Tollbooths vs. Billboards: Is CloudFlare Overvalued?

By Alex Pak




In the CloudFlare case, there was a discussion regarding the fact that it’s $1B+ valuation was perhaps based on the assumption that they could introduce advertising into their business model. What I found amazing about CloudFlare was that very quickly they were able to route approximately 1% of the entire internet’s traffic through their network. The investors’ enthusiasm seems to be built on a particular premise which is: If you build a bunch of roads and you can get people to drive on them, you can put up billboards and tollbooths and make a lot of money.

Now in the physical world, once you build efficient roads that become well traveled it is incredibly difficult to alter a person’s commuting behavior. Because of the capital expenditure needed to build alternate roads, you can go so far as to install tollbooths without fear of adverse customer or competitive response. In the physical world, direct sources of income (tollbooths) are used when alternatives are few and indirect sources of income (billboards) are used when alternatives are plentiful. In the physical world, revenues from tollbooths greatly exceed those from billboards but the question is whether this dynamic remains true on the internet and if so how sustainable can a toll road be in the ever changing virtual landscape.

While I think Cloudflare is an amazing company, I think it is worth thinking about whether their valuation was based on the assumption of tollbooth revenues (SaaS pricing), billboard revenues (advertising revenue), or both and whether that assumption was appropriate for their company at the time. A cautionary tale that is an interesting analog to CloudFlare is Cisco Systems. At one point Cisco was the most valuable company in the world with a market cap of $555B. The reason they were valued at such an astronomical amount was the fact that they held the lion’s share of the networking hardware market. Amid the heady Webvan and Pets.com fueled euphoria of the dotcom 90s, the prevailing belief in Cisco’s worth was based on this same tollbooth and billboard theory. The internet was going to be a big deal for a long time to come and as the primary manufacturer of the internet’s routers, switches, and gateways, they would be able to make a lot of money for a long time. Basically, they built the only roads that mattered and were able to charge heavy tolls (leasing/selling their equipment and software) and so their high valuation was justified.

So what happened? Well the internet evolved, software requirements changed, and startup competitors arose with better hardware and better pricing. Today Cisco is worth a mere fifth of what they formerly were valued at. Despite having a near monopoly on the roads and having access to all of the traffic, they failed to realize their investors’ expectations because someone was willing to challenge the status quo and built a comparable road with fewer tollbooths and billboards. Like we so often observe, the dominant player in the market was disrupted by the scrappy startup willing to offer more at smaller margins.

Now what does this mean for CloudFlare who find themselves to be the scrappy startup trying to disrupt a huge and established industry? CloudFlare has built software and server based express lanes that promise faster loading times, greater security, at low prices. The expectation is that once they scale to a certain level, the experience will be so sticky that customers will not change routes even if a few tollbooths go up and the roads are littered with billboards. This is a dangerous expectation for sure. While Moore’s law may be slowing down as far as transistor density goes, the pace of evolution of software and internet technologies continues to accelerate at an unprecedented pace. Someone will build a better road or perhaps develop the internet equivalent to air travel and the meticulously built roads will once again lose relevance.

This post is not a criticism of CloudFlare’s business model but simply a question regarding the optimism investors place on internet infrastructure in light of rapid technological change. As an innovator in a new space, perhaps you can enjoy the luxury of charging tolls without deterring too much traffic but competition inevitably forces you to either continuously build better roads or switch to a lower margin product like billboards to retain traffic. With that in mind and using history as a proxy, I would argue that you would want to use a pretty substantial discount rate when valuing a company such as CloudFlare given the inevitability of technological disruption and internet economics.

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