Cloudflare Inc: Struggling but With Great Opportunities

Cloudflare, Inc. NYSE: NET, like most IT stocks, has been hit hard by a number of macroeconomic challenges. These challenges include a hike in interest rates, soaring inflation, slowing global growth, and other headwinds. But the story doesn't just end here with Cloudflare. The company has also yet to turn a dollar of free cash flow for investors despite trading at a P/S ratio of 28.77. 

Cloudflare's problem, which mirrors that of its peers, is that tech stocks offer investors the chance of high and largely speculative returns in the future. This proposition falls apart when investors severely reduce their risk appetites. Tech stocks soared above their logical valuations post-stimulus and have since returned to Earth again. Cloudflare experienced a -47.38% loss YTD and is currently trading at 52.71% below the MarketBeat consensus price target. Meanwhile, investors are moving their money into more defensive investments such as gold and mature companies that have a proven earnings record.

Cloudflare’s Positive Fundamentals

Despite the extreme fear in the marketplace, Cloudflare has a lot of positives going for it. The company reported revenues of $212 million, which represents a 53% YoY gain. Cloudflare also upgraded its guidance for FY2022 from $929 million to $957 million in revenue. The quality of the company's earnings should also be taken into consideration, with the majority of it recurring either month-to-month or quarter-to-quarter. Cloudflare's annual recurring revenue (ARR) is strong, with over 1,537 clients on its books that pay the company $100,000 or more per year. This number of clients is increasing at a rate of 63% YoY. There are also a number of blue-chip clients on the company's books that pay the company between $500,000 and $5 million dollars per year for its services, with the $1 million dollar customer segment growing at 72% YoY.

Cloudflare’s Weakness Is Its Lack of Profitability

When moving down to examine Cloudflare’s margins we can see where the problem is. The company's non-GAAP gross margin was 80% for Q1 this year, which is a very positive sign, but GAAP profits continue to be in the negative, with the company recording a $261.73 million dollar loss in FY2021. The cause of the company's losses primarily comes from stock-based compensation, which reached a new peak of $34 million in Q1 of this year. The rationale behind the company operating at a loss was explained during the Q1 earnings call with Mathew Prince, Cloudflare's CEO. Prince said that Cloudflare is following a strategy of reinvesting all funds back into its business for future growth and therefore a negative EPS is to be expected. If the company had a significantly higher EPS than it has now, he said, this would be a cause for concern due to a lack of reinvestment in the company’s future.

Cloudflare Has Great Opportunities Ahead of It

Cloudflare is establishing itself not just as a cloud service provider but as a vanguard of the internet itself. The firm's free 1.1.1.1 DNS service app became one of the most downloaded applications in Russian app stores after the Kremlin put down heavy-handed censorship tactics following the Russian invasion of Ukraine. In the Q1 earnings call this year, Mathew Prince said that the business sees a "big opportunity" in continued cooperation with the federal government of the United States. These comments were made when Cloudflare and a number of other cyber security companies were consulted on the Critical Infrastructure Protection Act. The act seeks to protect the digital assets of the US government against retaliatory attacks in response to the sanctions placed on Russia.

Cloudflare’s Technicals Are Struggling to Hold On

Since tech stocks continue to be sold off, the technicals for Cloudflare don’t look too pretty. The stock recently became oversold on the Stochastics and has experienced significant downside momentum since April 14 this year. Cloudflare is trading well below its mean price and bounced off one of the lower Bollinger Bands to give bulls a break. Its steep sell-off is a sign that the downside momentum will persist for a while longer before likely consolidating sideways at lower levels on the daily charts.