This post is about Cloudflare, the only technology company in my portfolio and a stock that I’ve consistently held since 2020. Most of my other holdings are traditionally cheap value stocks, however, this is a company I understand well and have a lot of faith in the management. I’ve also struggled to find good values in today’s market lol (with this arguably not being a “value” in the traditional sense either).
What Cloudflare Does & How It Does It
Cloudflare is an edge network that functions as a reverse proxy for internet traffic. Traffic to internet properties (which include websites) is routed through a Cloudflare server to be more secure, fast and reliable.
According to one market study: Cloudflare is used by 78.0% of all the websites whose reverse proxy service we know. This is 18.8% of all websites.
The company is unique because it owns its underlying network and is not hosted on one of the big public cloud providers. This was a pivotal decision made in the early days at Cloudflare, because it required making fixed cost investments and solving difficult software engineering problems. There are hundreds of Cloudflare data centers (known as points of presence or POPs) around the world and 95% of the internet connected world is within 50 ms of the Cloudflare network.
People familiar with the HBO show Silicon Valley know of the fictional startup Pied Piper and the idea of a decentralized peer to peer internet. Cloudflare has some interesting parallels to that idea with a decentralized approach to their data centers. Each data center is built with the same hardware, and is not specialized for any one use case like what many other cloud infrastructure providers have built out. This allows any data center in Cloudflare’s network to run any app or service and software controls everything.
Here is how the Cloudflare management breaks down their strategy down into 3 acts:
Application Services
The company initially focused on offering a content delivery network (CDN) to deliver and host cached website assets around the world. It takes time (albeit not a lot) to make a network request and ultimately the speed of light traveling through the fiber optic cables is the limiting factor. Today, when you visit a website, instead of going all the way to a centrally located data center (such as Amazon’s us-east-1 data center located in northern Virginia), your network request likely hits a CDN near where you are located and delivers a version of the website.
Historically, CDN’s were very underpowered and primarily handled only storage use cases. You can think of Cloudflare as one of the first enablers of compute power for CDNs. Cloudflare also took a software defined networking (SDN) approach that did not require physical boxes on premise. Many companies to this day have physical boxes to handle networking and application services that aren’t adapted to today’s cloud native environment. There have always been other CDN providers in the market but Cloudflare took market share by bundling its offering with other best in class networking and security products (such as DDoS protection) effectively for free. This allowed it to amass a free user base of over 3 million people, something rare for an enterprise software company.
Network Services and Security Services
The next chapter for Cloudflare was the rapid launch of security products. The most prominent of this group is their suite of Zero Trust Security products. Zero Trust could be explained in much greater detail, but I’ll attempt to do so at a high level. Traditionally, corporate networks were built under a castle and moat model. Once you got past the moat (getting credentials or any sort of access) you were in with the power to do anything within the company network.
The Zero Trust philosophy is that when an employee accesses any individual resource, they should be authenticated and they should only have access to what they need. Cloudflare provides the infrastructure to enable this and competes with companies like Zscaler and Palo Alto Networks. Cloudflare offers many other Act 1 and Act 2 products and to not kill my readers from boredom (if they even made it this far), I’m going to end this section here.
Developer and AI Services (and other Future Trends)
Cloudflare is benefiting from this market euphoria and is establishing itself as one of the early beneficiaries of AI. Cloudflare has evolved over time to position itself as the fabric that ties together the different clouds. Cloudflare sits atop of the other cloud infrastructure providers and is well suited for some AI workloads. Customers already include top AI companies and startups like OpenAI and Hugging Face.
One example of this market positioning is Cloudflare’s object store called R2 (one less than Amazon’s object store called S3). Based on a market survey, it seems that S3 could be about a $1B revenue business (which almost equates to the entire revenue of Cloudflare today).
