Investment Thesis
Fastly (NYSE:FSLY) comes out with guidance that has taken investors, including me, by surprise. Not only is its revenue growth rate substantially lower than expectations, but its customers are also now spending less on its platform.
As we go through, I'll highlight the most important insights that investors should watch out for, and then, I'll discuss what I would do if I was a shareholder here.
But those wanting to jump to the conclusion, this is it: Fastly is still priced at 11x sales, with mid-teens CAGR. There are many stocks out there that are growing faster, yet priced with smaller multiples.
Fastly's Guidance Disappoints; Analysts Weren't Even Close
Source: author's calculations; company guidance
Fastly's Q2 2021 top-line was up 14% y/y and the guidance for the next couple of quarters is dramatically lower than practically anyone expected.
Source: SA Premium Tools
You can see here how analysts were largely expecting Fastly to be growing at much closer to mid-30s% CAGR, whereas its most recent guidance now points to a slower growth rate.
Discussing Fastly's Operating Leverage
As I've noted in the past, whereas Fastly's peer, Cloudflare (NET) is a very high-quality Content Delivery Network ("CDN"), with gross margins reaching 78%, what always stuck out to me about Cloudflare was how consistent its gross margins are reaching the high 70s%.
Source: author's work
Now, let's compare the graphic above with Fastly's non-GAAP gross margins below:
Source: Fastly Shareholder Letter
Here you can see two crucial dynamics at play above.
First, Fastly's whole operation has a tremendous amount of operating leverage. When Fastly was growing very quickly back in early 2020, its gross margins were expanding strongly. And investors were willing to reward the company's stock with a very high multiple.
And this brings me to my second point: operating leverage cuts both ways. As Fastly's growth rates start to compress, this is impacting its gross margins.
Furthermore, as you can see above, Fastly's gross margins are now approximately 58%. Accordingly, very few investors would now consider Fastly a high-quality company.
Next, we'll discuss Fastly's Net Retention Rate.
What's Net Retention Rate? Why Does it Matter?
Source: author's calculations; shareholder letters
NRR is an indication of the revenue derived from existing customers compared with the same period a year ago. I find it helpful because it does not account for new customers, in the same way as dollar-based net expansion rates ("DBNER") does.
Also, in the graphic above I have gone through the individual quarters to remove any smoothing out effect by looking at the trailing twelve months, as that would paint a slightly improved picture right now, but less helpful for investors looking to understand the progression of Fastly's revenue growth rates into its quarters ahead.
Investors passionately argue over which metric is more insightful. For my part, I believe that NRR works best and that you can see above how this figure is now below 100%. This means that customers are either lowering their contracts or churning out.
And I believe that this is a point worth discussing because the graph above shows that Fastly's NRR has been consistently falling for several quarters. The underlying issues facing Fastly are not new and relevant only to Q2 2021 - there's an undeniable trend that's trending lower.
Valuation - Very Difficult to Price
I'm a professional investor. My job is to go through and dispassionately appraise what I believe is a reasonable investment and deploy capital very selectively to where I believe, rightly or wrongly, are my best investment opportunities.
A month and a half ago, when I covered Fastly I wrote:
I simply don't have enough conviction that Fastly has what it takes to re-accelerate its revenue growth rates.
All considered I believe that there are better investments available elsewhere.
Today, the stock has dramatically sold off. While as a general rule, I don't sell into bad news, I would be disingenuous if I didn't admit that Fastly's near-term prospects are still misaligned with its valuation.
For now, even after the after-hours sell-off, Fastly is still priced at 11x its 2021 sales. There are many companies out there that are growing at more than 20% CAGR that are now priced at less than 10x sales - particularly amongst small-cap stocks.
The Bottom Line
Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it. – Peter Lynch
When I talk with my Deep Value Returns members, we often discuss that when a stock goes through a difficult period, the sooner we wake up and smell the coffee the better.
There's no need to play the hero when investing. Investing is difficult enough. It's absolutely OK to put our hands up and admit we've done a mistake and live to fight another day. The stock doesn't know you own it, and it won't be upset if you sell it and deploy your capital elsewhere.
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