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3 Reasons to Buy Cloudflare, and 1 Reason to Sell

Cloudflare (NYSE: NET) stock has produced impressive returns for its investors. Since its September 2019 IPO, it has gained around 420%. However, after its run-up and now, amid a wide tech sector sell-off, investors may want to revisit the question of whether it's a buy.

In my view, the outlook for this cloud company depends on how one weighs the benefits the company offers its clients against one critical headwind for the stock.

Image source: Getty Images.

Reason to buy No. 1: competitive advantages

Cloudflare offers its customers both network security and edge computing solutions. Its customizable firewall protects those clients from distributed denial of service (DDoS) attacks, bots, and other types of threats.

On the edge computing side, it operates data centers in more than 250 cities worldwide. Those include locations in more than 1,000 of the world's most populated office complexes, giving it a competitive advantage in many key locations.

Additionally, it provides simple and affordable plans, a feature that makes it a popular choice for small and medium-sized enterprises, which account for more than 99% of all U.S. businesses, according to the Small Business Administration. While such enterprises lack the resources of large corporations, the massive size of that market segment speaks to its tremendous potential. The company reported more than 132,000 clients as of the end of Q3, only about 1,300 of which it defined as "large customers."

Reason to buy No. 2: Cloudflare's support of the metaverse

Admittedly, Cloudflare is not a "metaverse stock" in a technical sense. Nonetheless, it will likely play a significant role in supporting its growth.

Cloudflare's network can reach 95% of the world's population in 50 milliseconds or less. As such, its software-defined network (SDN) model can better support metaverse applications than pricier hardware solutions. Moreover, the company's Zero Trust security can protect networks and support applications such as NFTs or distributed ledgers, bolstering the metaverse through a decentralized and private web.

Finally, the value of the metaverse market is expected to grow at a compound annual rate of 43% between 2021 and 2028, according to Emergen Research. According to that forecast, the market's size, which was $47.7 billion in 2020, will reach nearly $829 billion by 2028. Thanks to Cloudflare's supporting role, it could claim a significant portion of this rapidly expanding niche.

Reason to buy No. 3: massive revenue growth

Credit Cloudflare's functionality for contributing to its 52% year-over-year revenue growth in the first nine months of 2021, to reach $463 million. In comparison, operating expenses grew by 41% during the same period.

Nonetheless, interest expenses rose from $15 million to $33 million during that time frame, and the company added $72 million in debt extinguishment losses, which wiped out a before-tax profit. Due to a $191 million income tax expense during the first nine months of 2021, losses for that period amounted to $183 million, up from $85 million during the prior-year period.

However, its forecasted 2021 revenue of $648 million would amount to a 50% year-over-year increase, and analysts predict a 37% revenue increase in 2022. While that would technically mean a slowdown in growth, Cloudfare's growth will likely remain robust for some time to come.

The reason to sell: valuation

Despite all of these positive attributes, the answer to the question of whether Cloudflare stock is a buy now may hinge on valuation. Its stock price has fallen by more than 55% since November. Still, its price-to-sales ratio stands at 49. That makes it more expensive than cybersecurity companies like Zscaler, with its price-to-sales ratio of 45, or edge computing players such as Fastly, which has a ratio of 10.

Additionally, that sales multiple prices Cloudflare for perfection, a standard the company seems unprepared to meet. With earnings growing at a robust but slowing rate, investors may begin to question whether they want to pay close to 50 times sales. Furthermore, growth tech stocks have experienced a broad sell-off since November, making investors more likely to question higher valuation multiples.

Is Cloudflare a buy now?

Many investors will avoid Cloudflare stock for now due to its still-high valuation. But with its security features, edge computing capabilities, and metaverse applications, the company's robust top-line growth should continue, perhaps just not quickly enough to justify its current sales multiple, especially in today's trading environment. Though its shareholders may prosper in the long run, I wouldn't be surprised if the stock fell further in the near term.

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Will Healy has no position in any of the stocks mentioned. The Motley Fool owns and recommends Cloudflare, Inc., Fastly, and Zscaler. The Motley Fool has a disclosure policy.


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