Time to Buy the Dip on Cloudflare Stock?

Cloudflare stock just had its AI-powered 2024 rally erased, but perhaps for a very good reason. Read More...

Cloudflare stock just had its AI-powered 2024 rally erased, but perhaps for a very good reason.

Next-gen internet infrastructure provider Cloudflare (NET 0.77%) was among several stocks getting a price boost in 2024 from its association with artificial intelligence (AI). But Cloudflare’s AI rally faltered after the first-quarter update, though, leaving many investors wondering if this is a good time to buy the dip. Cloudflare is now down over 10% so far in 2024, but the stock still trades up more than 30% over the past 52 weeks.

There are reasons to remain optimistic about Cloudflare’s long-term prospects. There are also questions regarding the current financial condition of the business. Here’s what investors need to know.

A gut check for AI momentum

At its core, Cloudflare is what’s known as a content delivery network (CDN), data centers located close to internet users that store and deliver internet content (websites, video, etc.) on demand (when you click on an internet link, for example). On top of that core CDN service, Cloudflare has been building lots of software products, ranging from cybersecurity to software development tools.

For the better part of a year, Cloudflare stock has caught a second wind (after the brutal bear market sell-off in the aftermath of the pandemic-associated boom) thanks in large part to AI “news.” Like just about every other data center- and internet-based business, Cloudflare has been tapping into Nvidia‘s hardware and AI software algorithms to improve its CDN and software performance. However, Cloudflare originally announced this Nvidia partnership back in 2021, so it isn’t exactly news at all.

The AI momentum is starting to wear off, though, and Cloudflare’s Q1 2024 earnings update proves why that’s justified. Q1 revenue beat management’s outlook provided three months ago and came in at $379 million (up 30% year over year). However, as cited by co-founder and CEO Matthew Prince, global economic worry is still clouding the trajectory moving forward. Previous full-year 2024 revenue guidance of $1.648 billion to $1.652 billion provided three months ago was left unchanged, implying growth of about 27% over 2023.

To be clear, 27% growth is good. But it’s a continuation of the company’s cool-off from about 50% growth for several years following its initial public offering in 2019. The market was quick to voice its displeasure following the quarterly update, sending Cloudflare stock down about 20% in the days immediately following the report.

Is the sticker price worth it?

At this juncture, Cloudflare stock still trades at a premium of nearly 180 times trailing-12-month free cash flow (FCF), which will roughly align with Cloudflare’s stated expectations for adjusted earnings per share. Clearly, that price tag implies continued fast revenue expansion, as well as significant profit margin expansion along the way.

But even as Cloudflare loses some steam, profit margins are perhaps not beefing up as quickly as they should. Management did slightly boost its outlook for adjusted operating income and earnings (again, roughly aligning with FCF) to $160 million to $164 million for 2024. But the previous guidance was $154 million to $158 million, so it’s not much of an increase. The new guidance implies adjusted operating income and FCF profit margins of about 10%.

This is the key risk facing Cloudflare shareholders right now. And with profit not scaling up all that quickly — at least not yet — the stock is still hard for me to call a buy now. As it has been for quite some time, I think this is still best treated as a dollar-cost average stock for those who want to bet on Cloudflare long-term. Consider nibbling in batches, perhaps on a monthly or quarterly basis, to build up a desired position over time, rather than making a big buy-the-dip buy.

Nicholas Rossolillo and his clients have positions in Cloudflare and Nvidia. The Motley Fool has positions in and recommends Cloudflare and Nvidia. The Motley Fool has a disclosure policy.

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