Company: Cloudflare, Inc
Price of publication: $39.00
Market Cap: $12.75B
Shares Outstanding: 326.24M
Evaluating using a FCF Multiple approach.
Similar Companies, Peers & Competitors.
SBD & Share Dilution.
Cloudflare will evolve to a different monster.
First and foremost, I would like to clarify that this is a purely speculative approach. However, it gives you a number to look at and compare. At the end of the day, it’s something. In reality, I personally stick to Net-Net’s, NCAV’s, CMAR, or stocks trading at an excellent level to their DCF. But, as I said above, looking at a possible valuation through the lens I am about to share gives you a sense of where the company stands overall.
It makes little to no sense to value $NET based on its EPS or PE Multiples. Especially when it's a company focused on growth that’s made it very clear they have no intentions to remain profitable at the moment as they would like to keep investing money back into the business. This is a classic Amazon book trick. Remain unprofitable, keep reinvesting for growth, and in the future, we can flip the switch when the time is appropriate.
Thomas Seifert mentioned: Q1 2022 Earnings Call Transcript (Source)
"...Q1 was our third consecutive quarter of achieving operating profit. And as a reminder, we intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us."
Mathew Prince Said: Q1 2022 Earnings Call Transcript (Source)
"...So I think that we've been very consistent at saying that we are going to hold as close to breakeven on our operating margin as we can. I said on a previous call that if we showed massively positive earnings per share, that would mean that we did something wrong because if we can continue to grow at the rates that we're guiding towards, there's nowhere else we should be putting that money other than back into the business to grow the business as quickly as possible."
So, what can we do to give it a number? Well, we can approach it based on a possible FCF Multiple. Long story short, we can develop a possible FCF based on a reasonable margin from its revenue. How do we come up with this margin? We can look at several similar companies, competitors, and peers for the answer. By doing this, I believe we can come up with a very achievable number that makes sense.
The first thing we need to do is reverse engineer it. As Charlie Munger would say, “Let’s invert the problem.” I would first start by giving it an estimated 10-year future valuation that we then work backward from to see what the company would need to achieve to make that valuation possible. Once we get this format structured, only then can we begin to make adjustments and alter the possible outcomes. It will all make sense as we get closer to the end. You should even be able to move a few variables around to your liking and develop a personal speculative “target.”
As I mentioned above, I need to give it a future valuation 10 years out. I will start by giving it a target market cap value of $131,250,000,000 ($131.25 Billion). I can alter this number later, but at the moment, that’s not important. The goal is to see if it can even achieve something like that, then we can move things around realistically. Since we are going off FCF, we need to find a margin we will use to get that FCF based on its future revenue. But before that, let’s start with a “trading at 51.58x FCF.” Is that High? Yes, that is high but not impossible, given that CrowdStrike (Ticker: $CRWD) is trading at 77X FCF according to GuruFocus and Yahoo Finance. This means CrowdStrikes FCF to Revenue Margin is 30.39%. Another example is Zscaler (Ticker: $ZS) with a FCF to revenue margin of 22.83% with a FCF Multiple of 102x. (See more comparables below). Very Important; Keep in mind this is all after the market downtrend for the past ~7 months.
Image 1 - Created by author
So, going back to our numbers, that means a 10-year valuation of $131.25 billion divided by 51.58x (FCF-multiple) would give us a FCF dollar amount of $2,544,590,926.00 desired ($2.54 Billion). The question at hand now is what type of revenue do we need to achieve a $2.54 Billion FCF from the margin of revenue. Well, we can reverse the problem; looking at the comparables, we can give it a 25% achievable margin. This means the company would need to scale to a $10,177,518,684.79 ($10.17 Billion) in revenue in the next ten years. $2.54 Billion of $10.17 Billion is 25%. Is a 25% margin possible? The answer is yes; it is likely, especially after looking at other peers. (image 1)
Now that we have all those variables, we need to determine the revenue growth Cloudflare would need to achieve to reach $10.17 Billion in revenue in the next ten years. According to their estimates and the average of 22 analysts from Yahoo Finance, they expect to finish 2022 with ~$955 Million in revenue. That would mean they would have to achieve 24% YoY revenue growth to reach $10.17 Billion in the following ten years. Do I believe 24% growth in revenue YoY is possible? Absolutely. As a matter of fact, in the last 5 years, they have achieved an average of +50.7% YoY.
+24% Revenue Growth - created by author
$NET Income Statement, Total Revenue Growth Rate - Created by Author
I believe I would even be low-balling them at 24%. But, maybe the 24% will account for some growth slowing down in the future. Although I still believe that is lower than they’ll achieve. Just to give you an idea: Palo Alto Networks (Ticker: $PANW) has achieved a 25.4% average yearly revenue growth in the last 5 years, and that’s a $50 Billion Dollar Market Cap Stock. CrowdStrike (Ticker: $CRWD), standing at a market cap of $37 Billion, has achieved 95.17% on average yearly in revenue growth over the last 5 years. One more, Zscaler (Ticker: $ZS), has had a 53.2% average yearly revenue growth in the previous 5 years.
Let’s recap what we have so far. Is a $10.17 Billion in revenue from $955M in 10 years achievable at a 24% YoY growth rate? Yes. Is a 25% FCF margin to revenue plausible? Yes. Does all that justify a possible $131.25 Billion valuation with a 51.58x FCF Multiple? Sure.
