We recently compiled a list of the 10 Best Cybersecurity Stocks To Buy According To Hedge Funds. In this article, we are going to take a look at where Cloudflare, Inc. (NYSE:NET) stands against the other cybersecurity stocks.
The growth in internet use has made connectivity ubiquitous across the daily lives of businesses and individuals. It has also opened up more avenues for nefarious individuals or organizations to run financial heists, steal confidential data, or disrupt critical infrastructure and systems. The scale of these activities is staggering as well, with research outlining that as of 2021, cyber criminals caused a stunning $6 trillion in damages – an impact greater than all but the two largest economies in the world.
These threats have led to the growth of a vibrant cybersecurity industry which came into the spotlight of global media coverage in July 2024 after an outage affected an unbelievable 8.5 million computers worldwide. The outage shed light on the intricate nature of the global computing ecosystem as well as the risks that are present if security infrastructure has a single point of failure. While it’s too early to speculate on the losses, some estimates from insurer Parametrix show that insured losses could touch as much as $1 billion for Fortune 500 companies. As if this weren’t enough, the insurance firm’s CEO believes that the global impact could be several times higher. He estimates that the total financial losses could sit at $15 billion while global insured losses could range between $1.5 billion to $3 billion.
Looking at the scale of these losses, it’s only natural to ask, what caused the global cyber outage? Well, the problem started when a cybersecurity provider that was the third biggest cybersecurity company in the world, rolled out an upgrade for its Falcon security platform. This caused systems that used the Windows operating system to crash since the software upgrade included a corrupted file that works with the deepest level of a computer called a kernel. The OS showed the infamous blue screen of death, which is the software’s response to protect the user from damage to the kernel that can lead to a loss of data. The disruption lasted for quite a while too since all the systems affected by the update have to be manually booted into safe mode to remove the corrupted file before they can normally function.
Coming back to the financial side of the cybersecurity industry, like other sectors, it is also facing disruption through artificial intelligence. Research shows that the AI driven cybersecurity industry was worth $20 billion in 2023. From then until 2027, the sector is expected to grow at a compounded annual growth rate (CAGR) of 25.3% for a final value of $49.2 billion. In other words, the industry is expected to more than double in four years. As for the costs of cybersecurity breaches, they’re also expected to grow from 2021 levels in the age of AI. These costs are estimated to sit at $8 trillion by 2023 end and jump to $10.5 trillion by 2025 end. The current era in the finance industry is marked by high interest rates, and they’ve made their impact on cybersecurity mergers too. In 2023, 363 M&A deals were announced in the cybersecurity industry, for an 18.8% annual drop.
Within these deals, strategic buyers, i.e. those that buy firms that align with their business strategies, accounted for 57.3% of the deals. Despite the lower number of deals, valuations remained robust. Between Q4 2020 and Q4 2023, average EV/Revenue and EV/EBITDA multiples in the cybersecurity M&A sector were 3.3x and 11.6x, which were higher than the broader averages of 2.1x and 10.4x.
Delving deeper, despite the tough business spending and inflation in 2023, cybersecurity stocks did post some returns. These came at a time when broader software as a service (SaaS) stocks were struggling due to corporate uncertainty about future spending plans. The Houlihan Lokey Cybersecurity Index, which tracks the performance of 28 top cybersecurity stocks, increased by 83% year to date by 2023 end and jumped by 28% during the fourth quarter. These returns were accompanied by a revenue growth of 18% and a stronger earnings growth of 29%, showing the benefits of operating in a high margin software industry which allows cybersecurity stocks to eke out more pennies on the dollar when it comes to profit. While the 83% returns of the index themselves mark a strong lead of 58 percentage points over the flagship S&P, this band widens when we further narrow down the top cybersecurity stocks to only include the high growth firms. Their last twelve month returns as of 2023 end were 101% for an even wider band of 76 percentage points.
