Cloudflare Stock Can’t Rise Much More While R&D Costs Eat the Profits

Cloudflare (NYSE:NET) is a cloud company that provides reliability and security solutions for large internet companies. Sales have been growing quickly but the lack of profits will hurt Cloudflare stock sooner than later.

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For example, revenues will have doubled by the end of this year to over $400 million from the end of 2018 when they were $197 million. But the company is still forecast to be unprofitable on a net income basis.

Cloudflare expects to report its Q3 earnings on Nov. 5. Analysts don’t expect the company will make much progress in terms of profitability over the last quarter.

Last quarter the company made a non-GAAP loss of $9.5 billion on revenue of $99.72 million. That non-GAAP loss occurred even after adding back all of the non-cash expenses.

These are mostly stock-based compensation (SBC) expenses. Most other software companies tend to show non-GAAP profits when adding back SBC expenses. But not Cloudflare. It can’t afford to. Why?

Because it spends so much on research on and development. In Q2 Cloudflare made a negative 10% non-GAAP net income margin. But this was after spending 21% on a non-GAAP basis of sales on R&D. Most other software companies might spend 5% or 10%.

A Closer Look at Cloudfare Stock

The high percentage spent on R&D has been even higher in the past. You can see this in the company’s Q2 PDF investor presentation on page 29. Halfway down the middle of the page, you can see that Cloudflare has typically spent 27% on R&D over the last five years.

It was only by lowering that amount to 21% in Q2 was the company able to lower its net income losses.

Maybe that is a ray of hope for the future. If Cloudflare finds that as sales increase, it does not need to spend as high a percentage on R&D, it might be able to get profitable. On the other hand, that might be why its sales are growing so quickly and why it might be picking up an edge.

What Analysts Say About Cloudflare

Barron’s recently ran a story showing that a competitor to Cloudflare, Fastly (NASDAQ:FSLY) reported that its revenues this coming quarter would fall short.

However, B. Riley says this will not weigh on the broader industry, according to Seeking Alpha. This is because Fastly’s problems relate to their account, Tik Tok, an account that the other players don’t have.

Analysts polled by Seeking Alpha have a consensus earnings per share (EPS) estimate of 5 cents per share. This was about the same estimate as last quarter (6 cents loss), but the actual EPS came in at negative 3 cents, slightly better.

Nevertheless, Cloudflare is still losing money, on both a non-GAAP basis and a free cash flow (FCF) basis. This is not good in the long run. Cloudflare stock will have a limited upside as long as it cannot make profits or positive FCF.

What to Do With Cloudflare Stock

Analysts surveyed by have an average price target on Cloudflare stock of just $52.52 per share. This implies a drop of 6.43% or so in the stock from its present price of $55.82 as of Oct. 23.

Similarly, shows that 17 analysts have issued ratings and price targets on Cloudflare stock over the past 12 months. Their average price target is $41.38, implying a drop of over 25% from today’s price.

These polls all seem to show the same thing. Seeking Alpha says that its survey of 16 analysts has an average price target below the present price. The average is $51.69 per share which is 7.3% below the price as of Oct. 23.

Therefore, don’t expect Cloudflare stock to rise much as long as the company is still producing net income losses. Hopefully, there will be some good news on this front on Nov. 5, when the company produces its Q3 numbers.

On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.

Mark Hake runs the Total Yield Value Guide which you can review here.

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