Limelight Networks'(NASDAQ:LLNW) shareholders had legitimate reasons to fear third-quarter earnings. On Oct. 14, the competitor Fastly withdrew its full-year guidance and communicated surprisingly weak preliminary results because of reduced spending of some customers. That suggested lower-than-expected growth potential in the content delivery network (CDN) industry, which includes Limelight Networks.
Those concerns were justified: Limelight Networks' stock plunged by more than 25% after the company posted disappointing results. However, since management didn't change its full-year revenue guidance range, should investors take advantage of that post-earnings dip to buy the company's stock?
Disappointing gross margin
Limelight Networks developed a worldwide computing infrastructure to allow customers to host internet content closer to users and improve the user experience. As the company has been focusing on video, media, and gaming, the coronavirus pandemic had a mixed impact over the last several months. For instance, the increased consumption of video streaming and online gaming boosted the company's business. But the reduced number of online live events had the opposite effect.
Overall, in contrast with Fastly, Limelight Networks didn't experience reduced customer spending during Q3. Revenue grew 15.4% to $59.4 million, ahead of analysts' expectations. And CFO Dan Boncel confirmed its full-year revenue guidance range of $230 million to $240 million, which corresponds to 17.1% year-over-year revenue growth based on the midpoint.
However, the gross margin was surprisingly low. It dropped to 36.7% compared to 40.4% in the prior-year quarter, which contrasts with previous management's short-term ambitions. Chief strategy officer -- and ex-CFO Sajid Malhotra -- had claimed during the second-quarter earnings call: "I want to make sure we don't have another 36% quarter like we did in the first quarter and keep at the 40% mark about there, begin to move higher from there."
During the Q3 earnings call, management explained that the timing of the company's efforts to increase network capacity and face the high traffic demand negatively impacted the gross margin.
Granted, investors should not pay too much attention to quarterly volatile margins that can vary depending on the timing of contracts and expenses. But as Limelight Networks is scaling and improving its network, another quarter of disappointing gross margin in the medium term will suggest the company lacks pricing power, which should lead to reduced profitability.
Also, Limelight Networks has been generating weaker gross margins compared to its CDN competitors Fastly and Cloudflare because of Limelight's focus on large-traffic-volume video-streaming customers that command higher discounts. But with such large customers, Limelight Networks' sales and marketing expenses as a percentage of revenue remained modest. As a result, the company has been generating lower revenue growth and higher operating margins compared to its peers.
With those metrics in mind, Limelight Networks' valuation looks reasonable.
The company's market cap of $540 million corresponds to only 2.6 times the midpoint of the anticipated full-year revenue range. In contrast, the market values Fastly and Cloudflare at much higher forward price-to-sales ratios of 29 and 41, respectively.
Granted, Limelight Networks' revenue growth isn't likely to match Fastly's and Cloudflare's over the next several quarters. And the company is facing increasing competition in its video streaming market. For instance, the tech giant Cisco Systems recently partnered with the video-streaming specialist Qwilt to offer an as-a-service solution for telecommunication service providers.
But the company is close to becoming profitable under generally accepted accounting principles (GAAP). And the growing video, media, and gaming markets Limelight Networks addresses represent strong medium-term tailwinds. A study from Cisco estimates video traffic and gaming traffic will increase four-fold and nine-fold, respectively, between 2017 and 2022.
To capture that growth, Limelight Networks developed innovative offerings. For instance, it released its edge computing solution EdgeFunctions during Q3 to offer customers programmable capabilities at the edge of its network. In comparison, Fastly's edge computing solution Compute@Edge has yet to become publicly available.
Over the next several quarters, investors should make sure Limelight Networks' gross and operating margins will be improving with scale. But following the post-earnings dip, the stock has become much cheaper. Thus, investors looking for exposure to the growing CDN and edge computing markets should consider Limelight Networks as an interesting alternative to the highly valued high-growth peers Fastly and Cloudflare.