Cloudflare (NYSE:NET) is a leading edge computing and cybersecurity company. The company rose to prominence during the pandemic, as firms rapidly sought to build up their hosting and security capabilities. And, somewhat contrary to expectations, NET stock wasn’t just a Covid-19 momentum trade.
In fact, the firm saw something of a cost hit at first as demand ramped up. However, subscribers had locked in monthly or annual rates, leading to a short-term hit on profit margins. In 2021, however, Cloudflare enjoyed the full boost to earnings as organic demand and new customer figures continued to surge while pricing improved for existing accounts. All this led to a tremendous surge in NET’s stock price in recent quarters.
In 2022, however, Cloudflare shares fell victim to the same trends as the rest of the industry. As momentum in the software space has gone into reverse, valuations have tumbled. And that has hit high-fliers, such as Cloudflare, especially hard. The thing is, even after dropping by 50% from its 52-week highs, NET stock still isn’t a buy. Here’s why traders should hold off of the name for now.
Valuation Is The Biggest Concern
Right now, the biggest controversy around NET stock has to do with geopolitics. As my InvestorPlace colleague Josh Enomoto explained, Cloudflare has made the decision to keep offering its services in Russia. The company explained that it felt keeping internet access up was vital so that Russian citizens would have access to international news sites.
With the crackdown on domestic Russian news organizations, it is possible to see where Cloudflare is coming from. Regardless, it is a stance that is not winning Cloudflare much praise during the current political environment.
I’d argue that while the Russian situation offers tons of headline risk for NET stock, however, the longer-term issue remains the same as always: overvaluation. And to make that point, let’s recall the story of Cloudflare’s most direct rival.
Fastly: We’ve Seen This Before
Any investor considering a position in NET stock should remember what happened with Cloudflare’s closest rival. That would be Fastly (NYSE:FSLY), which skyrocketed during the pandemic.
Fastly enjoyed an unprecedented surge in demand for its edge networking and security services. Since it sells services in a metered fashion, it saw a quick upturn in its operating results and the stock went up nearly 10x in the span of months. At the time, Fastly was posting a triple-digit revenue growth rate and the opportunities seemed limitless.
However, reality quickly set in. Fastly had benefitted from an unusually robust period of demand for its services. As things returned to normal in 2021 and 2022, Fastly shares plummeted.
Ironically enough, the company is actually still growing. Analysts see a high-teens revenue growth rate going forward. For a business with normal expectations, that would be a fine result. However, for a firm that had been growing at a triple-digit rate, 18% revenue growth now isn’t going to cut it. Traders couldn’t dump the stock fast enough as expectations collapsed.
NET Stock Verdict
Fastly stock fell from an all-time high of $130 to around $16 today, marking an almost 90% loss in value. Will the same thing happen to Cloudflare? Probably not, or, at least not quite to that degree. By most accounts, Cloudflare has a more capable management team and strategic plan as compared to Fastly.
Still, there is more than a passing resemblance between the two firms. Fastly shares peaked at 48 times revenues and now sell for less than 6 times revenues. Cloudflare hit 100 times sales last year and is still at a shocking 52 times sales now. Would it be all that surprising if Cloudflare ultimately ends up bottoming at 15 or 20 times revenues? No, it would not. However, that would still represent massive additional losses to NET stock holders even after the recent decline.
If we’ve been taught anything over the past six months, it is that valuations still matter. During the meme stock frenzy of early 2021, the old laws of investing were thrown out the window. However, these rules are back in effect now.
Historically, it has almost never been a good idea to pay 50 times revenues for a business. Cloudflare is unlikely to end up being the exception to the rule. That is not a knock on the business’ quality. However, the price is all wrong at current levels.
On the date of publication, Ian Bezek 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.
