Cloudflare: The Edge Location Cloud

According to Phil Winslow, the VP of Investor Relations, "Over 1,900 AI companies are currently building on Cloudflare (NYSE:NET). Over the years, Cloudflare has established itself as the infrastructure for the internet due to having robust security solutions, network enhancing products, and a freemium version that is accessible for small businesses.

While there are significant headwinds that challenge Cloudflare’s position, I believe there is still room for growth considering that Cloudflare has a strategy in place for capitalizing on edge locations for enterprises, diversifying a growing customer base, and designing the payment rails for agentic web scraping.

Inference Capability is the Future

Due to AI demand, enterprises are transitioning from centralized data centers to edge locations to be closer to end users (Morningstar Report). Edge locations are used to run security checks, store content for websites, and compute code for applications so this can reduce latency and computing costs over time. Cloudflare has a differentiated advantage in this space because of their large existing network and unique architecture. This architecture allows "every service on every server" so this reduces latency and optimizes network activity for day-to-day operations (Investor Day). The reason this is important is because the long-term goal is to provide optimized infrastructure for inference. Inference is basically a trained AI model making predictions or generating outputs.

To further support this enterprise transition, Cloudflare also offers two key products that stand out from the competition. Workers AI is a product that allows developers to build machine learning models on serverless GPUs to provide compute for inference. The second product, Vectorize, provides a specialized memory feature for LLMs in edge locations so an LLM does not need to generate an output from scratch each time.

While the products mentioned are a key driver for future growth, it’s also important to note the freemium version Cloudflare provides for small to mid-size companies. Not only does this enhance a moat-developing network effect, it also provides a massive amount of data for Cloudflare to analyze for product development (Morningstar Report). This is a key differentiator because security and AI products are constantly changing so having an authentic pipeline of real-time data puts Cloudflare products one step ahead of the competition.

Growth Supports Valuation

The FY24 10-K explicitly states that no single customer accounted for more than 10% of revenue in 2022, 2023, or 2024. The number of large customers (defined as those with annualized revenue greater than $100,000) grew 27% to 3,497 at the end of FY 2024, up from 2,756 at the end of FY 2023 (10k).

Figure 1: Large Customer Growth Trend. Source: TipRanks

Cloudflare is closing larger and larger contracts by offering superior scalability, efficiency, speed, and cost savings for security products and inference workloads compared to hyperscalers (Investor Day). CJ Desai, the President of Product and Engineering, explained that major AI companies use Cloudflare as a "secure front door" to protect their models from denial-of-service attacks, abuse, and attempts to extract personal or proprietary data (JPM Tech Conference Transcript).

Along with customer contract expansion, Cloudflare has also bolstered its balance sheet by issuing $2.0 billion in convertible notes, providing substantial capital in the short term for continued investment in areas such as their developer platform, network expansion, potential M&A opportunities, and R&D. This excess liquidity can fund the growth strategy without constraints until June 2030 when the notes are due.

Agentic Web Scraping Payment Rails

Beyond customer growth, Cloudflare is positioning itself for an entirely new revenue opportunity. During the Investor Day presentation, Matthew Prince, the CEO and Co-Founder of Cloudflare, highlighted data that shows Google sends one visitor for every six pages it crawls, while some AI models crawl thousands of pages for every visitor sent. Cloudflare is positioning itself to be the transactional layer for this new AI-driven web, aiming to build the payment "rails" between AI companies and content creators.

Cloudflare is building tools to allow publishers to block AI crawlers or charge them for access. The ultimate goal is to create a marketplace where "humans should get content for free, and robots should have to pay." This opportunity sets Cloudflare up to enable the transactions and become the platform for an AI-driven internet. While the exact business model is still in development, management sees this as a massive new opportunity. (Earnings Call).

Key Risk and Headwinds

Although the idea of profiting off web scraping sounds enticing, management acknowledged the business model for the agentic web is undefined and stated it is "way too early" to model revenue (Investor Day). This is clearly a problem for advertising and e-commerce business models though because people aren’t clicking links like they did before due to search becoming an answer engine. If content creators cannot monetize their content, the amount of websites on the internet could decline, potentially shrinking the ecosystem Cloudflare secures and optimizes. There is a clear incentive for Cloudflare to provide a solution but competition will apply significant pressures on margins if Cloudflare has any sort of success with monetizing agentic web scraping.

On the topic of competition, a former AWS Lambda lead reportedly told the CEO that AWS views Cloudflare as its "top competitor" in the serverless space (Investor Day). Cloudflare offers a serverless compute and storage environment for edge locations and acts as a fourth cloud provider. Competing with the cloud giants (AWS, Azure, GCP) for customers is a risk since Cloudflare does not have enough free cash flow to actually compete with these incumbents. Cloudflare has been attempting to close larger enterprises so not only will the competition get worse, but the sales cycles will become more complex due to extensive contract requirements, pricing pressures, and overall bureaucracy.

Lastly, the macroeconomic environment is also a headwind for Cloudflare since customers still face a lot of uncertainty around tariffs. Companies have been able to absorb costs in the short term but they will eventually need to make a tough decision on product pricing if tariffs persist. Product cost increases can lead to less customer consumption so a decrease in customer revenue could impact Cloudflare in the long term if customers reduce their IT budgets due to lessened demand. Management addressed this concern though in the Q2 earnings call by stating these issues were not showing up in sales conversations and that pipeline growth remains strong (Earnings Call).

Valuation: A Reality Check

Despite these risks, investors continue to pay a significant premium for Cloudflare’s growth. Management recently acknowledged that historical revenue growth is not indicative of future performance, and growth rates have since slowed, but Cloudflare is still trading near all-time highs and has returned 166.34% over the past year (10k).

Figure 2: Forward EV/EBITDA Multiples for Cloudflare vs. Cybersecurity Peers. Source: Koyfin.

Compared to Crowdstrike (NASDAQ:CRWD), Zscaler (NASDAQ:ZS), and Palo Alto Networks (NASDAQ:PANW), Cloudflare is trading at a 130.4% EV/EBITDA multiple which highlights an extremely high valuation next to peers. A growth company with a high valuation is not uncommon; however, Cloudflare has less than 1.5% insider ownership, a negative return on invested capital, and has returned a negative GAAP EPS growth over the past five years (Koyfin).

Figure 3: Free Cash Flow Yield (LTM) for Cloudflare vs. Cybersecurity Peers. Source: Koyfin.

Along with low insider ownership and high multiples, Cloudflare has the lowest free cash flow to market cap yield in this peer group by a wide margin. GAAP gross profit margins fell from 77.8% to 74.9% during the last quarter (10Q) and it’s also worth noting that Cloudflare has a high beta (1.84) at this time. Management stated their sales pipelines aren’t affected by the macro environment for now but a high beta indicates this sentiment could quickly shift if the market experiences turbulence.

A High-Priced Bet on the Future of the Internet

While the valuation is high, it can be supported by a long-term focus on inference demand, enterprise contracts, and agentic payment rails for web scraping. Cloudflare has a real opportunity with edge location expansion due to its differentiated architecture, network, and product offerings. Considering that Cloudflare already owns a portion of the internet’s infrastructure, developing the payment rails for agentic web scraping is within the realm of possibility. There is a competition risk with this opportunity; however, it would be extremely difficult for a competitor to compete with Cloudflare’s network in the long term.

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This content was originally published on Gurufocus.com