Betting on a Rebound in Growth Stocks? Cloudflare Should Be on Your List

• NET has dropped 80% from November 2021 highs amid a rout in growth names
• Yet neither underlying performance nor the long-term outlook seems to have changed
• Valuation remains a question mark, but NET looks cheap enough for growth investors

Since hitting its all-time high in November of last year, Cloudflare (NYSE:NET) has declined just shy of 80%. Looking solely at Cloudflare itself, it’s difficult to see precisely why.

After all, the company’s performance over the past four quarters seems rather strong. Year-to-date revenue has increased 51% year-over-year. Cloudflare has topped Wall Street consensus in each of this year’s three quarters; it beat on revenue in the fourth quarter of 2021.

The core driver of the decline seems to be that the broad market has been spooked. Dearly-valued, high-growth stocks of all kinds have been pummeled since last year. NET, which traded above 70x forward revenue at its peak, unsurprisingly has not been spared.

In that context, it’s tempting to see NET as a compelling long-term opportunity. After all, the story here is a little different, if at all, from what it was 13 months ago.

That said, risks still lurk. Valuation remains a concern, and there are modest signs of weakness in recent results. Aggressive growth investors can still take the long view here, but there’s still some reason for patience for the rest of us.

The Story Sounds The Same

The simple argument for NET here is that the long-term case hasn’t changed. Cybersecurity remains paramount and a key focus for IT spending budgets at customers. It’s simply not an area that companies can afford to skimp on.

Cloudflare’s steady penetration of higher-spending customers continues apace. The company began focusing mainly on smaller developers and do-it-yourselfers; over half of revenue now comes from enterprise clients who spend at least $100,000 annually.

And the company still seems to be outpacing its competition. Zscaler (NASDAQ:ZS) is keeping pace in terms of revenue, but Cloudflare (NYSE:NET) is taking market share from CDN (content delivery network) peers like Akamai Technologies (NASDAQ:AKAM) and Fastly (NYSE:FSLY).

These core pillars of growth were what got investors excited last year. They all seem fully intact right now, yet Cloudflare is worth barely one-fifth of what it was last November.

The Valuation Problem

However, the one significant catch with this argument is that Cloudflare isn't cheap even after the big decline. Based on guidance for 2022, the company still is valued at about 16x revenue. Year-to-date adjusted operating profit is modestly positive, but that figure excludes significant stock-based compensation, which has totaled 22% of revenue.

This problem is hardly unique to NET, but it’s a problem nonetheless. After all, even near the year’s lows, Cloudflare still has a market capitalization of $16 billion. It’s still years from making a consistent profit when accounting for share issuance to employees. Yes, the company is growing quickly, but even at this level, the market is pricing in literally decades of growth ahead.

Earnings and The Long-Term Case

The third quarter report in early November highlighted that issue. The results for Q3 topped analyst expectations, and the outlook for Q4 was in line. The NET stock fell 18% the following day anyway.

Shares recovered those losses later in the month as growth stocks posted a brief, sharp rally. But a recent pullback leaves NET again, threatening the post-earnings price.

Higher interest rates or a weaker market doesn’t drive that trading. At 16x revenue, there’s little room for error or even in-line guidance in any market. NET is cheaper — but it isn’t cheap. Investors still are paying up for the long-term potential here.

Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.