Cloudflare (NYSE:NET) stock was one of scores of growth plays hammered lower by the recent market sell-off.
Falling from around $200 per share, to around $140 per share, NET stock seems to have found a floor.
Or has it? News of Covid-19’s Omicron variant may have sparked this recent bit of market volatility, but it has been hawkish remarks from the Federal Reserve that have sustained it.
As inflation remains at multi-decade highs, the central bank is inching closer to fighting it. A sharp change from its position earlier this year, when it was calling inflation “transitory.”
If the Fed finally takes action to combat inflation, speeding up its tapering program, plus possibly raising interest rates richly-priced growth stocks like this one could wind up giving back more of their gains.
Then again, maybe not. The Fed could end up acting in a way that helps temper rising prices, yet keeps growth stocks from crashing due to multiple compression.
Still, that doesn’t mean you should buy. Comparing its debatable prospects of making a full rebound, versus downside risk if conditions less accommodative to growth stocks emerge holding off may be the best move.
NET Stock: No Issue With Its Underlying Business
Although its shares have tumbled in the past month, things continue to hum along for Cloudflare’s underlying business. A provider of various network services, including content delivery, online security, and web infrastructure, demand remains strong. That’s clear from the solid results in the company’s last earnings report.
Released back on Nov. 4, for Q3 ending Sept. 30, it beat analyst revenue estimates—$172.35 million, versus $165.7 million consensus. It also beat on normalized earnings—breakeven, versus projections of a 4 cents per share loss. Sales growth on a year-over-year basis came in at 51%. Its growth among large customers came in even higher, at 71%.
This, plus its upping of guidance for full-year 2021—$647 million-$648 million, versus the $629 million-$633 million projection from last quarter—was well-received by investors.
Shortly before the above-mentioned post-Thanksgiving selloff, this news helped to propel shares above $200.
However, while it’s possible shares bounce back to above $200 per share, it’s debatable whether this happens. Not because of anything wrong with the company, but instead due to very possible changes in the market environment.
Vulnerable to Further Declines
As the market appears to calm down, you may suppose that a NET stock rebound may be just around the corner. After all, its underlying business remains in high-growth mode. However, there is a reason why the stock may fail to bounce back and perhaps could make its way to an even lower price, that would be valuation.
Trading for around 74.7x projected sales for 2021 and 54.5x projected sales for 2022, it’s hard to argue Cloudflare’s high growth isn’t reflected in its valuation.
Sure, this alone doesn’t guarantee further moves lower lie ahead. A lowering of its forward valuation will likely hinge on the Federal Reserve’s actions to fight inflation.
A gradual approach may prevent a market correction, limiting further drops for Cloudflare. If the Fed takes swifter action, though, a sharper plunge may occur.
Trading at such a steep premium to similar cloud services names like Akamai Technologies (NASDAQ:AKAM) and Fastly (NYSE:FSLY), NET stock could take a high-double-digit haircut and still trade at a more reasonable valuation. Assuming, of course, it does continue to expand at an above-average clip.
As it scales up, investors anticipate a bit of deceleration. But if its sales growth winds up slowing down faster/sooner than expected? This too could put downward pressure on shares.
The Bottom Line on Cloudflare
Cloudflare stock’s next direction hinges mainly on factors outside its control. That is, the Fed’s actions to fight inflation, plus the market’s reaction to these changes. Although theoretically higher rates means lower valuations for growth stocks, it may not necessarily play out that way.
Even if rates go up, they could still be at historic super lows. If interest rates stay under the rate of inflation equities will remain the only game in town in terms of getting positive real returns.
This may result in the market again shrugging off concerns. In turn, either bidding up equities, or at the very least, keeping them steady.
However, given its high premium to peers, plus the risk its growth starts to slow down, even if future Fed actions don’t cause a market correction, NET stock could still struggle to bounce back. With this, pass up on it, and look elsewhere for buying opportunities.
On the date of publication, Thomas Niel did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Thomas Niel, a contributor for InvestorPlace.com, has been writing single-stock analysis for web-based publications since 2016.
