Cloudflare Vs. Fastly Stock: Which Is The Better Buy?

Summary

• Cloudflare is a good business with great potential, and its stock price has rocketed up recently reflecting that potential.
• Fastly is a less good business with, in our view, less potential. Its stock price has cratered of late, as growth has slowed and cash flow worsened.
• Both stocks are shortly to report their Q2 earnings. We think earnings reaction risk is to the downside on Cloudflare, to the upside on Fastly.
• Ultimately, we believe Cloudflare offers more upside for long-term investors, but we own both names in staff personal accounts and intend to add to both on any post-earnings weakness.
• We would also flag that both companies look to us like they may raise capital soon - if, in the form of new equity, that can hit both stocks.
• Looking for a helping hand in the market? Members of Cestrian Fundamentals get exclusive ideas and guidance to navigate any climate. Learn More »

NeoLeo/iStock via Getty Images

DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security, or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.

Ping Times May Be Similar But Time To Live Likely Differs

Since consumer traffic started in earnest to course through the public Internet in the 1990s, content acceleration became important. The initial leader of this market, Akamai (AKAM), grew up in the dot-com era and remains a very solid business today. AKAM's original business model was simple and remains the foundation for content delivery network plays today; buy servers, rent space in telecom companies' datacenters, rent capacity on telecom networks, bill content owners for accelerated delivery of said content. As you can see, the business model is likely to be less cash generative than the now-commonplace cloud application software player, because, one, your gross margin gets hit with the telco pay-aways, and, two, your capex bill is heavy as you have to keep buying server kit. So scaling such a business - meaning, achieve a rate of growth in cash flow faster than the rate of growth in revenue - isn't so easy.

The two hot names in content acceleration today are Cloudflare (NYSE:NET) and Fastly (NYSE:FSLY). We've covered both of them on multiple occasions here on Seeking Alpha - you can read our past notes on Cloudflare, Inc here and our prior work on Fastly here. In addition, we own both stocks in staff personal accounts. We have a much greater allocation to NET than we do to FSLY (in a ratio of approximately 2:1). We have enjoyed an easy ride up on NET with even some poorly-timed averaging-up buys being forgiven by the Trading Gods, whereas we have been battling FSLY to average down our in-costs in the expectation of future gain and our valor has yet to be rewarded. In staff long-term accounts, we presently show a big paper gain on NET and a modest paper loss on FSLY. Along the way, we have also enjoyed separate short-term account gains in NET by buying dips and selling peaks to realize rapid cash gains. (We cover both stocks and our own trades blow by blow in our real-time, real-money Seeking Alpha Marketplace service, Cestrian Fundamentals).

Whilst Cloudflare and Fastly core services have plenty of overlap, their business models and management styles are very different and this informs our approach to owning the names and our expectations going forward. Allow us to walk you through our views here.

How Is Cloudflare Different From Fastly?

Well, first let's take a look at the similarities. Both offer content acceleration services to content owners, and both offer you something called edge computing, which is in essence the ability to place not just your content (movies, audio, etc.) on a machine near the user (as in, physically and logically near the user on the network - not in a data center thousands of miles away) but also an entire web application or parts thereof. To our investor eye, Cloudflare appears to have more product ambition; taking advantage of its edge network positioning, the company has launched a number of security services, for instance - the goal being to act as a single Internet on-ramp for its customers, a kind of Zscaler (ZS) embedded in the suite offer. If you want to deep-dive into product by product comparison on these two names - and if you do, take a tin hat, for opinions run high - take a look at a couple of engineers-turned-stock-people who cover both stocks in their work.

Now, putting aside for the moment our own investor view that NET has a superior span of product and indeed more extensive product ambition - let's turn to the numbers.

NET Financials

Source: Company SEC filings, YCharts.com, Cestrian Analysis

Lot of numbers there. Here are the highlights and lowlights as we see them.

The good:

• Revenue growth holding steady in the 50% range, gross margin holding steady in the 77% range.
• Remaining performance obligation (RPO) growth of 88% vs. prior year in Q1 2021. RPO is the total order book value, some of which is prepaid, most of which is not. RPO represents just over 90% of TTM recognized revenue so it is material vs. the recognized base, and it is growing faster than the recognized base. So, best guess, NET revenues can accelerate still further.
• Accounting profit in the guise of EBITDA (which we define as operating income, add back depreciation & amortization, add back stock-based compensation) has gone from very negative in 2019 to modestly positive in 2021 - we look at the TTM measure which is slow to respond up or down, it gives you a smoothed-out view of the direction of travel.

