Cloudflare (NYSE: NET) Analysis: CDNs, Web Security and the Future

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With the rapid onset of Covid-19 and the swift lockdowns that followed, 2020 was a rough year for many. Many of us had our routines broken as we were restricted to the confines of our homes, working switched from offices to makeshift arrangements in the bedroom and dining out was no longer even possible. But amidst all the chaos, for some certain special companies, opportunities were being made.

The rush to work from home arrangements and remote access working pushed for digital solutions to facilitate these arrangements. Companies that were offering such services such as virtual gateways and remote working networks were in high demand.

Of these companies, Cloudflare might have been one of the names that popped up on your radar.

Trading under the ticker NET on the NYSE, Cloudflare was founded by Matthew Prince, Lee Holloway, and Michelle Zatlyn in 2009 and IPO’d 10 years later in Sept 2019.

Cloudflare is a San Francisco headquartered Software-as-a-Service (SaaS) company, whose business deals with web infrastructure and website security. Some of Cloudflare’s notable customers include Shopify, Carousell and Upwork. Now I know all of that sounds really vague and ‘buzzword’-y but let’s take a deeper look into their products to understand their business model better!

Cloudflare's Products

Content Delivery Networks (CDNs)

A content delivery network (CDN) is a geographically distributed group of servers that allow content to be delivered across the internet quickly.

Imagine if you were trying to access a site which was hosted in the US. It would take a bit of time for the information on the site to be transmitted to us here in Singapore. A CDN uses cached content, which is sent from the servers closest to the end user, in order to get the information to them as quickly as possible, without having to connect to the original source all the time.

Not only does this greatly reduce the load times for the websites which pass through Cloudflare’s servers, CDNs also increase the uptime of the site through load balancing across its servers.

Moreover, Cloudflare’s CDN, when properly configured, can also help to mitigate the risk of Distributed Denial of Service (DDoS) attacks. Cloudflare’s network actually blocks an average of 72 billion threats per day!

Enterprise Solutions

Cloudflare also produces enterprise solutions for companies such as Cloudflare Gateway and Cloudflare Access. Cloudflare Gateway facilitates work from home arrangements with employees by protecting them from security threats, restricting uploads and downloads as well as access to certain sites.

Cloudflare Access, on the other hand, controls who has access into the company. This prevents unauthorised access into the company’s servers. Despite this, Cloudflare Access still makes it easy to allow third party providers to be onboarded and given access where required.

Just last year, Cloudflare released Cloudflare One, a cloud-based Network-as-a -Service system, which allowed users to access and work together from various devices, safely and securely, keeping the workforce secure in a world where many were working remotely.

Financials

Now that we have an understanding of Cloudflare’s products, let’s get to the numbers.

Strong Revenue Growth

As of 3Q 2020, Cloudflare boasts a 50% compounded annual growth rate (CAGR) in Annual Total Revenue since 2016, growing from $85 million in 2016 to $287 million in 2019. and a 68% CAGR in large customers (more than $100,000 in revenue) from 261 to 736 customers.

High Gross Margins

Much like other SaaS companies, Cloudflare does boast a strong gross margin as well, which has been hovering in the 76-78% range for the past few years. This is also projected to be the company’s long term gross margin in the future.

Customer Retention and Spending

More than that, Cloudflare also boasts a Dollar-Based Net Retention Rate of more than 115% for the past 10 quarters! Dollar-Based Net Retention Rate shows how much of the existing customer base is spending from one year to the next. This means that not only do customers stay with Cloudflare, but they are also increasing their spending on Cloudflare’s products with the new releases from Cloudflare as well as upgrades to their current products.

Diversified Revenue

Despite being a small company, Cloudflare’s revenue sources extend far beyond the borders of the United States, with 48% of their revenue coming from outside of the United States.

This is a good sign for me as it reduces geographical risk to a particular country and allows the company to have more stable revenue in the long run.

Increasing Operating Income (or rather, Decreasing Losses)

Now Cloudflare is not a profit-making company (yet). However, it should be noted that over the years, Cloudflare has shown a positive trend towards smaller operating losses (as a percentage of revenue). Especially in the most recent quarter, Cloudflare drastically reduced it’s losses from $18.1 million in Q3 2019 to $4.5 million in Q3 2020.

Moreover, in 2020, Sales & Marketing expenses have fallen from 55% of revenue in Q3 2019 to 45% of revenue in Q3 2020. Cloudflare aims to drop this to 27-29% in their long term business model.

Large Total Addressable Market (TAM)

Lastly, a significant tailwind for Cloudflare seems to be the fast growing TAM in which they are involved. Currently, they are looking at addressable markets worth up to $47 billion by 2022, involving industries such as 5G, Remote Work and Internet of Things (IoT). If Cloudflare executes on their plans for the future, they will be well-positioned to grow tremendously from here.

Competitors

A Cloudflare analysis would not be complete, without mentioning its close competitor, Fastly. Similar to Cloudflare, Fastly operates as a SaaS company providing CDN and edge computing services.

However, judging by their 3Q 2020 results, Fastly shows slower growth year on year as compared to Cloudflare, with revenue growth in the mid 40% region. Moreover, Fastly’s gross margin is lower as well, hovering in the mid 50% range.

Another competitor in the CDN arena would be Akamai Technologies. Akamai has been around since 1998 and commands a much larger revenue and profit than both Fastly and Cloudflare. However, due to its maturity as a company, Akamai also grows at a much slower rate, with revenue growing at around 7% per annum for the last 3 years and operating income following a similar path.

As such, I do feel that Cloudflare, as a business, is the most attractive to me out of the 3 of these players in the industry, based on financials alone.

Management

Another point I’ll like to touch on would be management. Co-founders Matthew Prince and Lee Holloway have been working together in the SaaS space for a long time now, starting in 2001 with Unspam Technologies. Their third Co-founder, Michelle Zatlyn has had strong management experience in Google as well as Toshiba.

Matthew Prince still remains as the CEO and Michelle Zatlyn still holds the position of COO. Personally, I tend to lean towards companies that are run by their founders as I believe this generally helps the company stick to its original vision. So, this point is a nice plus for me.

Between the three, they hold 17.35% of the shares in the company. The high insider ownership shows that the management (especially Matthew Prince, who holds the bulk of it), has ‘skin in the game’ and this pushes management to be more aligned with the shareholders of Cloudflare. As such, this is another plus for me.

Thoughts on Valuation

I won’t lie, Cloudflare does trade at a pretty rich valuation. As of writing this article, Cloudflare’s P/S ratio sits in the mid 60s. As such, I’m not sure that I would add to my position at this point.

However, Cloudflare’s earnings are just around the corner on February 11th 2021, after market close. If you’re not in any hurry, waiting till then to reassess the company might be a prudent move, especially in the volatile market climate that we are in. After all, a company as strong as Cloudflare definitely still has a long runway ahead of it.

Aside from that, slowly accumulating a position on large red days are certainly worth considering as well.

Conclusion

In short, Cloudflare is a strong contender in the SaaS scene. It boasts strong growth on all fronts and new product releases puts Cloudflare at the forefront of the CDN and website security business. This is a business that I am excited to watch and to see where the management will be able to take it to in the next 3 to 5 years.

Photo by NASA on Unsplash