Fastly's (NYSE:FSLY) stock price rose slightly on Thursday after the cloud computing services provider posted its third-quarter earnings report. Fastly's revenue rose 23% year over year to $87 million, which beat estimates by $3.3 million. Its adjusted net loss widened from $4.5 million to $13.2 million, or $0.11 per share, but still beat expectations by seven cents.

Analysts' expectations for Fastly were fairly low since its growth had already decelerated significantly in the second quarter following a temporary service outage in June. That's why its stock price is still down nearly 40% for the year.

Does Fastly's recent earnings beat indicate its troubles are finally over? Or does the company still face too many near-term challenges?

A visualization of network connections across the U.S.

Image source: Getty Images.

What does Fastly do?

Most websites and apps are hosted on "origin" servers, but their distance to the end-user can limit their maximum data transfer speed. To deal with those limitations, companies host cached copies of their content on "edge" servers, which are located closer to distant users and expand the origin server's reach like a digital spider web.

Fastly's platform, which runs on those edge servers, bundles together a content delivery network (CDN) for delivering digital media, cybersecurity services, bot blockers, and other services. Its top competitors in this market include Cloudflare (NYSE:NET) and Akamai (NASDAQ:AKAM).

Decelerating revenue growth with contracting margins

Fastly's high growth rates made it a Wall Street darling after its public debut in 2019. However, its revenue growth decelerated significantly this year after a disastrous service outage shut down hundreds of websites and services across the world for nearly an hour on June 8.

Several of Fastly's largest clients, including a "top 10" customer widely believed to be Amazon (NASDAQ:AMZN), didn't immediately return to the platform. Its gross margins, which rose throughout the pandemic, also contracted as its pricing power waned in a lower-demand market.

Fastly's revenue growth accelerated again in the third quarter as it moved past the crisis and reportedly regained Amazon as a customer, but its gross margin continued to decline:

Metric

Q3 2020

Q4 2020

Q1 2021

Q2 2021

Q3 2021

Revenue Growth (YOY)

42%

40%

35%

14%

23%

Adjusted Gross Margin

59.8%

63.7%

60.1%

57.6%

57.5%

Source: Fastly. YOY = Year over year.

But in the fourth quarter, Fastly expects its revenue to grow just 8%-12% year over year and for its gross margin to be "flat to down slightly," even though it acquired a higher-margin business (the web security company Signal Sciences) last October. That's mainly because Signal still generates much lower revenue per enterprise customer than Fastly's core platform.

Lower revenue per customer and lower retention rates

As a result, Signal's integration into Fastly's business reduced its average spending per enterprise customer to $698,000 during the third quarter -- compared to $702,000 in the second quarter and $753,000 a year earlier.

Fastly's other core customer retention metrics, including its last-12-month (LTM) net retention rate (NRR) and dollar-based net expansion rate (DBNER), also continued to decline:

Metric

Q3 2020

Q2 2021

Q3 2021

LTM NRR

141%

121%

114%

DBNER

147%

126%

118%

Source: Fastly.

Those metrics still remain comfortably above 100%, but its business clearly lost some luster after the summer outage.

On the bright side, Fastly's total number of customers and total number of enterprise customers (which generated 88% of its trailing 12-month revenue) continued to grow sequentially and year over year:

Metric

Q3 2020

Q2 2021

Q3 2021

Enterprise Customers

2,047

2,581

2,748

Total Customers

313

408

430

Source: Fastly.

The expectations and valuations are still too high

Fastly believes it can grow its revenue from $291 million in 2020 to $1 billion by 2025, which would represent a compound annual growth rate (CAGR) of about 30%.

That's a very aggressive long-term target, and one that could be easily derailed by another service outage or intensifying competition from Cloudflare, Akamai, and other similar CDN companies.

Fastly might achieve its goal by undercutting its rivals and sacrificing its margins, but that's a risky strategy for an unprofitable company with $932 million in debt and $1.12 billion in total liabilities.

Fastly's stock also isn't cheap at 18 times this year's sales. It might seem much more reasonably valued than Cloudflare, which is valued at over 100 times this year's sales, but Cloudflare is also growing at a much faster rate than Fastly.

Fastly isn't worth buying (yet)

Fastly's business is gradually recovering, but its flaws are easy to spot, and there's too much growth baked into its valuation. I'd avoid this beaten-down cloud services stock and stick with better run companies instead.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.