AI Potentially Transforms Business Operations, Raising Question over Stock Purchase Timing for This Enterprise. Is Investment Wise at Present?
Cloudflare (representing around 0.33% of NET) oversees the world's top Content Delivery Network (CDN) – a distributed cloud system that deploys servers closer to end-users, enhancing data transfer speed, security, and reliability for its clients and their customers. With servers in 330 locations worldwide, its estimated market share surpasses 42%.
Given its dominant position, Cloudflare stands to capitalize on a rapidly growing market. According to technology consulting firm SkyQuest, the CDN sector might witness an annual growth rate of nearly 22% from 2023 to 2031, potentially generating $94 billion in revenue by the end of the forecast period, up from about $19 billion in 2022.
Cloudflare has been consistently growing. The Q3 results it reported on November 7 showcased strong revenue and earnings growth. More importantly, it's venturing into a lucrative sector – cloud-based artificial intelligence (AI) services. This move could prove beneficial in the long run.
A vast potential market
Cloudflare reported a 28% year-over-year increase in revenue to $430 million in Q3, while non-GAAP earnings climbed by 25%. The revenue figure surpassed the Wall Street consensus expectation of $424 million.
However, management projected $451.5 million in revenue for the current quarter (at the midpoint of its guidance range), along with $0.18 per share in earnings. Analysts had been anticipating $0.17 per share in earnings on revenue of $455.7 million. This less-than-impressive guidance might explain why Cloudflare's stock dropped by more than 4% following the report's release.
Despite the less-than-impressive guidance, Cloudflare raised its full-year forecast. It now projects 2024 revenue at $1.661 billion (up from the earlier estimate of $1.658 billion). The earnings estimate was also revised to $0.74 per share (from a range of $0.70 to $0.71 per share). This updated forecast implies a revenue growth of 28% and robust bottom-line growth of 51%.
Still, traders opted for selling, possibly due to Cloudflare management's assertion that its customers remain cautious about spending. As CEO Matthew Prince mentioned on the earnings call:
"In Q3, the IT spending environment remained consistent with prior quarters, with customers scrutinizing every deal while emphasizing cost efficiency and seeking meaningful ROI. This cautious approach isn't new; it's something we understand, and as a must-have, not a nice-to-have, we benefit relative to some of our peers."
Yet, Cloudflare managed impressive growth despite the challenging environment. Moreover, it expanded its customer base and continues to secure a larger share of its customers' wallets. Cloudflare's paying customer base increased by 22% year-over-year last quarter to over 221,500. Plus, the number of customers generating more than $100,000 in annualized revenue for the company experienced nearly a 28% increase.
Moreover, existing customers increased their spending: Cloudflare's dollar-based net retention rate was 110%. This metric considers the annualized revenue from its customers in the latest quarter compared to the annualized revenue from the same customer cohort in the year-ago period. Evidently, established customers are purchasing additional products or extending their usage of the platform.
Cloudflare estimates that its total addressable market could expand from $176 billion this year to $222 billion in 2027, chiefly driven by incremental growth opportunities in areas such as AI. This explains why the company has been investing in AI-specific hardware like high-end graphics processing units (GPUs) to power its AI offerings.
In September 2023, Cloudflare unveiled an AI-specific suite of products, including Workers AI, a platform that enables customers to run AI models on Cloudflare's network, powered by GPUs from providers like Nvidia. Workers AI has already gained traction among users – Cloudflare has secured multiple deals in the millions for it.
It's probable that Cloudflare's cloud-based AI services will gain more traction as it makes its AI-related offerings accessible across nearly all of the cities it serves. It was already available in 150 cities as of April this year and is well on its way to its goal of deploying AI GPUs in 300 cities by the end of 2024.
Of course, Cloudflare has been augmenting its capital expenses as it acquires and deploys those GPUs.
This move could prove advantageous from a long-term perspective, as Mordor Intelligence projects that the size of the cloud-based AI services market will grow at an annual rate of 32% through 2029 to $274 billion. Furthermore, Cloudflare already has a large customer base to whom it can market its AI-focused offerings. As a result, it's unlikely that Cloudflare's growth will decelerate in the long run due to AI.
The valuation is steep, but there's a silver lining
Though Cloudflare has been reporting healthy growth, it currently trades at an expensive 19 times sales. This valuation is significantly higher than the S&P 500 index's price-to-sales ratio of just over 3. Similarly, Cloudflare's forward earnings multiple of 107 is also high compared to the S&P 500 index's forward earnings multiple of 24.6.
Investors on the hunt for tech stocks that won't break the bank might consider alternative strategies to profit from the AI surge. But for those with an appetite for growth, it's worth considering Cloudflare. Its revenue obligations for the future, known as RPO, are expanding at an impressive rate. In fact, during Q3, it saw a 39% increase compared to the previous year, far surpassing its revenue growth.
Given that RPO represents the worth of a firm's contracts yet to be fulfilled, this remarkable growth hints at a potential future surge in Cloudflare's revenue. This makes Cloudflare an appealing option for risk-takers, as its foray into AI appears to be unlocking a substantial long-term growth potential that could propel its stock skyward.
In light of Cloudflare's strong growth and venture into cloud-based AI services, potential investors might consider the company as an opportunity for substantial returns. With a rapidly growing market for AI services, projected to generate $94 billion in revenue by 2031, Cloudflare's investment in AI-specific hardware and services could yield significant returns.
Given Cloudflare's dominant position in the Content Delivery Network (CDN) sector and its increasingly large customer base, investing in the company could be a strategic move for those seeking to capitalize on the finance opportunities in this rapidly evolving technology market.
