Cloudflare Is Flaring Up After Post-Earnings Overreaction

As Cloudflare, Inc. NYSE: NET found out, when you operate in a high-growth market like cloud services, a slowdown can be viewed as a thunderstorm. 

From 2017 through 2022, the cloud infrastructure provider grew revenue at a 48% annualized rate. So when it posted 37% top-line growth for the first quarter of 2023, investors panicked. Cloudflare’s stock price dropped 21% on April 28th en route to a crushing five-day slide. The 33.1 million shares traded that day were the most since the company’s September 2019 IPO.

Was the selloff overdone? It appears so.

Since dipping below $40.00, Cloudflare has rebounded 24%. Several technical indicators — RSI, Bollinger Bands and MACD in particular — pointed to oversold conditions. But there’s more to the story.

Once the market got its head out of the clouds, it seemed to realize three things: 1) the Q1 report wasn’t that bad, 2) Cloudflare’s long-run growth prospects are still solid, and 3) its share price was too low. 

What Did Cloudflare Report in 1Q23?

On April 27th, Cloudflare announced that first-quarter revenue increased 37% to $290 million, which was roughly in line with the Street. However, this marked a significant slowdown from the 54% growth recorded in the first quarter of 2022. Adjusted earnings per share (EPS) of $0.08 beat consensus expectation by a nickel — and compared favorably to 1Q22’s EPS of $0.01 — but it mattered little. 

On top of the slowing growth, the company’s outlook spooked investors. Management lowered its full-year revenue guidance by $54 million to imply that growth will be 32% rather than 37%, as previously forecast. It cited “macroeconomic uncertainty” as the reason behind the downgrade.  

What the market ignored was Cloudflare’s upwardly revised profit forecast. The full-year EPS range was bumped up to $0.34 to $0.35. Reducing the sales forecast but raising the earnings forecast could be perceived as a positive. It suggests that costs are being well managed and that cross-selling efforts to existing customers are proving effective. 

What Are Cloudflare’s Growth Drivers?

The company’s cloud network services help websites and apps run faster and protect them from operational threats. Customers whose internet sites run on Cloudflare see all their web traffic routed through a smart global network. The benefit is that customers don’t have to continually manage their own hardware and install new software. This translates to cost savings.

Demand for Cloudflare services is rooted in the global shift from on-premise networking to cloud computing environments. Technology that keeps apps secure and running smoothly is a critical investment for businesses across many industries. Retailers and restaurants, for example, must have reliable digital sales channels to survive in the modern economy.

Despite the weak macro environment, Cloudflare continues to add high-value enterprise clients. The pace of these additions has slowed but big fish coming on board is a positive. It shows that there is a growing need for cloud infrastructure and that Cloudflare’s offerings appeal to larger businesses with deeper pockets. 

Cloudflare’s competitive positioning in global cloud services is encouraging. It operates in a market that, even with tech spending cuts and delays, is forecast to generate $146 billion in revenue this year. Cloudflare’s revised guidance implies that it will capture less than 1% of the market. This, too, is a positive because it means it has only scratched the surface.  The company has a ton of room to expand by enhancing its platform and entering new industries and geographies.

Are Cloudflare Shares Undervalued?

As interest rates have risen, investors have grown weary of low or no-profit tech companies because of the impact of higher rates on their stock valuations. In turn, Cloudflare has seen its share price plummet nearly 80% from its November 2021 peak. 

This suggests that the stock is way undervalued, but it's not the case. Since the relative newcomer’s profits are low, its valuation is still sky-high. Cloudflare is trading at 143x this year’s EPS estimate, which is well above the IT services average. To want to own the stock, investors have to look past the valuation and see the long-term opportunity to grow into the massive cloud services market. 

Cloudflare has a speculative element to it as well. Given the company’s strong customer base and depressed share price, it may be an attractive takeover candidate for a larger tech player looking to expand into cloud networking. 

From a fundamental perspective, though, analysts think the stock has limited upside. The consensus price target of around $53 implies just a 7% return, although some say the stock could go much higher. Earlier this month, Credit Suisse set a $75 target which would be a 50% gain from here. 

Whether Cloudflare’s sharp rebound sticks remains to be seen. What is known is that its five to ten-year growth potential is atmospheric.