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Cloudflare (NYSE:NET) Q3 Sales Beat Estimates But Stock Drops 11.8%


Full Report / November 03, 2022
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Internet security and content delivery network Cloudflare (NYSE:NET) beat analyst expectations in Q3 FY2022 quarter, with revenue up 47.2% year on year to $253.8 million. The company expects that next quarter's revenue would be around $274 million, which is the midpoint of the guidance range. That was in roughly line with analyst expectations. Cloudflare made a GAAP loss of $42.5 million, improving on its loss of $107.3 million, in the same quarter last year.

Cloudflare (NET) Q3 FY2022 Highlights:

  • Revenue: $253.8 million vs analyst estimates of $249.8 million (1.6% beat)
  • EPS (non-GAAP): $0.06 vs analyst estimates of $0 ($0.06 beat)
  • Revenue guidance for Q4 2022 is $274 million at the midpoint, roughly in line with what analysts were expecting
  • Free cash flow was negative $4.61 million, compared to negative free cash flow of $4.41 million in previous quarter
  • Gross Margin (GAAP): 75.5%, down from 78.2% same quarter last year

Founded by two grad students of Harvard Business School, Cloudflare (NYSE:NET) is a software as a service platform that helps improve security, reliability and loading times of internet applications and websites.

Cloudflare runs a large network of data centres around the world that serve as storage for their customers' content, shielding it from malicious attacks and delivering it in the fastest way possible.

The power of the product is in its size, used by tens of millions of internet properties, it is so big that it can protect customers even against state-sponsored attacks. And the massive volume of data flowing through the network allows their machine learning algorithms to improve every day.

The amount of content on the internet is exploding, whether it is music, movies and or e-commerce stores. Consumer demand for this content creates network congestion, much like a digital traffic jam which drives demand for specialized content delivery networks (CDN) services that alleviate potential network bottlenecks.

Cloudflare competes in the market for network and content delivery services with companies like AKAMAI (NASDAQ:AKAM) or Fastly (NYSE:FSLY) and partly with cloud cybersecurity and vendors like Zscaler (NASDAQ:ZS).

Sales Growth

As you can see below, Cloudflare's revenue growth has been exceptional over the last two years, growing from quarterly revenue of $114.1 million in Q3 FY2020, to $253.8 million.

Cloudflare Total Revenue

And unsurprisingly, this was another great quarter for Cloudflare with revenue up 47.2% year on year. But the growth did slow down a little compared to last quarter, as Cloudflare increased revenue by $19.3 million in Q3, compared to $22.3 million revenue add in Q2 2022. We'd like to see revenue increase by a greater amount each quarter, but a one-off fluctuation is usually not concerning.

Guidance for the next quarter indicates Cloudflare is expecting revenue to grow 41.5% year on year to $274 million, slowing down from the 53.7% year-over-year increase in revenue the company had recorded in the same quarter last year. Ahead of the earnings results the analysts covering the company were estimating sales to grow 37.2% over the next twelve months.

Profitability

What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. Cloudflare's gross profit margin, an important metric measuring how much money there is left after paying for servers, licenses, technical support and other necessary running expenses was at 75.5% in Q3.

Cloudflare Gross Margin (GAAP)

That means that for every $1 in revenue the company had $0.75 left to spend on developing new products, marketing & sales and the general administrative overhead. Despite it going down over the last year, this is still a good gross margin that allows companies like Cloudflare to fund large investments in product and sales during periods of rapid growth and be profitable when they reach maturity.

Cash Is King

If you follow StockStory for a while, you know that we put an emphasis on cash flow. Why, you ask? We believe that in the end cash is king, as you can't use accounting profits to pay the bills. Cloudflare burned through $4.61 million in Q3.

Cloudflare Free Cash Flow

Cloudflare has burned through $64.7 million in cash over the last twelve months, resulting in a negative 7.24% free cash flow margin. This below average FCF margin is a result of Cloudflare's need to invest in the business to continue penetrating its market.

Key Takeaways from Cloudflare's Q3 Results

Since it has still been burning cash over the last twelve months it is worth keeping an eye on Cloudflare’s balance sheet, but we note that with a market capitalization of $16.3 billion and more than $137.8 million in cash, the company has the capacity to continue to prioritise growth over profitability.

We were impressed by the exceptional revenue growth Cloudflare delivered this quarter. And we were also happy to see it topped analysts’ revenue expectations, even if just narrowly. Overall, this quarter's results seemed pretty positive and shareholders could feel optimistic. But the market was likely expecting more and the company is down 11.8% on the results and currently trades at $44.35 per share.

Is Now The Time?

When considering Cloudflare, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. We think Cloudflare is a good business. We would expect growth rates to moderate from here, but its revenue growth has been exceptional, over the last two years. And while its cash burn raises the question if it can sustainably maintain its growth, the good news is its efficient customer acquisition is better than many similar companies, and its strong gross margins suggest it can operate profitably and sustainably.

Cloudflare's price to sales ratio based on the next twelve months of 13.4x indicates that the market is certainly optimistic about its growth prospects. There is definitely a lot of things to like about Cloudflare and looking at the tech landscape right now, it seems that it doesn't trade at an unreasonable price point.

The Wall St analysts covering the company had a one year price target of $81.7 per share right before these results, implying that they saw upside in buying Cloudflare even in the short term.

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