Don't Let TikTok Scare You Away From Buying Fastly Stock

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Emily Flippen about the latest headlines and earning reports from Wall Street. They talk about why a particular group of shareholders are having a rough day, a stay-at-home stock hits all-time high, they've got some news to share from the fitness industry and much more.

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This video was recorded on Oct. 15, 2020.

Chris Hill: It's Thursday, October 15th. Welcome to MarketFoolery. I'm Chris Hill, with me today, she's back, it's Emily Flippen. Good to see you.

Emily Flippen: Hey, good to see you, too, Chris.

Hill: We have got yet another stay-at-home stock that's hitting a new high, we have some news in the fitness industry that we will get to, but we're going to start with a rough day for one particular group of shareholders.

Shares of Fastly (FSLY 2.87%) down 25% at the moment, the edge cloud platform cut revenue guidance for the current quarter because of a reduction in business from its largest customer, which is TikTok. Now, they didn't say that in the announcement, but Fastly has previously said that TikTok is their biggest customer. When you look at this business and you look at the stock [laughs] falling, and you know, the stock has had a great run, but when you look at it falling 25%, do you think that's an overreaction or do you think, no, for an unprofitable business cutting revenue from its largest customer, yeah, this seems about right.

Flippen: I think it's a natural reaction. When you have a stock like Fastly, which as you mentioned, has been a [laughs] high-flyer for this entire year, and you have negative news coming out, decreasing revenue guidance 3.5% on the low end, up to 8% on the high end, so a pretty substantial decrease in expectations for the next quarter, it's natural to see a really volatile reaction. We saw that yesterday with the stock falling 25%, 30% afterhours. What is worth mentioning though is that it brings the stock back to the price [laughs] it was maybe about a month ago. And that's not to say that you should ignore this news, it's just to say that the context for Fastly leading up to this announcement was that there were really, really high expectations. This is going to impact them next quarter, management has been upfront about that. Long-term, I don't think it changes the thesis if you're an investor in Fastly at all.

Hill: And it's a reminder that this is the cost of doing business. When you [laughs] are buying shares of unprofitable growth company, I mean, you know, for everyone who likes to look at the P/E ratio, you know, if you're not profitable, you're looking at that revenue number and this is what happens, [laughs] this is why there are some people who say, no, I'm not interested, [laughs] get back to me when you're actually profitable. Do you think it's a buying opportunity?

Flippen: It's hard to say [laughs] whether or not it's a buying opportunity, because we don't know the full impact. I think if you are interested in Fastly's business, the stock is clearly more attractive today than it was yesterday or the day before. So, I'm not sure -- I'm not a personal investor in Fastly, because of the fact that it's a revenue model that's based on usage. And when you're trying to predict usage from large customers like TikTok, it's naturally going to be really volatile here.

So, when I look at the company, actually, the thing that stands out to me most in this report is the fact that usage was so down for TikTok, its largest customer. And for context, TikTok is around 12%, I think is the estimated number, for Fastly's revenue that is resulted from TikTok. And the reason why I'm surprised that usage is down is because, as we saw earlier this year when FaceApp was a subject to these privacy concerns, a Russian-owned company that has an app, plays around with your face a bit, we saw downloads for FaceApp skyrocket just because it was in the news and people were becoming aware of it as a program. I had half-a-mind to believe the same thing would happen for TikTok as it came into the news, people willing and interested in downloading the app would increase, but it does just go to show that how many people have been impacted by the privacy concerns of TikTok that TikTok is not using Fastly's business as much as they were in prior quarters.

If you're an investor in Fastly, I wouldn't overthink this news. Whether TikTok leaves entirely as a customer or otherwise, Fastly provides a really, really necessary services for the companies that it serves, but it is important to understand that this is a usage-based model and the only way they keep their dollar-based net retention rate greater than 130%, which is about where investors have anchored expectations for Fastly, is by increasing usage and upselling their current customers. Clearly, unsuccessful in doing that this quarter.

Hill: Last thing before we move on. So, TikTok is their biggest customer. They represent 12% of their revenue.

Flippen: I believe so, yes.

Hill: I would have thought it would have been higher, just on a percentage basis, just based on what we saw here. I mean, we've seen examples in the past decade of companies that are key suppliers to Apple, and Apple represents, you know, 40% or higher of their revenue. And you know, it's great to be a key supplier to Apple right up until the moment that Apple [laughs] decides to take their business somewhere else. So, the fact that TikTok represents 12% of their revenue, it's like, oh, OK, like, I can see the case you're making.

