Cloudflare (NET)
With the mission of helping build a better internet, Cloudflare (NET) is poised to be a significant player in the infrastructure for tomorrow’s internet. Founded in 2009, Cloudflare is headquartered in San Francisco, CA. The company made an initial public offering on the NYSE in September 2019.
Core Business
Cloudflare operates in the cloud infrastructure space, focusing on security, performance, and reliability.
A cloud delivery network, or CDN, is a mesh of edge servers, caching application data for last-mile delivery to end users. Instead of hitting the main servers, requests resolve at an edge server in proximity to the end client, resulting in faster response times. While this concept is not new, Cloudflare has significantly simplified the implementation as well as expanding on the idea to add significant value.
Cloudflare has data centers spanning the globe. Cloudflare’s CDN sits on top of any existing web application, implemented through a simple network configuration change. All requests for that service will hit Cloudflare first. The requests are either resolved instantly on the edge server or passed on to the application’s server in the case of dynamic requests.
Extending into security, Cloudflare’s frontline platform acts as a gatekeeper, providing access rules to allow or block traffic. Cloudflare provides protection against common attacks such as distributed denial of service attacks (DDoS) and cross-site scripting (XSS), amongst others.
Cloudflare provides comprehensive performance and security coverage for the entire web application. Legacy solutions are piecemeal and may require time-consuming changes to the application code and infrastructure configuration for implementation.
Management, Team, & Culture
Co-founder Matthew Prince serves as Cloudflare’s Chairman and CEO. Prior to Cloudflare, he co-founded Unspam Technologies, “a software and services company helping governments implement and enforce effective laws to control unwanted messages.” Matthew Prince holds an M.B.A from Harvard Business School (2007–2009) and J.D. from the University of Chicago Law School (1997–2000).
Co-founder Michelle Zatyln serves as Cloudfare’s COO. Prior to Cloudflare, she launched two startups of her own and mostly recently worked at Google as an MBA intern. Michelle holds an M.B.A. from Harvard Business School (2007–2009).
The Cloudflare team continues to grow quickly. As of March 31st, 2020, Cloudflare had 1,368 employees, compared to 960 a year earlier.
While not the scoring the highest marks for word of mouth recommendations, Cloudflare boasts a strong CEO approval rating on Glassdoor. Employees have many positive comments, particularly emphasizing the strong, mission-driven team. Some of the cons seem to be rooted in the company’s rapid growth.
Cloudflare’s mission is to help build a better internet. The company is consistent and persistent in their narrative, leading with their mission in press releases, quarterly and annual reports, investor presentations, and even in their ticker, NET. Their mission fuels the innovation and creativity to create an integrated cloud platform focused on security, performance, and reliability.
Opportunity
Cloudflare’s core platform opens up many growth opportunities.
It is estimated that Cloudflare is the first point of contact for over 10% of the internet, enabling Cloudflare to benefit from important network effects. Any additional customer brings more traffic, providing additional signals. Those signals can be used to increase the value of existing services. Consider website A and website B, both of which are on Cloudflare’s network. A bad actor attempting an attack on website A will be blacklisted on website B. Cloudflare refers to their competitive advantage with this data as “Shared Intelligence.”
Cloudflare continues to innovate on top of their existing platform. Extending into more granular access management, Cloudflare announced Cloudflare for Teams in January 2020. This offering is a next-gen solution for virtual private networks, or VPNs. Instead of tunneling traffic through a particular server, Cloudflare can gate general internet access to protected internal applications allowing employees flexible and easy access while maintaining security. Considered critical infrastructure for enabling employees to work from home, Cloudflare made the offering free for small businesses in response to the coronavirus emergency in March 2020. Cloudflare is quickly becoming a significant player in the private networking space.
Cloudflare first entered the cloud computing space in 2017 with Cloudflare Workers. In July 2020, Cloudflare announced the next evolution of the service, Workers Unbound.
Similar to Amazon’s development of AWS, Cloudflare originally developed Workers out of an internal necessity. Built on top of its existing platform, this service provides on-demand computational power on its edge nodes. Limitless and cost-effective, Workers Unbound competes directly with established cloud platforms: “75% less expensive than AWS Lambda, 24% less expensive than Microsoft Azure Functions, and 52% less expensive than Google Cloud Functions.”
