Rising Cybersecurity Regulation And Hyperscaler Pressure Will Erode Margins

Key Takeaways

• Rising regulatory and geopolitical pressures are increasing Cloudflare's costs, limiting market expansion, and threatening long-term margin and earnings growth.
  
• Intensifying competition, open-source adoption, and sustainability mandates are eroding product differentiation, pricing power, and operational efficiency.
  
• Cloudflare's accelerated innovation, strong enterprise sales, scalable network, and strategic position in AI-driven internet models underpin sustained revenue growth and expanding profitability.

Catalysts

Operates as a cloud services provider that delivers a range of services to businesses worldwide.

• Ongoing fragmentation of the global internet environment-driven by rising geopolitical tensions, stricter data sovereignty laws, and increased regulatory scrutiny-may force Cloudflare to replicate infrastructure within key regions, raising compliance and operating costs while narrowing its effective addressable market. This would ultimately weigh on future revenue growth and compress net margins over the long term.
  
• The accelerating global shift toward stronger cybersecurity regulation and compliance obligations is poised to significantly increase Cloudflare's legal risks and operational complexity, which may slow its pace of product innovation and lead to sustained upward pressure on R&D and G&A expenses, undermining efficiency gains and limiting future earnings growth.
  
• Persistent and growing competition from hyperscalers integrating edge security and networking directly into their end-to-end offerings could further erode Cloudflare's pricing power, drive commoditization of core CDN products, and contribute to a structural decline in gross margins and net revenue retention-especially as large enterprises consolidate spend with single vendors.
  
• Intensified focus on sustainability and mounting scrutiny over the energy consumption of global network infrastructure is likely to result in new regulations and higher operational expenses for Cloudflare's data centers, leading to margin headwinds and limiting improvements in free cash flow conversion.
  
• The rapid development and adoption of open-source networking and security tools threatens to undermine Cloudflare's proprietary platform moat, potentially leading to increased customer churn, downward pricing pressure, and stalling cross-sell of higher-margin products such as Workers AI-hindering both revenue diversification and the ability to sustain premium valuations on future earnings.

Cloudflare Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Cloudflare compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Cloudflare's revenue will grow by 24.5% annually over the next 3 years.
• The bearish analysts are not forecasting that Cloudflare will become profitable in next 3 years. To represent the Analyst Price Target as a Future PE Valuation we will estimate Cloudflare's profit margin will increase from -6.2% to the average US IT industry of 7.0% in 3 years.
• If Cloudflare's profit margin were to converge on the industry average, you could expect earnings to reach $254.4 million (and earnings per share of $0.7) by about August 2028, up from $-117.1 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 214.9x on those 2028 earnings, up from -583.9x today. This future PE is greater than the current PE for the US IT industry at 29.5x.
• Analysts expect the number of shares outstanding to grow by 1.54% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.85%, as per the Simply Wall St company report.

Cloudflare Future Earnings Per Share Growth

Risks

• The accelerated pace of innovation-including the launch and rapid customer adoption of new platforms like Workers AI, Zero Trust, and the coming Act 4 initiatives-positions Cloudflare to further increase gross and recurring revenues over the long term, countering pressure on share price.
  
• Strong enterprise momentum, demonstrated by record growth in million-dollar and multi-million-dollar deals and expanding relationships with large customers, suggests increasing net revenue retention and long-term revenue visibility.
  
• The architectural advantage of Cloudflare's globally distributed, multi-use edge network supports robust gross margins by lowering incremental costs even during massive cyberattacks, bolstering profitability despite competitive pricing pressures.
  
• Cloudflare's effective land-and-expand strategy, combined with increased sales productivity, new strategic partner relationships, and a growing sales force, is driving higher pipeline attainment and larger average contracts, supporting sustained top-line growth.
  
• Cloudflare's unique role as a foundational intermediary in new AI-driven internet business models, especially as it facilitates transactions and monetization between publishers and AI companies, positions it to capture new revenue streams and enhance long-term earnings as these opportunities materialize.

Valuation

• The assumed bearish price target for Cloudflare is $116.43, which represents two standard deviations below the consensus price target of $209.01. This valuation is based on what can be assumed as the expectations of Cloudflare's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $255.0, and the most bearish reporting a price target of just $90.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $3.6 billion, earnings will come to $254.4 million, and it would be trading on a PE ratio of 214.9x, assuming you use a discount rate of 8.8%.
  
• Given the current share price of $196.17, the bearish analyst price target of $116.43 is 68.5% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.