The bad:

• Actual money-profit in the guise of unlevered pre-tax free cash flow, has gone from horribly negative in 2019 to, er, only very negative in 2021, which in and of itself is good, but, did we mention, cash flow was very negative on a TTM basis to the end of the March 2021 quarter. This is the whole nag with this business model - can they actually become cash flow positive, after capex, after change in working capital? Akamai is, but then it has nothing like the growth ambitions of these names.
• Only $643m of net cash in the bank at the 31 March point. Given the cash burn, we would not be at all surprised to see the company raise money via an equity or debt placement and, if equity, we would expect a material hit to the stock price on a short-term basis at least. (We are watching closely for this and hope to buy any major dip that comes along).

The visually challenged:

• Huge capital expenditure ("capex") bill. Capex as you know is simply money that you spend on stuff that makes a noise when you drop it. Capex at NET, and for that matter FSLY, is mainly computing hardware. We expect significant capex here. But capex as a % of revenue is yet to show a consistent falling pattern - and only if we start to see some yield improvements here, some growth without much capex, can we conclude that scale benefits are beginning to flow. Right now the jury is out, and this is a big deal fundamentally.
• Terrible working capital management. This sounds complicated but isn't. If that "change in working capital" line was mainly positive, it would mean that in essence, the company collects money from its customers faster than it pays its suppliers. If mainly negative, it pays suppliers faster than it collects cash from its customers. You can see from the numbers that the latter is true. So here we have a business which, already bleeding money into the capex line, further leaks cash into working capital. This again is a big deal fundamentally. Best case, it says the business lacks the management discipline to tell suppliers to wait whilst it chases up customers. Worst case, it means the business is merely a commodity provider of services which can easily be found elsewhere, and they don't chase their customers lest they churn. Now we don't think that latter point is true; we think NET has a differentiated and sticky set of services - and if that's right, it means management just needs to get religion on cash management. They don't have it today.

As we shall see in a moment, Cloudflare's stock price flatters its fundamentals. It's not as good a business as its stock trajectory implies.

FSLY Financials

Fastly, an early huge winner in the immediate response to the Covid crisis, now looks all beaten up if you look at its stock price, to which we shall turn in a moment. But if NET is not as good a business as its stock price implies, FSLY is not as bad a business as its stock price implies. As investors, we must respect price before all else, everything else is just an input. But fundamentals do sometimes matter - very often you can see value building in the fundamentals that isn't reflected in the stock price, or indeed value waning that is yet to be reflected. Which means that sometimes, just sometimes, you can get ahead of the price game by reading the numbers. (If you read our Cloudflare notes linked above, you can see us making just that argument - hidden value - which did then come to fruition in the stock price).

Let's take a look at Fastly's numbers.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

OK, another lot of numbers. Less numbers though, because the company doesn't disclose its remaining performance obligation in its SEC reports. This is likely because there isn't much of it - they make much of the fact that billing (and by implication contracting) is usage-based and in arrears, so we wouldn't expect a great deal of revenue visibility here.

Turning to the reported revenue - the deceleration is material, as you can see, and coupled with the lack of visibility, this is what we think is hurting the stock right now. Today's market is positively growth-addled and if your growth is coming down, well, your stock is going to get a beating. That said, it looks to us like folks' expectations just got all ahead of themselves. Look at the TTM revenue line - remember, this is a slow-burn indicator, gives you a smoothed-out look at how things are going. TTM revenue growth peaked at 47% in Q3 2020, and in Q1 2021, it stood at 44%, which isn't really very different if you zoom out far enough. It's just that early Covid Q2 2020 +62% vs Q2 2019 growth rate that got everybody overexcited.

Skipping around a little here, the valuation stands at 16.5x TTM revenue in exchange for 44% TTM revenue growth. That is positive cheap by current standards.

Cloudflare is asking you to pay 76x TTM revenue in exchange for 51% TTM revenue growth.

Now don't get us wrong. Cloudflare is a better business. And we like how their management team rolls, all humblebrag-aw-shucks-what-me? whilst quietly stating that their aim is to be the dominant development environment and runtime for Internet 3.0 (we paraphrase a little, but yes, that is what their grand plan is, and it might work). But it's not that much better a business.

Back to FSLY numbers. Remember how NET eats capex and leaks money into working capital? Well, same at FSLY.

First, let's compare their capital expenditures using that slow-burn TTM method.

The company has TTM capex standing at 12% of TTM revenue, and is chalking up revenue growth of +44% on a TTM basis. Cloudflare, Inc is spending 18% of TTM revenue on its capex, again on a TTM basis; in exchange for +51% TTM revenue growth. So as a snapshot, FSLY is actually more efficient with its capex. The counter to that is, NET is building a big book of long-term business - as evidenced by its chunky RPO number - and that's what the additional capex is for. This is an interesting-if-true point to make. As in, it might be true and if so, it's a good use of their checkbook. But it has yet to translate into sufficient additional revenue growth vs. the competition to truly justify the expenditure on fundamental grounds.