Shifting towards valuation, like the broader SaaS industry, cybersecurity stocks are primarily evaluated through their enterprise value to revenue. The high growth cybersecurity stocks had a median EV/2024E Revenue ratio was 9.8x. For the medium and low growth stocks, the median ratios were 5.9x and 3.0x. respectively. Crucially, ratios for high and medium growth cybersecurity stocks were significantly higher than the EV/Revenue ratios of acquisition targets that we’ve shared above. This implies that as far as the current environment for cybersecurity acquisition goes, value seems to be driving at least some deals as businesses find it difficult to raise capital because of high interest rates. As for revenue growth percentage, the median values ranged between 33% for the high growth firms to 4% for the low growth firms.
Our Methodology
To make our list of the best cybersecurity stocks to buy according to hedge funds, we ranked the holdings of multiple cybersecurity ETFs by the number of hedge funds that had bought the shares during Q1 2024 and selected the stocks with the highest number of hedge fund investors.
Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).
A close-up of a server array powering a cloud-services system.
Cloudflare, Inc. (NYSE:NET)
Number of Hedge Fund Investors in Q1 2024: 44
Cloudflare, Inc. (NYSE:NET) is a software company that provides cloud based cybersecurity, website management, routing, and developer cybersecurity services. The diversity of its business models means that Cloudflare, Inc. (NYSE:NET) offers businesses a one stop solution for their different cybersecurity needs. This allows the firm leeway to gain market share in an economy constrained by tight spending as businesses prefer to deal with one firm as opposed to several cybersecurity providers. Additionally, the firm is positioning itself early in the AI industry by acquiring GPUs to allow customers to deploy AI models. These include generative AI at the edge, and given the tight GPU capacity the industry is suffering from right now, an early move advantage could create revenue tailwinds for Cloudflare, Inc. (NYSE:NET). Management is also looking to expand its presence in the enterprise cybersecurity market, which it believes presents a $222 billion TAM.
Cloudflare, Inc. (NYSE:NET)’s management also believes that it is looking at a $5.6 billion recurring revenue pie within its current customer base. ARR is a key evaluation metric for software firms as it provides them with a stable source of revenue. On this front, winning new deals is key, and here’s what Cloudflare, Inc. (NYSE:NET)’s management had to say during its Q1 2024 earnings call:
“Speaking of customers, let me share some great wins for the quarter. The National Cyber Security Centre, the UK’s technical authority for cyber threats, signed a three-year contract with Cloudflare to deliver its protective domain name service. PDNS protects over 1,400 UK organizations in central government, local government, healthcare and emergency services from malware and cyber threats. This was a very competitive process with several vendors and a rigorous technical evaluation. We tightly collaborated with Accenture, a partner we’re looking forward to working with even more closely on this landmark UK public sector win. A leading technology company expanded their relationship with Cloudflare, signing a three-year, $40 million pool of funds contract, $8.5 million of which are expansion.
This deal is an example of a strategic platform deal that we’re increasingly seeing customers opt for with a rate card for more than 40 Cloudflare products and services. These include Cloudflare One, Magic Transit, R2, as well as Workers AI, which the customer was quick to dive in and start trialing. As a textbook land and expand story, this customer first came to us in 2017 for our application security services and has continued to expand over the years with this deal encompassing the vast majority of Cloudflare’s platform. A Fortune 100 financial services company signed a similar four-year, $10 million pool of funds deal. This customer represents our largest new logo win with a major financial institution. We successfully completed six different proof-of-concepts, and the main business drivers for going with Cloudflare were resilience, the operational efficiency from a single unified platform, and our ability to meet data sovereignty requirements with complete flexibility at the country-level, a requirement that no other vendor was able to accommodate.”
Overall NET ranks 10th on our list of the best cybersecurity stocks to buy. You can visit 10 Best Cybersecurity Stocks To Buy According To Hedge Funds to see the other cybersecurity stocks that are on hedge funds’ radar. While we acknowledge the potential of NET as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than NET but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.