forward P/E of 1,118: by all conventional metrics, this company is severely overvalued and could easily be considered already in bubble territory.
Although the company is not yet profitable, it has all the characteristics to become a powerful cybersecurity player. Indeed, the adoption of Zero Trust security, a network protection model that requires authentication for every access, is currently being catalyzed from several strong forces, the main one being the surge in cyberattacks. According to a report by SonicWall, ransomware attacks have increased 151% since 2020, affecting 37% of all industries: Zero Trust environments pose as a solution to this problem, as they inspect all traffic moving throughout the network, which makes malicious code execution considerably more difficult for cyber criminals. Furthermore, considering that more employees than ever are working from home in potentially unsecured environments on unmanaged devices, companies are every day more incentivized to adopt appropriate security measures. Generally speaking, the market for Zero Trust solutions is growing fast: according to Grand View Research Inc., the Zero Trust security market will grow at a CAGR of 15.2%, reaching a $59.43 billion valuation by 2028.
Financially speaking, since 2016 Cloudflare increased its revenues with an average CAGR of 51% and, if the management’s guidance will be proven right, it could show positive earnings within two years. While the negative earnings should worry most investors under times of uncertainty such as the current one, most of the companies in Cloudflare’s industry are still unprofitable, so it’s hardly shocking. The revenue growth the company experienced is beyond impressive, and was the result of two factors: the large customer growth, and the strong retention rate.
Indeed, as we can see from the chart above, there is an increasing traction among large customers, as they grew by an average CAGR of 69% over the last few years and contributed to total revenues by increasing margins. On the other hand, the dollar-based net retention rate proved to be extremely strong, and is likely to remain so thanks to the secular growth tailwinds of the internet. As we can see from the chart below, at the end of 2021 the dollar-based net retention rate was 125%.
Furthermore, in 2021 almost half of the revenue came from outside the United States: it’s easy to understand why, then, the company wants to further penetrate those markets. While the earnings are still negative, gross margin has been fairly stable around 78%, allowing the company to expand internationally without entering a debt spiral.
On the competitive side of things, one stated advantage Cloudflare has over other vendors is the sheer number of applications it can support. Furthermore, since the majority of applications can run on one network, these can be controlled through a centralized control panel to help speed up deployment, also making the maintenance and access control of these assets easier. Cloudflare also powers one of the fastest networks on the planet and claims to be able to reach 95% of the world’s population in under 50ms. Moreover, thanks to its shared intelligence, the company is able to identify cybersecurity threats before they can cause damage to clients on its network. In addition, Cloudflare has a strong brand presence. While the competitive advantage is enormous, there are many alternatives customers have when choosing a cloud, zero trust, and security product to meet their needs, and the differentiation between vendors is pretty low: the management will have to play all its cards perfectly in order to maintain the currently strong competitive position.
In conclusion, the company is set to fully leverage the increasing demand for cybersecurity solutions and internet growth. However, the market valuation is extremely high, and we cannot in good faith recommend buying this stock, when there are so many other quality names in the tech sector trading at healthier multiples. Honestly, at these levels, anyone who buys has higher chances of not making money than it has of outperforming or even trailing the market.
Business
Cloudflare generate revenues primarily from sales to its customers of subscriptions to access Cloudflare’s network and products. The offerings include a variety of free and paid options depending on the required features and functionality. The company recognizes two kinds of customers: pay-as-you-go customers, and contracted customers.
- For pay-as-you-go customers, Cloudflare offers the ability to purchase its products through its website. These offerings are available in several configurations. For customers securing and accelerating their Internet properties using the company’s external-facing infrastructure product, Pro and Business subcription plans are offered through Cloudflare’s website per registrered domain, and it is common for customers to purchase subscription to cover multiple Internet properties. The Pro plat provides basic functionality to improve the security, performance and reliability of applications, such as enhanced web application firewall and image and mobile optimization. The Business plan includes additional functionality often required by larger organizations, including service level agreements of up to 100% uptime, dynamic content acceleration and enhanced customer support. The implementation period for pay-as-you-go customers is extremely short with most customers implementing Cloudflare’s services within a matter of minutes. These customers can subscribe to more than one solution and purchase add-on products and network functionality offered to meet their more advanced need. These customers typically pay monthly with a credit card.
