Fastly (FSLY -0.47%), a fast-growing content delivery network provider, may very well be a great company. It's certainly been a great stock this year: Through Oct. 14, shares of the growth darling were up over 500%.
But when you attach a sky-high valuation to a red-hot growth stock like Fastly, any bad news has the potential to cause a major crash. At its 52-week high, Fastly traded at a forward price-to-sales ratio of roughly 50. Not price-to-earnings, because Fastly doesn't have any earnings. Price-to-sales. For comparison, CDN giant Akamai trades for around 6 times sales and 20 times forward earnings.
There's probably some scenario in which paying 50 times sales for a content delivery network stock turns out fine in the long run. I'm not sure I'm capable of imagining such a scenario, but maybe that's just me. Fastly is growing fast for sure: Second-quarter revenue surged 62%. But the higher the valuation, the longer this kind of growth must continue -- and the longer the narrative must remain intact -- for the valuation to make any sense.
Image source: Fastly.
The story changes
For a stock to gain so much so quickly, the narrative pretty much has to be something along the lines of, "Everything is going right, and nothing can possibly go wrong." Until recently, nothing was going wrong for Fastly. Revenue growth was accelerating due to the pandemic, and it didn't look like anything could stop the company's momentum.
That view turned out to be wrong. On Wednesday, Fastly lowered its third-quarter guidance. Fastly now expects to produce revenue between $70 million and $71 million for the quarter, down from a previous range of $73.5 million and $75.5 million. At the midpoint of the new guidance range, revenue will grow by 41% year over year, a substantial slowdown from the second quarter.
On an absolute basis, 41% revenue growth is still great. But relative to the expectations built into the stock price, it's not. Shares of Fastly had tumbled around 25% by the following afternoon.
Two factors drove Fastly's guidance cut. First, usage of its platform by its largest customer fell short of expectations. That customer is ByteDance, the Chinese owner of social media sensation TikTok.
There's been plenty of geopolitical drama surrounding TikTok recently. A deal involving Oracle and Walmart taking stakes in TikTok's U.S. operations as a way to quell U.S. concerns about privacy and security was agreed to last month, but plenty of uncertainty about TikTok's future in the U.S. remains. It's not clear whether the lower revenue from ByteDance was due to reduced TikTok app usage or the company moving traffic off of Fastly's platform.
If the TikTok issue was Fastly's only problem, the guidance cut wouldn't be a big deal. But there was a second factor pushing down the company's revenue expectations. Late in the third quarter, Fastly started to see lower-than-expected platform usage from a few customers. This could be a macroeconomic issue, with some of Fastly's customers beginning to see a negative impact from the pandemic. Or it could be a competitive issue, with some of Fastly's customers shifting to alternatives.
"The current global environment has in some ways fueled our business, but has also created areas of uncertainty. While our preliminary third-quarter results reflect the challenges of a usage-based model, we believe the fundamentals of Fastly's business remain strong, as does demand for our platform," said Fastly CEO Joshua Bixby.
Still a very expensive stock
Fastly pulled its full-year guidance, and the new full-year guidance it issues when it reports its full results on Oct. 28 will include revenue from the acquisition of Signal Sciences. Based on its old guidance, Fastly stock now trades at a forward sales multiple of roughly 35.
A price-to-sales ratio of 35 sounds a lot better than 50, but the story has changed. Everything is no longer going right for Fastly. If more Fastly customers start to feel a pinch from a weak pandemic economy, growth could slow further. The pandemic tailwind may be turning into a pandemic headwind, which would likely be a disaster for the stock given its nosebleed valuation.
In the short term, Fastly stock could do just about anything. But the long-term narrative certainly took a hit from the guidance cut.
