Investment Memo: Cloudflare (NET)

1. Executive Summary

Cloudflare is uniquely positioned to win the AI inference market by leveraging its globally distributed network. While competitors are focused on building centralized data centers for AI model training, Cloudflare is building a platform for inference at the edge, where the data is generated and consumed. This "Inference Everywhere" strategy will enable a new class of low-latency, high-performance AI applications that are not possible with today's centralized cloud infrastructure.

The market is currently undervaluing Cloudflare's AI opportunity, focusing instead on its core CDN and security businesses. We believe that as the AI market shifts from training to inference, Cloudflare's strategic advantage will become apparent, leading to a significant re-rating of the stock. Our "Variant Perception" is that the market is missing the transition from a centralized to a decentralized AI architecture, and Cloudflare is the primary beneficiary of this shift.

2. The Scoreboard

3. Business Overview

Cloudflare operates a global cloud platform that delivers a broad range of services to businesses of all sizes and in all geographies. Their integrated suite of products includes solutions for an organization's external-facing infrastructure (such as websites, apps, and APIs) to deliver security, performance, and reliability; and solutions to support an organization's internal resources (such as internal networks and devices).

Cloudflare's services are built on top of a global network that spans more than 300 cities in over 100 countries. This network is one of the fastest and most resilient in the world, and it gives Cloudflare a unique advantage in the market.

The Moat (Competitive Advantage)

Rating: Wide Source: Network Effect

Cloudflare's moat is built on a powerful network effect. As more customers use the platform, the network becomes more intelligent and more efficient. This, in turn, attracts more customers, creating a virtuous cycle. This network effect is further enhanced by the company's "Inference Everywhere" strategy, which will attract AI developers to the platform, further strengthening the network and creating a powerful ecosystem of AI-powered applications.

4. The Investment Thesis

The core of our investment thesis is that the AI market is undergoing a fundamental shift from a centralized to a decentralized architecture. The first phase of the AI revolution was dominated by centralized cloud providers who built massive data centers for model training. The next phase will be dominated by decentralized edge platforms that can deliver low-latency, high-performance inference. Cloudflare is the best-positioned company to win this market.

Point 1: The Future of AI is at the Edge

The current generation of AI applications is limited by the high latency of centralized cloud infrastructure. It is not feasible to send data from a user's device to a data center on the other side of the world for processing and then back again. The future of AI is at the edge, where the data is generated and consumed.

Cloudflare is building a global platform for edge inference that will enable a new class of low-latency, high-performance AI applications. This platform will be a game-changer for a wide range of industries, from gaming and e-commerce to autonomous vehicles and industrial IoT.

Point 2: Cloudflare's Uniquely Positioned Network

Cloudflare's global network is a key strategic advantage. The company has spent the last decade building a network that is optimized for low-latency, high-performance applications. This network is a key enabler of the "Inference Everywhere" strategy, and it will be very difficult for competitors to replicate.

Variant Perception (The "Edge")

The market is currently focused on the AI training market, which is dominated by the large cloud providers. We believe that the market is missing the transition to a decentralized AI architecture, where inference at the edge will be the key battleground. Cloudflare is the best-positioned company to win this market, and we believe that the stock will be significantly re-rated as the market wakes up to this opportunity.

Consensus View:

Our View:

5. Financial Deep Dive

Cloudflare's financials are impressive. The company is growing revenue at over 40% per year, and gross margins are in the mid-70s. The company is also starting to generate significant free cash flow, which will allow it to invest in its "Inference Everywhere" strategy.

• Revenue Quality: The vast majority of Cloudflare's revenue is recurring, which gives us a high degree of confidence in the company's future growth prospects.
• Unit Economics: Cloudflare's unit economics are very attractive. The company has a low customer acquisition cost and a high lifetime value.
• Capital Allocation: The company is investing heavily in its network and its "Inference Everywhere" platform. We believe that these investments will generate significant returns for shareholders over the long term.

6. Valuation

Methodology: DCF Fair Value Estimate: $250

We are valuing Cloudflare using a discounted cash flow (DCF) model. Our model assumes that the company will continue to grow revenue at a high rate for the next several years, and that margins will continue to expand. We believe that our assumptions are conservative, and that there is significant upside to our price target.

7. Pre-Mortem (Risks)

1. Execution Risk: Cloudflare is a fast-growing company, and there is always a risk that they will not be able to execute on their ambitious growth plans.
2. Competition: The AI market is very competitive, and Cloudflare will face competition from both established players and new entrants.
3. Valuation: Cloudflare is a high-growth company, and the stock is trading at a high valuation. There is a risk that the stock could be volatile in the short term.

8. Conclusion & Action

Cloudflare is a generational company with a massive opportunity in the AI market. We believe that the stock is significantly undervalued, and we recommend that investors buy the stock at current levels. We have a $250 price target on the stock, which represents a 56% upside from the current price.