4 Red Flags for Fastly's Future

Fastly's (FSLY 1.87%) stock price plunged 27% during after-hours trading on Feb. 16 after the cloud computing services provider posted its fourth-quarter earnings report. Its revenue rose 18% year over year to $97.7 million, which beat estimates by $5.2 million. Its adjusted net loss widened from $10.5 million to $11.7 million, or $0.10 per share, but topped expectations by six cents.

Those headline numbers look decent, but a deeper dive into the report reveals four bright red flags for the company's future.

Image source: Getty Images.

1. Decelerating revenue growth

Fastly's platform bundles together a content delivery network (CDN), which accelerates the delivery of digital content on websites and apps, with other cybersecurity services and bot blockers.

Fastly's services run on "edge" servers, which are physically located closer to users than "origin" servers. Hosting cached copies of digital content on edge servers enables websites and apps to operate faster and more efficiently.

This approach sounds disruptive, but plenty of other companies -- including Cloudflare (NET 0.70%) and Akamai (AKAM -0.61%) -- target the same market. All that competition, along with a major service outage last June, caused Fastly's year-over-year revenue growth to decelerate.

Data source: Fastly. YOY = Year over year.

Fastly's revenue rose 22% to $354.3 million in 2021, representing a slowdown from its 45% growth in 2020 (which was boosted by its acquisition of Signal Sciences) and its 39% growth in 2019.

It expects its revenue to grow 14%-18% year over year in the first quarter of 2022, and to rise just 13%-16% for the full year. By comparison, Cloudflare's revenue jumped 52% to $656.4 million in 2021, and it anticipates 41%-42% growth in 2022. 

2. Wobbly retention rates

Fastly gauges the stickiness of its ecosystem with its trailing 12-month net retention rate (NRR) and its dollar-based net expansion rate (DBNER).

Its NRR improved sequentially and year over year, but its DBNER declined by both measures. That imbalance suggests that Fastly is retaining its existing customers, but it's struggling to cross-sell additional services.

Data source: Fastly.

By comparison, Cloudflare posted a DBNER of 125% in the fourth quarter, representing a 600 basis point increase from a year earlier.

3. Slowing customer growth

Fastly ended the fourth quarter with 2,804 customers. That represented a 35% increase from a year earlier (thanks to its acquisition of Signal Sciences), but just 2% growth from the third quarter.

Looking back, Fastly's customer count rose 6% sequentially in the third quarter and 17% sequentially in the second quarter. That ongoing sequential slowdown -- along with its declining DBNER and weak forecast for 2022 -- indicates Fastly's high-growth days are over.

4. Declining margins and widening losses

Fastly's growth is peaking and it remains deeply unprofitable on a generally accepted accounting principles (GAAP) basis.

When a company is faced with this situation, it should probably focus on cutting costs, stabilizing its margins, and narrowing its losses. But even on a non-GAAP basis, Fastly's gross margins continue to wither:

Data source: Fastly. *Non-GAAP.

Meanwhile, Cloudflare's non-GAAP gross margin rose 110 basis points year over year and stayed flat sequentially at 79.2% in the fourth quarter.

During the conference call, CFO Ronald Kisling attributed Fastly's gross margin contraction to "the timing and extent of our network investments, network utilization, and the mix of our revenue between customer segments." Kisling said Fastly didn't "see an increase in price compression across our customer segments" -- but a simple comparison against Cloudflare's gross margins suggests that Fastly doesn't have much pricing power.

Can Fastly turn things around?

Fastly's post-earnings plunge reduced its market cap to about $2.5 billion, or about six times its revenue forecast for 2022.

That price-to-sales ratio makes Fastly seem a lot cheaper than Cloudflare, which trades at 39 times its projected sales for 2022, but investors are clearly willing to pay a premium for the latter's superior growth.

Fastly is an unprofitable growth stock that has lost its momentum. That makes it a very risky stock to own as inflation, rising interest rates, and geopolitical headwinds shake weaker stocks out of the tech sector. Investors who are still interested in the edge networking and CDN market should simply stick with Cloudflare as a growth play or buy Akamai as a value play instead.