Next, margins. FSLY's gross margins are terrible, in the mid-50s%. It resembles Twilio (TWLO) in this regard, a big pay-away to telcos before you even get started. It's the biggest determinant of weak TTM EBITDA margins - which stand at negative 11% vs positive 3% at NET. And whilst those EBITDA margins at NET have been moving up, at FSLY, they have been moving down.

Turning to cash flow - we've talked about capex already, now let's look at that boring-but-important point, change in working capital. (Remember this is simple. To do this well, pretty much all you have to do is collect cash from customers faster than you pay it to suppliers). If working capital management is bad at NET, and it is, then it is terrible at FSLY. TTM unlevered pre-tax free cash flow margins of negative 33%. This thing just eats money. And again, it has just $166m of net cash on hand vs. a TTM pre-tax pre-debt service cash burn of $104m as of the end of Q1. That means the company is very likely to raise money, via equity or debt placement. And off the back of a weak stock price that's likely to cause more pain in the stock.

OK. You get the picture. NET is growing a little bit faster and spending more capex to do it; but its gross margins are much better so it has more money to burn in the first place. It appears to be building a big book of forward business in a way that FSLY is not, but right now, that is jam tomorrow, not revenue or earnings today. NET needs to raise capital soon in our view, and FSLY needs to raise capital sooner. So, on fundamentals, NET is a better pick, no question. But the valuation, yikes!

NET and FSLY Stock Prices

Since the Cloudflare IPO in 2019, NET has way outperformed FSLY and indeed the Nasdaq (shown here by way of the proxy ETF, Invesco QQQ Trust (QQQ).

As we state above, that NET has outperformed FSLY is justified to us on fundamentals. It's a better business with higher growth and more visibility of future growth. But right now, as earnings approaches for each of the stocks (FSLY reports on August 4th, NET on August 5th), which is the better bet for long-term investors? In short ...

Is Cloudflare or Fastly Stock The Better Buy?

This isn't such a simple answer in our view. Allow us to ramble somewhat, and bear in mind, all we are talking about here is our own plans for our own money. You must, of course, do your own work and factor in your own risk appetite, time horizon, etc. But here's our approach.

Cloudflare Stock

As delighted as we are with the run-up in our NET holdings, and as much as we do in fact think that NET can deliver on some of those Internet 3.0 promises, the price is punchy indeed. So we rate NET at Neutral, meaning we ourselves aren't buying the stock at this point. We have a nice paper gain in long-term accounts and we've cashed a series of gains in short-term accounts along the way. But neither are we selling, because as extended as that stock price is, we think that the stock can move higher, maybe much higher, over the coming years. We think that 5-10 years out, $120/share for NET has every chance of looking like peanuts. We have about the right level of allocation now in those long-term accounts and so we are doing nothing there. If Q2 earnings are anything other than blowout, there is every chance the stock takes a dive and, if it does, we expect to play short-term once again, over and above our long-term holdings. (We keep totally separate accounts for long- and short-term holdings so we never get confused about what game we are playing).

Fastly Stock

As much as everybody got too excited about FSLY last year, so, we think, has everybody gotten too miserable this year. We have a modest allocation to FSLY in long-term accounts because ultimately we don't think the company will form part of the fabric of Internet 3.0, at least not as an independent. We don't see sufficient force of management personality, sufficiently broad product vision, nor the surround sound of Twitterati talking the thing up. We do think the persistent rumors of FSLY being acquired have every chance of playing out and so at any given moment, we see a 20-30% or better premium available should Cisco (CSCO) or another strategic come calling. So, again, long-term holdings, we're doing nothing. We're tempted to add a little right now but with earnings so close, why take the risk? Once again our approach here is to wait for earnings. We are likely to trade it short term on any unjustified stock cratering - and indeed if the fundamentals are improving, as we have a funny feeling they will - look at the below-the-radar improvements in deferred revenue above in the last two quarters for instance - we may well add to our long-term positions at that point. For now, doing nothing before earnings, so, again, Neutral. In each case, a one-word rating doesn't really convey our plans here which is why we lay them out in such wordy detail - now you can shoot them down in flames when doing your own work!

Cestrian Capital Research, Inc - 4 August 2021.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of NET, FSLY, ZS, TWLO either through stock ownership, options, or other derivatives.

Business relationship disclosure: See disclaimer text at the top of this article.

Cestrian Capital Research, Inc staff personal accounts hold long positions in NET, FSLY, ZS, and TWLO.