Why NET Stock Dipped Sharply

When the Nasdaq corrected somewhat in the last month, Cloudflare (NYSE:NET) fell sharply from the 52-week high. The content delivery network supplier, NET Stock posted quarterly earnings that failed to impress investors.

Close up of Cloudflare logo at the Company's headquarters
Source: Sundry Photography / Shutterstock.com

NET stock may have unfavorable valuations. This is not a good enough reason to justify the stock’s recent stumble. Growth investors who want good value for an innovative firm should consider Cloudflare from here.

Losses Weigh on NET Stock

In the third quarter, Cloudflare posted revenue of $172.3 million, up by 51% year-on-year. It added more large customers. This indicates corporations recognize its innovative platform will support serving more businesses. While non-GAAP earnings per share were break-even, the GAAP EPS was a 34 cent loss.

Cloudflare expects Q4 revenue at up to $185 million. It will earn between a one-cent loss or break-even. With markets bracing for higher interest rates, Cloudflare’s unsustainable valuations will pressure the stock price. Markets value the stock at a price-to-sales of almost 80 times.

Strong Prospects for NET Stock

Cloudflare has a large and growing addressable market. It has a widely distributed global cloud platform that offers its customers stability and accessibility. Its product portfolio is expansive. For example, it is rolling out new products it calls innovation lease. This includes Speedweek, which gives customers the fastest security and zero trust networking.

The company welcomes developer innovation. Its investments in innovation will attract more customers to its platform.

Market sentiment shifted in the last few weeks. Instead of paying a premium for its expected growth, investors want to wait for Cloudflare to deliver on accelerated revenue growth first. Investors may look at Palantir (NYSE:PLTR) as a comparable software firm. Palantir is booking deals with companies in the healthcare and government industries. Yet the contract sizes start small. Similarly, Cloudflare is signing deals with Fortune 500 companies.

Chief Executive Officer Matthew Prince highlighted the company’s deal with a Fortune 500 pharmaceutical company. It expanded its use of the Cloudflare 1 platform. The customer signed a $600,000 expansion deal. The contract total is now over $2 million. The customer is using an array of services like Cloudflare Gateway, a Zero Trust web application gateway.

Other companies will use Cloudflare’s many offerings. Their contract size will also rise. But the market capitalization in the $50 billion range may prove too expensive for growth investors. The technology software sector did not face a meaningful valuation correction in a long time.

The stock market needs to adjust for the Fed’s rate-tightening cycle starting in 2022. Inflation keeps climbing in the U.S. and worldwide. Not only will stocks need to correct on valuations, but Cloudflare must demonstrate that its business will grow in this tighter environment.

Related Investments

In the software infrastructure industry, investors may consider bigger, more proven firms. Microsoft (NASDAQ:MSFT) has a strong Azure cloud platform. Demand for its database and office productivity software is not slowing. Oracle (NYSE:ORCL) recently posted strong results, proving that as customers shift to the cloud, they need Oracle’s solution.

In the digital transformation space, people need Adobe (NASDAQ:ADBE). The PDF reader is the standard app for consumers and corporations. Subscriptions for its creative cloud solution continue to grow.

Fair Value

On Wall Street, analysts rate the stock as a “buy,” though more rate NET shares as a stock to hold. The average price target is $207.50, according to tipranks. The price target range is wide, at between $117 and $250.

Cloudflare's stock score is mostly fair to poor. The grades will improve once the company posts stronger margins.

Cloudflare’s stock score is mostly fair to poor. The grades will improve once the company posts stronger margins.

Chart courtesy of Stock Rover

In the table above, Cloudflare’s valuation rating is low. This is due to its unfavorable price-to-earnings and earnings per share. Conversely, the stock has a decent quality score. Light margins are hurting the stock’s quality score.

Cloudflare seasonality relative to the S&P 500 index

Cloudflare seasonality relative to the S&P 500 index

Chart courtesy of Stock Rover

In the ten-year seasonal chart, Cloudflare usually outperforms the S&P 500 from January to July. As the Stock Rover research report indicates, the out-performance is greatest in June and October every year.

Risks

Competition for secure cloud services may intensify. CEO Prince said that the competitive landscape did not change significantly. The company will move its business upmarket, strengthening its moat. Also, its strong win rates across competitors are improving. Customers need to replace legacy hardware boxes. That trend will continue in the next 10 years, supporting Cloudflare’s growth rates.

Your Takeaway

Cloudflare is attracting larger-sized companies. The revenue from contract wins will not show up yet. Customers are evaluating the cloud solution first. Once they conclude that the product offerings meet their needs, they will buy more Cloudflare solutions.

Wait for the selling pressure in Cloudflare stock to ease first. It will eventually find support when the correction ends. After the break-even earnings in the next quarter, the company positioned itself to post a rising profit next.

On the date of publication, Chris Lau 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.


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