NET Stock: Cloudflare does not offer security to investors at this price

Cloudy (NYSE:REPORT) is a leading IT and cybersecurity company. The company rose to prominence during the pandemic, as companies quickly sought to build hosting and security capabilities. And, somewhat contrary to expectations, the NET stock was not just dynamic Covid-19 trading.

Source: Igor Golovniov / Shutterstock.com

In fact, the company initially saw costs drop as demand increased. However, subscribers had locked in monthly or annual rates, resulting in a short-term decline in profit margins. In 2021, however, Cloudflare enjoyed full revenue growth as organic demand and new customer numbers continued to rise while pricing improved for existing accounts. All of this has resulted in a huge increase in the NET stock price over the past few quarters.

In 2022, however, Cloudflare stocks fell victim to the same trends as the rest of the industry. As momentum in the software space has reversed, valuations have fallen. And it has hit high-flyers, such as Cloudflare, particularly hard. The thing is, even after falling 50% from its 52-week highs, NET stock is still not a buy. Here’s why traders should refrain from the name for now.

Valuation is the biggest concern

Right now, the biggest controversy surrounding the NET stock involves geopolitics. Like my InvestorPlace explained his colleague Josh Enomoto, Cloudflare has made the decision to continue offering its services in Russia. The company said it believes maintaining internet access is vital for Russian citizens to access international news sites.

With the crackdown on Russian national news outlets, it’s possible to see where Cloudflare is coming from. Either way, this is a position that does not praise Cloudflare in the current political environment.

I would argue that while the Russian situation offers tons of risk for NET stocks, however, the longer-term problem remains the same as always: overvaluation. And to make that point, let’s recall the story of Cloudflare’s most direct rival.

Quickly: we have already seen this

Any investor considering a position in NET stock should remember what happened with Cloudflare’s closest rival. It would be Quickly (NYSE:FSLY), which exploded during the pandemic.

Fastly has seen an unprecedented increase in demand for its edge networking and security services. Since it sells services by the meter, its operating results have grown rapidly and the stock has increased almost 10 times in the space of a few 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 enjoyed an unusually robust period of demand for its services. As things returned to normal in 2021 and 2022, shares of Fastly fell.

Ironically, the business continues to grow. Analysts predict a high income growth rate for teens in the future. For a company with normal expectations, this would be a good outcome. However, for a company that had experienced triple-digit growth, 18% revenue growth is no longer going to reduce it. Traders couldn’t get rid of the stock fast enough as expectations crashed.

Verdict on NET stocks

Quickly, the shares fell from an all-time high of $130 to around $16 today, marking a loss in value of almost 90%. Will the same thing happen to Cloudflare? Probably not, or at least not quite so. By most accounts, Cloudflare has a more capable management team and strategic plan than Fastly.

Yet there is more than a passing resemblance between the two companies. Fastly shares peaked at 48 times earnings and are now selling at less than 6 times earnings. Cloudflare increased its sales 100x last year and is still at a shocking 52x its sales now. Would it be so surprising if Cloudflare ended up hitting bottom at 15 or 20 times its revenue? No, it wouldn’t. However, this would still represent massive additional losses for NET stock holders, even after the recent drop.

If we’ve learned anything over the past six months, it’s that valuations still matter. During the stock market frenzy of early 2021, old investment laws 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 a company’s revenue. It’s unlikely that Cloudflare will end up being the exception to the rule. It’s not a knock on the quality of the company. However, the price is all wrong at current levels.

As of the date of publication, Ian Bezek had (neither directly nor indirectly) any position in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com publishing guidelines.

Ian Bezek has written over 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a junior analyst for Kerrisdale Capital, a $300 million New York-based hedge fund. You can reach him on Twitter at @irbezek.

Ann J. Cox