Flippen: So, what's really interesting here is that, while the focus has been on TikTok, when I mentioned that lowered guidance, that's 3.5% on the low end to 8% on the high end for the next quarter, there is more baked into that number than just decreasing usage from TikTok, there's a handful of other customers, we can assume, that are also seeing decreased usage. So, it's not just TikTok. But what's also worth mentioning, I think is relevant to point out in this situation, we've gotten questions about it, is the shareholder lawsuit against Fastly right now. It's a class action lawsuit, essentially saying Fastly should have disclosed the reliance that it had on TikTok in terms of revenue, because of the political issues associated with serving Fastly as a customer.

And the reason why I think that lawsuit probably doesn't go anywhere is because, Fastly, just like every other U. S.-based company isn't obligated to break out customers unless they represent more than 20% of their revenue. So, the fact that TikTok was below that number I think protects Fastly a little bit in terms of that lawsuit. I don't want to dismiss it completely; I am clearly not a lawyer. But that was just my two cents when I saw that. And it's worth mentioning, it's only around 12% of revenue. So, it's not a huge deal if you're a Fastly shareholder.

Hill: Third-quarter profits and revenue for Sleep Number (SNBR 10.52%) came in much higher than expected. Shares of the mattress retailer up 10% hitting a new all-time high. Sleep Number, if you're of a certain age, you remember this is the company that used to be called Select Comfort, changed their name, you know, for obvious reasons. I get this. [laughs] You know, this is a business that has struggled in the past because they're selling an expensive item. It's not the repeat purchase that we like to see, it's not a subscription model like we like to see. But as more and more people are looking around their homes, and let's face it, I mean, some of the articles I've read over the last [laughs] six months in terms of the stress level of people in America and people having trouble sleeping, yeah, I get why they're investing in better ways to sleep.

Flippen: [laughs] Maybe some of those Fastly shareholders are now thinking about how they can improve their sleep tonight thinking about getting themselves a sleep ...

Hill: [laughs] Right, they're like, what's the name of that company, again? Where do I get a new mattress?

Flippen: [laughs] There are very clear tailwinds this quarter for Sleep Number as a result of the pandemic. And management specifically caught it out in their call, they said people are investing in their homes, we've seen them spend money on things that they perceive to be important for their home life over this year. And mattress, believe or not, is actually one of those things.

But I don't want to downplay just what a turnaround story this has been for Sleep Number. They've been investing in their product line far before the pandemic, they released what's known as the first Smart Bed, their Sleep Number 360 bed. And that's supposed to automatically adjust specific associations of your mattress, depending on your specific sleep needs. So, it's part of the digitization that we've seen of people's homes. Sleep Number plays really, really well into that.

But what's really interesting to me about this quarter is not just the digitization, not smart beds or the pandemic, it's the differing expectations that analysts from Wall Street had versus what we're seeing reported this quarter. Sleep Number had to close a lot of their stores, their showrooms because of the pandemic. And I think there's a belief among investors and consumers that when you spend money on a mattress, you want to have the opportunity to lay on it first. And we've seen companies, Casper and Purple being good examples, disprove that concept by selling a lot of mattresses digitally with this 30-day back return policy.

So, the fact that Sleep Number had 11% comparable sales this quarter, with net sales up 12%, which is pretty outstanding for Sleep Number, even though their showrooms were closed, just goes to show that, I think, more customers are becoming willing to purchase big-ticket, really important items like mattresses online.

Hill: And when you look at the technology that they're using, I'm saying, within the beds, within the mattresses, there is a differentiation there. You know, they are selling a premium product, but it is different from what you're getting from Casper, Purple, you know, any of the direct consumer businesses we've seen pop up over the last five years or so, or any of, sort of, the traditional mattress retailers as well.

And thank you for highlighting, sort of, the turnaround because this was a business that, in the early part of this century, did really well, and then the kind of all came crashing down for a variety of reasons. So, the resurgence of Sleep Number is pretty impressive.

We've got a couple of different things going on in the fitness industry. On the downside, two more fitness chains, small chains, but chains nonetheless, declaring bankruptcy. One is YogaWorks, the other is Cyc Fitness, which is an indoor cycling fitness chain, I believe, based in the Greater New York City area. YogaWorks has around 70 locations.

At the other end of the spectrum, Peloton, which isn't quite at an all-time high, but is within shouting distance of an all-time high, got a couple of upgrades on Wall Street. Bank of America increased its price target on Peloton to $150/share; right now, it's around $133, $134. I have a few thoughts on this, but when you see this pair of news items, what goes through your mind as an analyst?

