Cloudflare (NET -1.71%) has come a long way since its late 2019 IPO. When it made its debut as a publicly traded stock, annualized revenue was just shy of $300 million. Just three years later in Q3 of 2022, Cloudflare surpassed $1 billion in annualized sales for the first time.
In spite of this incredible growth, though, shares have languished since the end of 2021. Cloudflare's stock has fallen 80% from its all-time highs, and fell 66% in calendar year 2022.
The bear market still isn't over, and given its enduring hypergrowth expansion in 2022, it seems clear that the market is looking for more than simple revenue growth to solve problems with the stock. Could shares begin to rise again in 2023?
Cloudflare addresses multiple secular growth trends
We're at an interesting crossroads for the tech space. As the early pandemic digital business boom wears off, lots of big tech companies have announced layoffs as they admit they overhired.
That hasn't happened at Cloudflare yet. During the Q3 2022 earnings call, management said total headcount increased 42% year over year to 3,180 employees. Revenue slowed down to "only" 47% growth year over year, and CEO Matthew Prince and the top team now have their sights set on reaching $5 billion in annual revenue within the next five years.
Clearly, Cloudflare is catching on to something big. The core business is centered around internet-based application services. Cloudflare is a CDN (content delivery network), meaning it acts as an internet infrastructure provider for companies hosting websites and apps and moving data around. Built atop that are cybersecurity services that help a company embed security solutions directly into their apps.
More recently, Cloudflare has begun adding more complex data storage and software development tools to create a well-rounded platform that can begin disrupting public cloud giants like Amazon AWS.
In other words, Cloudflare is riding multiple secular growth trends, from cloud computing to cybersecurity. This should be a fast-moving business for the foreseeable future, and Prince and company believe it can achieve its growth goals organically with the computing technology tools it currently offers today.
Recent announcements like an expanded partnership with Palantir to provide cost-effective cloud computing infrastructure flesh out the thesis that Cloudflare can continue growing along with its existing customers.
A first-ever price increase on its basic subscription plan (the Pro Plan will go from $20 a month to $25 a month, and a Business Plan from $200 a month to $250 a month) also just went into effect in January 2023. These monthly subs only account for about 15% of Cloudflare's total revenue (the 85% from large enterprise deals), and the pricing reflects the significant additions in tools and quality of service that has taken place since the company's founding over a decade ago. This should also help with revenue growth in the coming year.
Growth isn't the issue; profitability is
But the market is clearly looking for more than revenue expansion. Indeed, still trading for over 16 times sales at the start of 2023, investors already expect Cloudflare to continue growing revenue at a brisk double-digit percentage in the years ahead.
Like so many other software upstarts, a lack of profitability is the issue with Cloudflare's stock performance. Over the last 12 months, GAAP net losses were $225 million, and free cash flow was -$100 million. The primary difference between the two metrics is stock-based compensation paid to employees.
However, unlike a lot of other software companies that are now scrambling to try and turn a profit and appease shareholders, Cloudflare is still focused on its long-term potential. Sure, it is making progress toward free cash flow breakeven (free cash flow was only -$4.6 million in Q3 2022), but management is sticking to its guns and investing for growth first and foremost.
Free cash flow is expected to be positive for Q4 of 2022, but don't expect Cloudflare to make some grand pivot toward more focus on the bottom line. Even in an environment where new customer acquisition has slowed and big businesses are taking more time before signing a new deal, Cloudflare expects revenue to grow north of 40% to close out 2022. Expect this focus on new enterprise customer onboarding and new product rollouts to continue in 2023.
Will the stock bounce higher in 2023?
Given where Cloudflare is at today, and what the market currently wants to see, I have my doubts this stock will mount a meaningful rally -- at least, not as long as the U.S. Federal Reserve continues to hike interest rates to throttle economic growth and bring inflation down.
If you're looking for a stock to move your portfolio in a big way this new year, Cloudflare may not be the company you're looking for. Instead, focus on companies that are already (or close to) turning a healthy profit.
That being said, for investors taking a longer-term view, Cloudflare is actually in an enviable position right now. It clearly has the right ingredients working in its favor to help it grow at such a rapid pace. Meanwhile, competitors are slashing costs to try and shore up their balance sheets and improve operational efficiency. These are the times when future industry leaders are born.
Perhaps Cloudflare will be in that market leadership position in another decade. Just don't expect that to translate to a quick profit on any investment you make in the business right now. This remains a stock only for those who plan to buy and hold for the ultra-long term.