As the world becomes more connected with 5G and IoT, execution latency savings provided by a delivery network will become increasingly significant.
Cloudflare participates in a large and growing market. Considering their core operations, their total addressable market was $32 billion for 2018 and is estimated to grow to $47 billion in 2022. Their expansion into new areas provides additional opportunity.
Given their data moat, network effects, and vast opportunities stemming from their core platform, Cloudflare is poised for significant growth.
Financials
Growing total revenue at a CAGR of 50%, Cloudflare has demonstrated a strong product-market fit since inception. All of Cloudflare’s revenue is subscription-based.
Cloudflare has been able to consistently achieve dollar-based net retention above 115%, demonstrating their ability to land and expand with their customers.
For the first quarter of 2020, Cloudflare announced $91 million in revenue, 48% year-over-year growth. Reinvesting in the significant opportunities, the company reported a GAAP loss of $32.7 million. The company’s balance sheet is healthy, sporting $588 million in cash and cash equivalents as of March 31, 2020.
Regarding guidance for 2020, Cloudflare expects revenue of $389-$393 million, the mid-point of which represents 36% year-over-year growth.
As mentioned above, Cloudflare Teams, the company’s VPN-replacement offering, is free until September. Assuming conservative metrics on conversion, this offering has the potential to provide a boost in the coming quarters.
Valuation & Target
As of August 2020, with the current stock price near $41, the company is trading at a market cap of roughly $11.7 billion. With estimated ARR of $391 million in 2020, the company is trading at 30x 2020’s revenue.
Cloudflare is by no means cheap. However, given the company’s early stage and vast opportunity, I believe there is opportunity for significant upside. Cloudflare has established an extensible platform, on top of which they continue to innovate and provide critical infrastructure services.
Cloudflare’s long-term operating model targets gross margins between 75% and 77%, and operating margins above 20%.
Consider revenue growth continuing at 30% for the next 5 years. The company would have revenue of roughly $1.5 billion. Given the vast opportunity, assume the company would continue to trade on a revenue multiple. Given the company’s larger size, assume the revenue multiple compresses from 30 to 15. Cloudflare would potentially be worth $22.5 billion.
Compared to today’s valuation of $11.7 billion, a valuation of $22.5 billion in five years would represent an increase of 92%, or a compound annual growth rate (CAGR) of roughly 14%.
Extrapolating further out to operating maturity provides another useful lens. Consider Cloudflare continues growing at 25% over the next 5 years after achieving $1.5 billion. Cloudflare’s revenue 10 years out could be roughly $4.6 billion. With an operating margin of 25%, the company would have $1.1 billion in operating profits.
Considering the continued opportunity and growth, this company would still fetch a healthy multiple on operating earnings. The best way to gauge this is through comparison to larger peers — Salesforce trades for 63x operating earnings, Workday trades for 93x operating earnings. Conservatively, we will assume a multiple of 30.
Derived from $1.1 billion in operating profit and a 30x multiple, Cloudflare’s value could reach $33 billion in ten years. Compared to today’s valuation of $11.7 billion, this would yield a return of 182%, or a CAGR of roughly 11%.
Risks
Uncertainty, an inherent risk in any investment, is amplified in evaluating growth companies. More art than science, the growth valuation requires extrapolation and is particularly sensitive to assumptions.
If growth continues or accelerates in future years, the valuation could be much higher. Conversely, if growth slows, the valuation could take a significant dive.
The back-of-the-envelope calculations done above illustrate a potential outcome. It is difficult, perhaps impossible, to accurately project five or ten years out. While momentum is likely to continue, it is not guaranteed.
For the reason mentioned above, investment in growth opportunities like NET tend to involve significant volatility. If revenue growth slows, or accelerates, in a given quarter, the market tends to react quite significantly.
There are other systemic and company-specific risks that one should be aware of. This includes, but is not limited to, the actual growth of the market, increased competition, and other internal and external factors.
That being said, Cloudflare is emerging as a leader in a growing market. With significant potential and a large opportunity, an investment in Cloudflare can prove fruitful over time.