Market Positioning & Competition
Amazon makes a strategic move with S3 to charge users to move data off their cloud, but not charge to move data in. The costs to transfer out are known as egress fees, and this is inflated to cost users exponentially more than what it costs Amazon. Intuitively this does not make sense because Amazon made fixed cost investments to set up their network. Data travels in and out on the same fiber optic cables they laid out in the past. It doesn’t make sense to charge different prices for data in vs data out since the underlying cost is the same and approaches 0. The key objective for Amazon is to lock you in. Amazon stands to benefit if customers pick them and over their competitors. Cloudflare on the other hand, actually wants to enable so called multi cloud systems, since it can serve as the control plane for data movement and capture that new market.
With egress fees it can be economically unviable to use multiple cloud providers. Say Microsoft has the best AI APIs because of their OpenAI tie up, but you’re a user of AWS. Moving the data off AWS to use the Azure offering would cost a lot of money. Often times, training data sets are also massive, so moving them is even more costly. Cloudflare eliminates this cost and is slowly becoming a platform of choice for AI startups for this use case.
Another market that Cloudflare seems poised to capture a share of is what is known as inference, the act of AI models making conclusions and judgements. When you ask ChatGPT a question, it is doing inference. It is attempting to make a “prediction” based on all the training data it has. Most use cases of AI will likely be inference since you want the model to generate a response based on what you ask it. A lot of inference today occurs in the centralized data centers and high latency adversely impacts customer experience. When Cloudflare built out their network, every point of presence was built out with the same hardware and they even reserved a slot for GPUs, processors needed for AI workloads. Now, the network can easily be upgraded and retrofitted with GPUs with minimal additional capital expenditures. Cloudflare management thinks a lot of AI inference will likely happen closer to the end user, since it is not as demanding as training which has to be done in the centralized data center.
We are seeing this “inference cloud” of sorts from Apple as well, further validating this idea. I need to read more, but Apple’s Private Cloud Compute they announced at WWDC will be a network of their own servers to offload some of the compute from iPhones for more intensive AI tasks. Apple predictably is doing this in house and has the advantage of using their own silicon. However, this proves that local devices aren’t necessarily powerful (RAM is the limiting factor) to run large models we use today.
Cloudflare’s edge network is beneficial in data governance/localization use cases as well. Some progressive governments have introduced data collection and privacy laws. In the EU there is GDPR, regulations that give users more control over their data. One trend developing is that nations are requiring data of their citizens to stay within their borders. This is a very costly problem to solve for many of the public clouds today (even Amazon, Microsoft, and Google). They would have to spend a lot of money to reconfigure how their data centers are set up and create new software to handle how that data is routed.
The last market expansion avenue I’d like to highlight is Cloudflare Workers. Workers is a framework used to program Cloudflare’s edge network. There are many use cases for Workers and Cloudflare does not use it in its total addressable market estimates since it is so hard to estimate. One use case mentioned during Cloudflare’s investor day was Meta using it for WhatsApp. Each WhatsApp message is injected with some information used for authenticating the message by a Cloudflare Worker. This happens for billions of messages per day and really demonstrates its scale and versatility. I imagine Workers will be a huge driver of revenue at some point in the near future.
Workers AI was recently launched and seems like a very easy way for developers to build apps and connect services to Cloudflare’s network. I will be monitoring this and seeing if there are new apps launching that use this and would love to see the developer community explode here.
Valuation
Cloudflare’s products strategically complement each other and are economically attractive because of the upfront financial and technical decisions that were made when the company was founded.
Cloudflare benefits from a zero/low marginal cost structure that technology companies often benefit from. The high fixed cost investments (building servers and laying fiber optic cables to create the network) are slowly depreciated over time through the income statement and appear in the form of capital expenditures on the cash flow statement. The network also benefits from being incredibly efficient and operates at a high utilization rate where traffic is routed optimally.
The company generates over 1.4B in ARR and is growing at around 30%. It operates at north of 75% gross margins and is slightly free cash flow positive, but some amount of shares are being issued to fund employee stock based compensation. Stock based compensation expense is the unfortunate reality at most technology companies and many try to falsely claim profitability with adjusted figures where that cost is excluded.