- Cloudflare’s contracted customers, which consist of customers that enter into contracts for the company’s Enterprise subscription plan, have contracts that range from one to three years and are typically billed on a monthly basis. These customers sales cycle typically lasts less than one quarter. Enterprise subscription plan agreements, which is tailored and priced to meet their varying needs and requirements, generally include a base subscription and a smaller portion based on usage.
Furthermore, some solutions are offered for free. Indeed, free customers are an important part of Cloudflare’s business, as they are typically individual developers, early stage startups, hobbyists and other users, that create scale, serve as efficient brand marketing and help the company attract developers, customers and potential employees. These free customers expose the company to diverse traffic, threats and problems, often allowing it to see potential security, performance and reliability issues at the earliest stage. This knowledge allows Cloudflare to improve its products and deliver more effective solutions to its paying customers.
Competitors
Clouflare competes in the market for network services primarily across three categories:
- On-premise network hardware vendors, such as Cisco Systems Inc., F5 Networks Inc., Check Point Software technologies Ltd., FireEye Inc., Imperva Inc., Palo Alto Networks Inc., Riverbed Technology Inc., and Broadcom Inc. Cloudflare competes with these companies to provide security, performance and reliability services. However, the company is positioned favorably against these vendors with its cloud-based, multitenant approach that is better suited to an increasingly cloud-based world and that allows customers to treat its services as operational, as opposed to capital costs.
- Point-cloud solution vendors in various categories including cloud security vendors (such as Zscaler Inc. and Cisco Systems Inc. through Umbrella, formerly known as OpenDNS, and Menlo Security Inc.), CDN vendors (such as Akamai Technologies Inc., Limelight Networks Inc., Fastly Inc. and Verizon Communications Inc. through Edgecast), DNS services vendors (such as Oracle Corporation through DYN, Neustar Inc. and UltraDNS Corporation), and cloud SD-WAN vendors. These providers are all focused on providing point-cloud solutions. However, customers are increasingly looking for an integrated infrastructure platform offering security, performance, and reliability through a single vendor.
- A subset of services provided by traditional public cloud vendors such as Amazon.com Inc. through AWS, Alphabet Inc. through Google Cloud Platform, Microsoft Corporation through Azure and Alibaba Group Holding Limited through Alibaba Cloud. However, Cloudflare do not sell user data, making it stand compared to the other data-intensive business models.
The principal competitive factors in the markets in which Cloudflare operates include:
- Breadth of network and product features and continued innovation;
- Integrated solutions across security, performance and reliability;
- Unified control plan across on-premise, cloud, hybrid and SaaS infrastructure;
- Performance, availability and effectiveness;
- Network scalability;
- Total cost of ownership;
- Ease of adoption and use;
- Global network coverage;
- Quality of customer support;
- Programmability and extensibility of platform;
- Independence, reputation and trust.
- Based on these principal competitive factors, Cloudflare appears to be well positioned against its competitors.
Our valuation
We evaluated the company using our discounted cash flow model. The model relies on the past 6 years worth of financial statements data in order to estimate the future growth of the company. Each company is valuated in a slightly different way, and in this specific case we estimated the future free cash flows for the next 10 years by estimating line by line each of the three main financial statements.
We made some assumptions in order to valuate the company:
- The terminal growth rate is 5.00%;
- The total shares outstanding are 324.08 millions;
- The effective tax rate will be constant at the standard U.S. corporate tax rate of 21.00%;
- The United States 10-year treasury bond yield will reach 3.00% by the end of 2022;
- The risk premium is 8.00%;
We used those assumptions to model the weighted average cost of capital, which resulted equal to 10.50%, and to estimate the future revenue growth and free cash flows. We estimated a fair value of $34.69, meaning that according to our valuation there is a possible downside in the stock price of 69.45%. Therefore, we give the company a “strong sell” rating. A lot of factors could influence the valuation, including but not limited to economic policies, markets development and real economic growth: therefore, we will update this valuation at the start of the next quarter.
