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Cloudflare Stock Could Be at the Beginning of a Very Long Correction

InvestorPlace - Stock Market News, Stock Advice & Trading Tips NET stock is set to face the market pendulum as it swings back in the opposite direction and shaves its...

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This story originally appeared on InvestorPlace

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

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As I write this, Cloudflare (NYSE:NET) stock trades at $131. Without beating around the bush, that’s a bargain.

An illustration a Cloudflare (NET) logo is seen displayed on a smartphone
Source: IgorGolovniov / Shutterstock.com

Well, it appears to be a bargain at least. Cloudflare is a stable company with a growing business, and that growth is expected to continue for the foreseeable future. 

There are two overarching ways to look at Cloudflare’s prospects moving forward. It’s either entering a continued slide downward from unsustainable price levels, or this company is slated for even higher highs. 

Let’s begin with the reasons to believe NET stock should logically move higher. 

A Closer Look at NET Stock 

Cloudflare is a cloud-based website security platform that continues to perform well. Broad measures of the company indicate that the future is bright.

Between 2018 and 2020 Clouflare witnessed strong revenue growth. The $193 million of total 2018 revenues increased to $431 million by 2020. That’s a compound annual growth rate (CAGR) of 50% over the period. 

Expectations are that Cloudflare will reach $647 million in revenue, which should increase to $884 by 2022’s end. That’s a 43.21% CAGR over the two-year period from 2020 to 2022, lower than the 50% between 2018 to 2020. Nevertheless, Cloudflare is doing well.

One particular strength the company has is that large customers are increasing. Large customers – those that generate over $100,000 of annual revenue – account for greater than 50% of the firm’s total revenues.

The positive thing to note here is that based on Q3 revenues, Cloudflare has seen 67% CAGR from that revenue source. That suggests the firm could recapture those 50% total revenue compound annual growth rates in the future. 

Indeed, Cloudflare did achieve 51% year-over-year revenue growth between Q3 20 and Q3 21. The company counted 1,320 large customers in Q3 21, up from 736 in Q3 of 2020. Again, this reinforces the idea that Cloudflare could hit an overall 50% CAGR again in the future by targeting large client growth. 

This is the larger bull thesis for NET stock, but Cloudflare faces significant hurdles.

Bearishness Abounds

The argument goes that Cloudflare essentially became overhyped and overvalued. NET stock began 2021 trading at $75. Even after its recent downturn, Cloudflare is still up 75% year-to-date. 

Most valuation metrics point to the idea that Cloudflare is still overvalued even after the downturn. Its current price-to-sales ratio sits at 67. That’s worse than 98% of its software industry peers.

My colleague Ian Bezek summarized the meteoric rise in Cloudflare’s PS ratio in his recent article. His assertion that NET stock is at the beginning of a prolonged correction certainly makes sense given the perspective.

Cloudflare, by contrast, started trading around 15 times revenues following its own 2019 IPO. The stock gradually advanced to around 30 times revenues early in the pandemic. It shot up to 60 early this year and leveled off around there for awhile. In October, shockingly, NET stock topped 100 times sales. That’s ludicrously excessive.

Again, even though NET stock’s P/S ration has dropped down to 67, it remains among the lowest 2% of industry-wide performers. That very strongly suggests that Cloudflare may continue to experience a market that considers it ludicrously excessively priced. Even at 67 times sales.  

What to Do

My thought is this: Cloudflare is likely to suffer a continued correction. It’s safer to err on the side of caution currently. At the very least, take time to watch NET stock for the time being. It will suffer fits and starts rather than a steady correction if it turns around at all. 

That said, Wall Street analysts do give some strong projections in regard to target prices. Their average price target sits at $212.50, it trades at $144 today. That’s likely inflated given the rapid increase based on PS ratio over the past quarters but remains encouraging.

Cloudflare remains fundamentally a strong business. No one is arguing that. The question right now is how investors subjectively feel about the firm’s valuation metrics. 

On the date of publication, Alex Sirois 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.

Alex Sirois is a freelance contributor to InvestorPlace whose personal stock investing style is focused on long-term, buy-and-hold, wealth-building stock picks. Having worked in several industries from e-commerce to translation to education and utilizing his MBA from George Washington University, he brings a diverse set of skills through which he filters his writing.”

 

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