Cloudflare’s Balance Sheet
On to the balance sheet, where there isn’t a ton of capital in this business at only about ~2B. There is only about 700M worth of equity (assets – liabilities), meaning it trades at a massive premium at 35x equity. With a stock like this you’re betting on very high revenue growth and the ability to earn an incredibly high return on invested capital and equity. Although there is network capex (about 10-12% of revenues), Cloudflare is still very asset light and its servers seem to be easily upgradable with minimal additional investment.
As mentioned earlier, the foresight to equip every data center with the same hardware and even leaving a slot for GPUs really illustrates this point. The asset light model is advantageous because inflation always eats away earnings growth. If you need to keep putting up a lot of capital to simply operate your business you’re really fighting an uphill battle. Furthermore, given Cloudflare’s mission critical offerings of security, speed, and reliability, there is potential of eventual pricing power in my view. The consistent addition of new products and services also increase the value proposition and enables future price increases.
Despite all that, it is still very difficult to value this company because it implies the analyst can predict the earnings potential of the limited amount of capital that exists in the business. There is a lot of so called “economic goodwill” (not traditional accounting goodwill) in this business and it demands a price that is far in excess of what is measurable.
However, given the cost structure, total addressable market, efficiency of the network, and strategic vision, I believe the revenue growth can be above 20% for the next 5 or so years and the company can achieve high levels of profitability. Serving an additional customer is not very costly and reaching greater scale results in greater profitability. In regards to competition, I think being the only vendor to offer products across a wide range of business needs is favorable.
I did a simple DCF model where I attempt to value the company. Most of the value comes in the terminal stage, as this company is reinvesting back into the business to fund its growth ambitions and produces no meaningful cash today. The management team aims to generate $5B in revenue by the year 2026, which may be ambitious.
I find it to be worth about $15B in today’s dollars and that approximates the price I paid for it. I have added stock based compensation back in the cash flows and also increased the share count. I’ve assumed most of the capex will eventually be maintenance capex. Cloudflare has proven with their architectural advantages that growth capex is fairly low. As a result, the net margin could be very similar to the free cash flow margin (lower if you add back SBC in FCF).
Cloudflare’s Management
The CEO of Cloudflare is Matthew Prince who owns about 10% of the company. Prince has made brilliant strategic moves as discussed throughout this article and often sees things before they happen. The founding team was inspired by their professor at Harvard Business School, Clayton Christensen.
Christensen is credited with one of the most influential business theories of all time: Dispruption Theory. His book, the Innovator’s Dilemma, discusses how many of the world’s largest companies over the course of history have faced an existential crisis leading to their fall from grace. This typically happens because incumbent companies are slow to adopt change. They ignore disruptive technologies that do not meet the needs of their main customers.
These technologies improve over time and eventually overtake the existing technologies and it’s too late by the time incumbents adjust. In Christensen’s terms, Cloudflare started as a classic low end disruption business model. They captured a large market share in networking and security products by offering their products for free. Now they are aiming to move up market to displace traditional security vendors and find a niche to coexist in the cloud infrastructure market dominated by Amazon, Microsoft, and Google.
The analysis above was produced by easymoneyboi and he continues to believe that Cloudflare is a promising company that trades at an expensive price. He believes it is one of the few technology companies that can grow into its premium valuation over time and it remains one of my highest conviction companies. There is always risk and uncertainty when the company’s value primarily stems from its terminal cash flows (and is also the only company in my portfolio with such an extreme setup).
However, I am comfortable taking a risk on Cloudflare and anticipate it will be a very successful business.
Editor’s Note: This analysis the first in a series of company studies that will be rolled out in this publication in going forward. Please review the Disclosure and Risk Disclaimer and bear in mind that the analysis you see here is for informational purposes and should not be taken as investment advice.
