Cloudflare Just Soared $31, But There's a Problem Everyone Missed

Cloudflare Just Soared $31, But There's a Problem Everyone Missed

SAN FRANCISCO — Friday delivered exactly what Cloudflare investors wanted. Shares rocketed 13.86% after the cloud security company crushed expectations. Revenue hit $562 million for the third quarter. Wall Street had predicted just $545 million.

The stock closed at $253.30. That's a $30.84 gain in one day. Cloudflare's valuation now exceeds $94 billion.

Here's what nobody's discussing. The same earnings report hiding a troubling trend. Gross margins aren't just slipping—they're collapsing. And the company's most critical executive just resigned.

The Margin Mystery Wall Street Ignored

Non-GAAP gross margin dropped 350 basis points year-over-year. It fell from 78.8% to 75.3%. For a software company, that's not minor. It signals something fundamental changed in how this business operates.

Think of gross margin like a restaurant's food cost. If your burger suddenly costs way more to make, you've got a problem. Cloudflare's "cost of goods" just exploded higher.

Yet traders partied anyway. Revenue grew 31% compared to last year. Non-GAAP earnings per share reached 27 cents, beating estimates by four cents. Management raised guidance for the fourth quarter to $588.5-$589.5 million. Analysts expected only $580 million.

Free cash flow jumped 66% to $75 million. The margin expanded from 11% to 13%. Remaining performance obligations—future contracted revenue—grew 43% year-over-year. That's significantly faster than actual revenue growth, suggesting companies are locking in multi-year deals.

The company scored 44% on the Rule of 40. This metric combines revenue growth and free cash flow margin. Anything above 40% typically screams "excellent software business."

What the Celebration Concealed

Look closer at the numbers. GAAP operating loss totaled $37.5 million. The company remains unprofitable by traditional accounting standards.

How'd they report $85.9 million in non-GAAP operating income? They excluded $119.7 million in stock-based compensation. That's 21% of quarterly revenue just disappearing from the calculation.

The net loss improved from $15.3 million to $1.3 million year-over-year. Sounds great until you realize why. Interest income surged because Cloudflare's sitting on $4 billion in cash. The operational business didn't actually improve—the company's treasury department did the heavy lifting.

Three Explanations, None of Them Good

Why are gross margins tanking? Three possibilities exist.

First, network infrastructure costs might be spiraling. Cloudflare's expanding its global footprint aggressively. More servers mean more expenses.

Second, they're slashing prices to win big contracts. Enterprise customers negotiate hard. If Cloudflare's discounting heavily to land Fortune 500 companies, margins suffer.

Third, product mix shifted. Compute-intensive services carry lower margins than pure software. If customers are buying different products, economics change.

Management claims 75-77% represents a sustainable range. That's not reassuring. Direction matters more than the number itself. If margins keep sliding toward 74%, the entire investment thesis breaks down.

The Executive Exodus Nobody Expected

CJ Desai just quit. He was president of product and engineering. He's leaving to become CEO of another public company.

This isn't some mid-level manager. Desai controlled the product roadmap. He oversaw engineering teams. In a business where innovation speed determines winners and losers, losing this executive introduces massive risk.

Questions immediately arise. What's happening with the product pipeline? Will key engineers follow Desai out? Why'd he really leave?

Cloudflare's trading at a massive premium. Investors are paying for expected innovation. Losing the person driving that innovation should terrify shareholders.

Capital Spending Just Exploded

Cloudflare spent $251.6 million on property, equipment and software in the first nine months of 2025. That's an 88% increase from last year's $133.9 million.

This aggressive network build-out signals confidence. Management clearly believes demand will justify the investment.

But it's also burning cash. Fast. These expenditures must generate returns. Revenue needs to keep accelerating. Return on invested capital better materialize.

The Valuation Doesn't Make Sense Anymore

Cloudflare trades at 43-44 times its expected 2025 revenue of roughly $2.14 billion. That's extraordinarily expensive, even for a high-growth security company.

The enterprise value-to-free cash flow ratio exceeds 325x. These multiples work for "story stocks" where investors bet on the future. But any misstep triggers violent selloffs.

Bulls still have arguments. Remaining performance obligations suggest customers are buying multiple products. The global network creates competitive advantages. The company raised $2 billion through convertible notes in June, providing firepower for acquisitions or infrastructure.

If margins stabilize around 76%, growth continues, and fiscal 2026 revenue exceeds $2.6 billion, today's price works.

However, reality might disappoint. Growth could slow to the high-20% range. Margins might anchor at 75%. Free cash flow margins plateau at 12-14%. The Federal Reserve's rate policy could normalize. Any combination forces multiple compression.

The bear case looks scarier. Margins sliding toward 74%. Leadership disruption slowing innovation. Macroeconomic weakness. These factors could push valuation down to 30-35 times fiscal 2026 sales. That implies significant downside from current levels.

What Investors Should Actually Do

Is Cloudflare's stock price already assuming years of perfect execution? Almost certainly.

At these valuations, risk-reward favors patience. Don't chase gap-ups. Post-earnings surges typically retrace 30-50% of the initial move. The $230-235 range offers a better entry point.

Cloudflare's technology remains impressive. The market position looks strong. But at 43 times sales with eroding margins and executive departures? There's virtually no room for mistakes.

NOT INVESTMENT ADVICE