Selling Cloudflare – need to expect moon and stars to justify valuation

What seems like ages ago (August 2020) I did a small writeup on Cloudflare. I wrote then:

The company does a ton of things but in my opinion the easiest way to describe them is a solution for companies that want internet security as a service as well as other general cloud services for things like scaling and reliability (load balancers, content delivery networks (CDNs), fast Domain Name System (DNS) resolution). You could almost think of them as an AWS competitor, but one that in my opinion doesn’t require as much vendor lock-in and can be used alongside AWS.

I’ve had really good experiences with Cloudflare and use it for caching on a WordPress blog, workers (competitor to AWS Lambda) for a toy project and occasionally for day job stuff. The company is extremely well run and I’ll always appreciate that CEO Matthew Prince was a network admin and has lived his problem space. I told a friend the other day I think NET as of now is growing to be as important to a functional internet as AWS, and I still believe that.

The business is fantastic. From the last investor deck:

53% revenue CAGR, 80% gross margins (75%+ long term) and management is telling us to bank on 20%+ operating margins. This is a really good company that management is telling us long-term will have fantastic operating metrics.

The valuation though? Even if NET does a billion in sales in FY21, it still trades ~55x+ sales when you take out the cash. If we assume a 15% IRR at 50% top line growth and ending 30% EBITDA margin, this company still trades at 50x EBITDA in 2026:

In short, if you want to own NET, you’re gonna have to get very comfortable with an insane valuation for the next five years.

For those of who you read my VMEO post from a while back explaining why I sold, this analysis isn’t much different. I like the business, I hate the valuation. I generally believe selling because of valuation is a bad reason to sell, but I don’t want to sit on the edge of my seat every quarter hoping for 50% revenue growth. This to me is no different from your favorite NBA team using a max contract on a good player. It’s all fun and games until performance is slightly less than great, at which point everyone gets upset. When you pay top dollar, there is no margin for error.

Unlike VMEO, I may still hold a little NET for curiosity and learning reasons. Cloudflare’s offerings are beloved by customers and their global network for many is a must-have for speed and security reasons. Because this company impacts my job so much, I feel obligated to hold a little.