Cloud-based website security company Cloudflare (NYSE:NET) stock has proven itself a success since its 2019 IPO. In that relatively short span of time shares have appreciated from $18 to recent historical highs of $135.
While its success has been a positive story, it has faltered of late. NET stock has plummeted since Sept. 22, quickly moving from $135 to $112 before beginning to rebound today.
It’s no secret that Cloudflare shares are relatively expensive. That doesn’t explain why the market soured on NET shares over the past two weeks, but it does pose a question: Is this a buy-the-dip situation, or a sign of greater trouble on the way?
To answer that it’s necessary to begin with the most recent financial results for NET stock.
Historically Strong
Cloudflare posted what it characterized as its strongest quarter ever since becoming a publicly traded entity back in 2019.
Revenues grew by 53% in Q2 on a year-over-year basis, reaching $152.4 million. But even at that time Cloudflare was trading near the $124 levels analysts believe it should. That was a sign that it might be oversold at that point.
Hindsight is 20/20, but it doesn’t help much. At that time it would have been difficult to bet against the company in any case.
The company had increased the number of large customers to 1,088 at that time. Further, it added 140 such customers in the quarter, who account for $100k annually each. Things were going well. That is still true, but the market became scared of its valuation.
On top of those strong figures, Cloudflare also recorded an all-time high net retention rate of 124%.
SaaS Strength
SaaS companies are subject to a unique set of metrics. Fortunately for Cloudflare, it recorded a net retention rate of 124% in the quarter. In essence the metric measures how well a company sustains its customer revenue base while also generating increased revenue therefrom.
The calculation for net retention rate is fairly straightforward. It can be done in this way according to Revtek:
… adding the MRR and Expansion Revenue together. This is the total revenue for the month. You then subtract the month’s revenue lost due to downgrades and cancellations. Then divide by the original MRR number. This result should be a percentage over 100% if your business is operating with healthy growth.
Again, NET stock reached 124%, and therefore is operating within a very healthy growth rate.
That again should leave pundits scratching their heads. It should have continued to rise based on its growth. But the reason it didn’t has been covered in depth by my colleagues. It simply was overpriced.
Too Costly
I’ll borrow a quick explanation from my colleague, Dana Blankenhorn, in understanding why NET stock dropped. As he mentions, “I get nervous when stocks start selling for 10 to 20x a company’s revenues. At more than 60x revenue, you can have it. But Cloudflare stock is down 12% in the last week so some will tell you to buy the dip.”
He has a very good point; you cannot expect the market to uphold oversold equities indefinitely. It looks like the bottom simply fell out around Sept. 22.
But it also poses a question moving forward. Cloudflare is poised for continued growth. The company is anticipated to bring in $632 million in 2021 revenues. And that growth is not projected to slow down as the consensus is that it will hit $843 million in revenues in 2022.
What to Do With NET Stock
If NET stock continues to move toward more reasonable valuations, then next year’s revenues may not matter. The company could hit or exceed those figures and share prices could decrease anyway. All that has to happen is for the market to continue to view it as overpriced. Therefore, sit it out.
The company is clearly strong, but the market also clearly gave it excessive reward that made it too expensive.
On the date of publication, Alex Sirois did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.