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Cloudflare Is Due For A Correction After Its Spectacular Run

After an incredible 66% gain during the month of October, does Cloudflare (NYSE:NET) stock have any juice left in the tank?

Close up of Cloudflare logo at the Company's headquarters
Close up of Cloudflare logo at the Company's headquarters

Source: Sundry Photography / Shutterstock.com

It’s been a mind blowing run for San Francisco-based cybersecurity company. Cloudflare specializes in website security has seen its share price rally 128% over the past six months. At its current price of just over $190 a share, NET stock is now up 268% in the last 52 weeks.

And despite repeated calls from analysts for the stock to course correct, it has continued to defy the skeptics and keeps marching higher. While the median price target on the stock is currently $130, which would represent a 32% decline from current levels, there remain some on Wall Street who feel Cloudflare stock has more steam in its engine and could vault over $200 in coming weeks.

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Huge Growth Opportunities

Cloudflare is one of the newer cybersecurity stocks. The company only went public in September 2019. Since its initial public offering, NET stock has gained 960%, trouncing the gains of most other technology companies.

The main reason for the stellar returns has been Cloudflare’s focus on cloud computing security. The company is positioned as a service provider and it works to bolster the speed, reliability, and security of its clients’ websites. The market in which Cloudflare operates is growing quickly and positioned for explosive growth in coming years. The company has forecast that its worldwide addressable market will reach $100 billion by 2024.

It is that huge and expanding market that is the reason Cloudflare’s compound annual growth rate averaged 50% between 2016 and 2020. While most companies growth trajectory would level off after such a run, Cloudflare’s growth has accelerated. Its revenues grew 53% year-over-year in its most recent quarter. That accelerating growth rate is what helped to push NET stock up more than 65% in the month of October this year.

The company now has 1,088 large customers globally (those that spend more than $100,000 with the company) and boasts a retention rate of 90%, meaning that those customers are renewing their services with Cloudflare.

Reason for Caution

The October rise in NET stock was underpinned by the company’s announcement that it has formed a partnership with Microsoft (NASDAQ:MSFT) and other companies such as Yandex (NASDAQ:YNDX) to make their online search engines faster and provide more timely results. The arrangement with the various search engines gives a boost to Cloudflare’s value proposition.

The company claims it will notify Microsoft’s Bing, and other search engines, when content is created, updated, or deleted, helping them more efficiently align searches across the internet. Search engine optimization is a service Cloudflare says it plans to perfect and market to businesses of all sizes.

While Cloudflare’s growth and share price appreciation have been nothing short of spectacular, there are reasons for investors to be cautious with NET stock. First of all, Cloudflare now has a market capitalization of more than $56 billion and a price-sales ratio of 89, which makes it one of the most expensive stocks not only among cybersecurity companies but the entire stock market.

To give an idea of how overpriced Cloudflare’s stock is currently, consider that its closest competitor, Fastly (NYSE:FSLY), has a price-sales ratio of 16. Cloudflare’s valuation is now five times bigger than Fastly’s and the two companies have, basically, the same revenue growth.

Additionally, while Cloudflare has been growing leaps and bounds, the company remains unprofitable. While it is not unusual for young, fast growing companies to be unprofitable, particularly in the technology space, investors should be wary of red ink. Cloudflare has forecast that it will report a loss of $28 million to $24 million on revenue of up to $633 million this year.

Wait On NET Stock

Cloudflare next reports quarterly results on Nov. 4. The company’s stock has been rallying in the lead-up to its next earnings and could sell off immediately after its financials are made public.

Even if it doesn’t sell off now, it is clear that the stock is at a sky high valuation and is extremely expensive as it approaches $200 a share. Add in the fact that the company is unprofitable and its massive year-to-date run of 158%, and there is every reason to believe that Cloudflare’s stock will pullback in the near term

Investors who missed the current rally should wait for the stock to decline to $150 per share or lower. Watch for a bottom and then try to catch the next rally higher. Right now, NET stock is not a buy.

On the date of publication, Joel Baglole held a long position in MSFT. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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