Artificial Intelligence (AI) Could Become a Game Changer for This Company. Should You Buy Its Stock Right Now?

Cloudflare (NYSE: NET) operates the world's leading content delivery network (CDN) -- a distributed cloud platform that puts servers closer to where end users are, making data transfer faster, more secure, and more reliable for its clients and their customers. With servers in 330 locations across the globe, its estimated share of the CDN market exceeds 42%.

As such, Cloudflare is in a solid position to make the most of an opportunity that's growing rapidly. Technology consulting firm SkyQuest estimates that the CDN market could clock annualized growth of almost 22% between 2023 and 2031, generating $94 billion in revenue at the end of the forecast period as compared to just over $19 billion last year.

Indeed, Cloudflare has been growing at a solid pace. The third-quarter results it released on Nov. 7 showed healthy gains in revenue and earnings. More importantly, it has been expanding into another lucrative niche -- cloud-based artificial intelligence (AI) services. That could turn out to be a smart move in the long run.

A massive addressable market

Cloudflare's revenue rose 28% year over year in Q3 to $430 million, while non-GAAP earnings increased by 25%. The top line exceeded Wall Street's consensus expectation of $424 million.

However, management said it anticipates $451.5 million in revenue in the current quarter at the midpoint of its guidance range, along with $0.18 per share in earnings. Analysts had been looking for $0.17 per share in earnings on revenue of $455.7 million. That less-than-impressive guidance helps explain why Cloudflare stock fell by more than 4% following the report's release.

Cloudflare did raise its full-year guidance. It now expects 2024 revenue to land at $1.661 billion as compared to the earlier estimate of $1.658 billion. Its earnings estimate was also boosted to $0.74 per share from an earlier range of $0.70 per share to $0.71 per share. The updated guidance would amount to a revenue jump of 28% and impressive bottom-line growth of 51%.

Still, traders decided to press the sell button -- perhaps in part due to Cloudflare management's assertion that the company's customers remain cautious about spending. As CEO Matthew Prince said on the earnings conference call:

In Q3, the IT spending environment remained consistent with prior quarters, with customers closely scrutinizing every deal, emphasizing cost efficiency and seeking meaningful ROI. This cautious approach isn't new. It's something we understand, and as a must have, not a nice to have, benefit from relative to some of our peers.

However, Cloudflare still delivered healthy growth despite the challenging environment. More importantly, it expanded its customer base and continues to win growing shares of its customers' wallets. Cloudflare's paying customer base increased by 22% year over year last quarter to just over 221,500. Even better, the number of customers generating more than $100,000 in annualized revenue for the company grew by nearly 28%.

Moreover, existing customers continued to increase their spending: Cloudflare's dollar-based net retention rate was 110%. This metric compares the annualized revenue from its customers in the latest quarter to the annualized revenue from the same customer cohort in the year-ago period. Clearly, established customers are buying additional products or are extending their usage of the platform.

Cloudflare estimates that its total addressable market could grow from $176 billion this year to $222 billion in 2027, driven by incremental growth opportunities in areas such as AI. This explains why the company has been investing in AI-specific hardware such as high-end graphics processing units (GPUs) to power its AI offerings.

In September 2023, Cloudflare announced an AI-specific suite of products that included Workers AI, a platform that allows customers to run AI models on Cloudflare's network, powered by GPUs from the likes of Nvidia. Workers AI is already gaining healthy traction among users -- the company has landed multiple deals running into the millions of dollars for it.

It won't be surprising to see Cloudflare's cloud-based AI offerings gain more traction as it makes its AI-related offerings available across nearly all the cities that it serves. It was already available in 150 cities as of April this year, and it's well on its way to its goal of deploying AI GPUs in 300 cities by the end of 2024.

Naturally, Cloudflare has been increasing its capital expenses as it buys and deploys those GPUs.

NET Capital Expenditures (TTM) data by YCharts.

This looks like a smart move from a long-term perspective, as Mordor Intelligence estimates that the size of the cloud-based AI services market will increase at an annualized rate of 32% through 2029 to $274 billion. Moreover, Cloudflare already has a large base of customers to whom it can cross-sell its AI-focused offerings. As a result, it won't be surprising to see the company's growth accelerate in the long run thanks to AI.

The valuation is rich, but there's a silver lining

Though Cloudflare has been clocking healthy growth, it trades at an expensive 19 times sales right now. That's significantly higher than the S&P 500 index's price-to-sales ratio of just over 3. Similarly, Cloudflare's forward earnings multiple of 107 is also lofty compared to the S&P 500 index's forward earnings multiple of 24.6.

So investors looking for tech stocks that aren't too expensive will probably consider other ways to capitalize on the AI boom. However, growth-oriented investors should note that Cloudflare's revenue pipeline is expanding at an impressive pace. Its remaining performance obligations (RPO) jumped 39% year over year in Q3, significantly outpacing its revenue growth.

As RPO refers to the value of a company's contracts that will be fulfilled in the future, the terrific growth in this metric suggests that Cloudflare's top line should grow at a faster pace in the future. This is why investors with a tolerance for risk can still consider buying Cloudflare, as its dive into AI seems set to unlock a terrific long-term growth opportunity that could send its stock soaring.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Cloudflare and Nvidia. The Motley Fool has a disclosure policy.