Image 1 (repeat) - Created by author
Can we begin to alter the variables to play with different outcomes? No, not so fast. Why? With this current template, “if approachable,” the stock price per share would reach $402.26 in 10 years. That’s a possible 905.65% ROI. Too bad that does not include SBC (Stock-Based-Compensation) & Share dilution. The current amount of outstanding shares will likely increase over the years. Don’t worry; we can come up with an estimate of how many outstanding shares there will be in 10 years. We can get an estimate of YoY shares outstanding by averaging the previous 5 years' change. Doing so, you get a 6.90% average share dilution per year. (This excludes the jump from 2018 to 2019 as I don’t find that realistic in the future.) At 6.90% YoY compound growth in shares outstanding, we can round it up to 7% for a more significant margin of error. This would mean that by the end of the 10th year, there could be a “possible” 641,684,773 shares outstanding. At a $131.25 Billion valuation with 641,684,773 shares outstanding, the per-share price would be at $204.53. From its current price point of $40 per share to $204.53, it would make it a 5.11x bagger. And, if I am being honest, I believe 7% share dilution each year for the next 10 years to be a stretch.
At the end of the day, that was all play pretend. But, now that the overall template is complete, we can alter the variables to our liking. If you think 24% revenue growth on average is too slow, you can up that to 30%. Too high, decreases it to 15%-20%. Or, for example, you can lower or increase the margin possibility from revenue to FCF available. If you ask me, the current outcome already appears to be beyond possible, and that is using a lower revenue growth which can offset the high FCF multiple if you are uncomfortable with it by increasing it. You see, the point I am making here is there are many occasions where no matter the changes made, Cloudflare shows it can surpass a $100 billion dollar market cap and then some.
Let me further justify that; for starters, I do not believe Cloudflare will carry a 7% YoY share dilution. It should be closer to ~5%, which alone decreases the estimated amount of outstanding shares, meaning a higher value from the $204.53. Second, I do not believe it will scale revenue at 24% YoY; I believe it could be a lot closer to ~30%, bringing the previous value even higher.
Third, that does not include the possibility of a higher FCF multiple. If you recall what I stated at the beginning, the FCF Multiples we are comparing are after everything the market has gone through. So, these are the bearish case multiples? Does this mean it can see 2-3X those multiples during a bull market? Absolutely. Those FCF multiples are after most of those stocks have crashed, while $SPY is down roughly -22%. Oddly enough, during the bottom of the market in March 2020, another bear case, the multiples were similar to current market conditions. That's two bottom bear market examples with multiples at the levels we used, so I imagine those will be much higher during a bullish and more optimistic market.
You may argue that the larger the company becomes the smaller the FCF multiple would be. However, my above statement over us using lower multiples based on the current market conditions may essentially cancel that. In other words, (going of image 1) if they all usually achieve 2X to 3X those stats, a 50X multiple today shown on image 1 may be closer to 150x during an optimistic market. So, decreasing FCF Mutipes from those higher numbers would lead to a 50X possibility. At the end of the day, that's where it becomes very subjective & speculative.
In conclusion, I would not put it past Cloudflare to grow at an estimated 30% average YoY in the next 10 years, which will bring their total revenue to around $17 Billion. Using a 25% FCF to revenue margin, it would have their FCF dollar amount roughly at $4.2 Billion. Using a 50x FCF multiple during a bull market raises their market cap valuation to a little over $210 Billion, diluting shares YoY at a rate of 5%, bringing their possible price per share to $402.63. Essentially a potential 10x bagger from its current $40 price per share. Or an ROI of 906.57%. Even a 7% YoY share dilution would mean a share price of $333.40. You may also go ahead and include inflation to decrease today's dollar worth to 10 years from now. Just keep in mind that this is all speculative.
All that being said, the best part is that none of this includes the path Cloudflare is taking on. In the next 10 years Cloudflare should be a whole different monster as it scales into new markets and ventures unaccounted for above. We already know that it has a history of beating estimates, which only strengthens our model above.
Seeking Alpha, Earnings, Earnings Surprise
Additionally, management has never given us a reason not to trust them. They have achieved everything they have set out for thus far. I have no doubt they will slowly take up more market shares. In fact, AWS, which is one of their competitors, told one of their own customers to "just go to Cloudflare."
Quoting Mathew Prince: Q1 2022 Earnings Call Transcript (Source)
...One last story. A Fortune 1000 gaming company signed a $3.3 million, 3-year contract. I love this story. They were using AWS, but found their security couldn't prevent the attacks they were seeing. After struggling to keep their application online, AWS's team eventually told them, "You should just use Cloudflare." And so they did. [indiscernible] that let them and lots of other customers know that R2 is progressing to open beta next week, and we expect we'll be able to save them lots of AWS egress fees as well."
What about the entire FedRAMP Certification approval that should come up anytime now and will open new doors and trust in government-related institutions. Cloudflare also runs very efficiently. Plus, when you look deep into the company, you will realize it's not just another CDN & Cyber Security company; it’s much more. Should we even get started with the endless possibilities that Cloudflare can take on within WEB3.0? It could very well be the AWS of web3.0 helping run the entire ecosystem.
"Cloudflare to offer Zero Trust cybersecurity to the federal government, as agencies look to modernize infrastructure"