Flippen: I'm interested to hear your thoughts, but what goes through my mind is, this story totally depends on how you paint it. I think it's easy to look at these numbers and look at these bankruptcies and say, at-home fitness is going to permanently kill gyms, or paint it as COVID has put a lot of small businesses under pressure, and the fact that gyms have been closed, sure, while it's been a tailwind for Peloton and at-home fitness companies, at the same time, it doesn't completely destroy the value proposition of going out to the gym.

I think I land somewhere in the middle. I think a lot of these businesses that we're seeing struggle, and fitness companies, gyms in particular, have obviously been impacted by the pandemic, but need to provide some specific value to their core customers to justify them leaving their homes every day to go to the gym. I don't think every gym [laughs] is going to be replaced by Peloton. At-home fitness companies, I think, while obviously trendy, obviously desired by a very large subset of the population, aren't going to kill gyms entirely. I think Planet Fitness (PLNT 1.82%) comes to mind; provides a very clear value proposition to the customers that go there. They're convenient, they have locations all across the United States, but more importantly, they're affordable and they offer variety. Those are two things that Peloton and at-home fitness companies have struggled with.

So, do I think that Peloton and at-home fitness is [laughs] going to completely destroy all the gyms? Of course not. But I think that gyms that were struggling before have been forced into bankruptcy or will be forced into future bankruptcies as a result of, both, the trend of COVID and at-home fitness.

Hill: So, my first thought was, we are seeing in the fitness industry what we are seeing in a lot of other industries, and that is the separation between, obviously, from a stock perspective, but also, I think, from a business perspective as well. We're certainly seeing it in retail. We're seeing retailers, big retailers like Target and Walmart who are able to make investments in curbside pickup and delivery probably at a much faster rate than they would have if we weren't dealing with the pandemic. And they're able to not only survive, but also thrive in an environment when a lot of other big national retailers are struggling, and in some cases going under. We're seeing that here with fitness as well.

I do think, and I'm glad you mentioned Planet Fitness, that a business like Planet Fitness and others, whether they are national chains or regional chains, if they can get through the pandemic, I think we're going to see a serious uptick. There are always going to be people who want to get to a gym, partly so they can [laughs] leave their house, partly because they want to be in a class, a fitness class with people, not just, you know -- and I'm not knocking Peloton, what they're doing is amazing, it's going to be interesting to see what Lululemon does over the next three- to six months with the Mirror acquisition they made, and the extent to which that boosts their results. But I think Planet Fitness is in a pretty good position if they can get through the next six months or so, I think we could see a pretty significant rebound for them.

And by the way, that stock really isn't down all that much. Planet Fitness started the year at $75/share, it's around $67 now, you know, I mean, it's basically down $10. So, you know, for all of the growth that we're seeing in Peloton, we're not seeing the mirror opposite with Planet Fitness in terms of the stock.

Flippen: Planet Fitness has a really lucrative model. And I think the reason why we haven't seen Planet Fitness, in particular, down as much as we have other gyms, even though Peloton has succeeded, is simply because they're not buying into this false dichotomy, i.e., somebody who is paying for a Peloton is also never going to pay for a gym membership. And if they do pay for a gym membership, maybe they want to lift weights one day and their Peloton subscription doesn't really provide that specific level of workout. It's really affordable to have a $10/month subscription to Planet Fitness and go there once or twice a week when you want to have muscle workouts; that's their target audience.

So, I think people aren't necessarily buying into the idea that Peloton is going to kill every gym, especially not Planet Fitness. What I think people are buying into, in terms of how businesses like Peloton and Lululemon Mirror acquisition, how those businesses impact companies like YogaWorks. [laughs] The issue with these companies is that actually, I think the talent that they attract, the leaders of these classes, people who engage with their audience, they risk losing those people to at-home fitness companies.

So, when you have a sticky audience, a loyal audience that subscribes to a class, maybe a cycling class because they really like their cycling instructor, and that cycling instructor makes a transition to doing classes virtually on some sort of app, whether it be Peloton, Mirror or otherwise, that's a bigger risk to SoulCycle, [YogaWorks] (sic) in my opinion, then just the idea of having alternatives; it's the ability for these alternatives to engage with their audience in a class format that I think makes it the most scary for those particular companies. Again, doesn't really impact a company like Planet Fitness though.

Hill: And you and I were talking right before [laughs] we started the show today about how today was the day we both learned that YogaWorks is actually a public company. It's a penny stock; it's obviously in very real trouble, and it's currently trading for, I think, about $0.04/share, but technically a public company.

Flippen: Technically a public company.

Hill: Emily Flippen, always great talking to you; thanks for being here.

Flippen: Thanks for having me on.

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd, I'm Chris Hill, thanks for listening, we'll see you on Monday.