Many growth stocks' valuations are difficult to justify in this bull market. But that doesn't mean investors should avoid them entirely. Some fast-growing companies trade at premium valuations for good reason: their current growth trajectories and long-term prospects are extremely compelling.
Fastly (FSLY -5.79%), I believe, is one growth stock that falls into this category. It's worth considering despite its high valuation multiples. The edge computing specialist has seen rapid business growth since its IPO last spring -- and that strong growth looks poised to continue in 2020 and beyond.
Here's a closer look at this young, fast-growing tech company.
Meet Fastly and its market opportunity
Fastly was founded in 2011 as the result of founder Artur Bergman's efforts to solve a technological pain point at his former company: Content-delivery networks (CDNs) were inefficient and too far away from end users. Working as director of engineering at community-hosting website Wikia at the time, Bergman bought two servers in the U.S. and brought them to London, setting up his own point-of-presence (POP) in order to build a more efficient CDN for the Wikia. This venture into edge computing would eventually morph into Fastly.
The company's specialty in edge computing is its modernized CDN, which helps process and secure enterprise customers' web content as close as possible to the locations in which content is delivered, hence the term "edge computing." Further, with its servers built using solid-state drives (SSDs), they are costly up front but are more economical than traditional solutions at scale. SSDs are particularly nimble when it comes to executing content delivery changes.
With 66 POPs and access to 58 Tbps (one trillion bytes per second) as of the end of the company's third quarter, Fastly is now a force to be reckoned with. The company is growing rapidly, with two of its 66 POPs being added in Q3 and its Tbps increasing 12% sequentially. Its customers include The New York Times, Yelp, Buzzfeed, Pinterest, Shopify, and many more.
Importantly, there's plenty of room for growth. Fastly's $182 million in trailing-12-month revenue only accounts for a small sliver of the company's addressable market. Management estimates the market for its computing services -- edge computing, streaming, cloud security, and application delivery control -- at about $18 billion as of 2019. Further, management anticipates this market to grow to about $36 billion by 2022.
A pricey but well-deserved valuation
Fastly currently trades at 11.2 times sales, highlighting the significant growth priced into the stock. This compares to Fastly's much larger and more established competitor Akamai Technologies' (AKAM -1.13%) price-to-sales ratio of 5.5.
But a quick overview of the two companies' growth trajectories easily captures why Fastly trades at a higher price-to-sales multiple. In Akamai's most recently reported quarter, revenue grew 8% year over year. In Fastly's most recent quarterly update, revenue jumped 35% year over year.
Sure, Fastly isn't profitable yet. The company lost $12 million in Q3. But it is on a clear path to profitability with its gross profit soaring 73% year over year in Q3 and its non-GAAP (adjusted) gross profit margin expanding from 55% in the year-ago period to 56%.
Several key catalysts
Investors interested in the stock should consider some specific areas where Fastly is seeing strong momentum.
First, there's the company's impressive growth in its dollar-based net expansion rate (DBNER), a key metric that management considers to be a meaningful indicator of increased activity from existing customers. DBNER in Q3 was 135% -- up from a 132% growth rate in Q2. Since Fastly operates with an infrastructure-as-a-service (IaaS) business model that charges customers based on usage of its platform, increased activity from its customers easily translates into incremental into revenue.
Second, Fastly is seeing significant traction with enterprise customers, or customers generating annual revenue greater than $100,000. These customers accounted for 86% of the Fastly's revenue for the 12-month period ending in Q3. This is up from 84% of revenue for the TTM period ending in the third quarter of 2018. The company's success with these customers bodes well for Fastly's growth potential since larger customers can move the needle for the company. Highlighting how large these customers are, Fastly's average enterprise customer spend in Q3 was $575,000. "Enterprise customers continue to be the primary growth driver in our business," management said in Fastly's third-quarter shareholder letter.
Finally, the company is focusing most of its direct selling and support efforts on its large and fast-growing companies, where management said in its third-quarter shareholder letter that it is seeing "the most applicable edge computing use cases, the most rapid usage expansion, and the budget to purchase additional products and features on our platform." These efforts are beginning to pay off, Fastly said in its third-quarter update. "As just one example, this quarter we had a large customer ramp to enterprise status in a single month," management explained.
Expect a bumpy ride
Despite the company's strong underlying growth, large addressable market, and momentum in key areas like DBNER, enterprise customers, and direct-selling efforts, there are still no guarantees. As is the case with any individual stock, there's always potential that competition can prove more fierce than expected, growth opportunities could dwindle, other technologies could disrupt Fastly's business, or other unforeseen issues could arise.
The risk of owning Fastly is particularly high given the stock's high price tag relative to its revenue and given that it isn't profitable yet. Shares will likely see significant volatility as investors do their best to continually assess whether the company's growth prospects are fully priced into the stock or not.
I suspect, however, that Fastly's $2 billion market capitalization today compared to Akamai's nearly $16 billion market cap will someday look like a great entry point in hindsight.