Is Fastly Stock a Buy Now?

Fastly's (FSLY -1.21%) stock price plunged 18% on May 5 after the cloud computing services provider posted its first-quarter earnings report.

Its Q1 revenue rose 21% year over year to $102.4 million, which beat analysts' estimates by $3.4 million. However, its adjusted net loss widened from $13.6 million to $18.0 million, or $0.15 per share, and missed analysts' expectations by a penny. According to generally accepted accounting principles (GAAP), its net loss widened from $50.7 million to $64.3 million.

Image source: Getty Images.

Those headline numbers were mixed, but Fastly's stock now trades about 13% below its IPO price and nearly 90% below its all-time high. Should investors consider buying some shares of this fallen growth stock?

What does Fastly do?

Fastly's platform hosts a content delivery network (CDN) that accelerates the delivery of digital media to apps and websites. It accomplishes this by storing cached copies of that content on "edge" servers, which are located physically closer to users than "origin" servers. It also bundles bot blockers, cybersecurity tools, and other services into its platform.

That approach is innovative, but plenty of other companies -- including Cloudflare (NET -3.87%) and Akamai -- also offer similar CDN services. In addition, Fastly's reputation was tarnished by a major service outage last June that resulted in the departure of several major customers.

How fast is Fastly growing?

Fastly's revenue rose 45% in 2020 (partly boosted by its acquisition of Signal Sciences) but grew just 22% to $354 million in 2021. Its growth was severely curtailed by its service outage during the second quarter, but it gradually recovered over the following three quarters:

Data source: Fastly.

Unfortunately, Fastly is still growing at a much slower clip than Cloudflare, which grew its revenue 52% to $656 million in 2021 and another 54% year over year to $212 million in the first quarter of 2022. Cloudflare's ability to grow faster than Fastly while generating more than twice as much revenue raises a bright red flag for the underdog.

Fastly ended the first quarter with 2,880 customers -- which represented 30% growth from a year ago but just 3% growth from the fourth quarter. Its average customer spend declined 10% year over year to $722,000 (due to its integration of Signal Sciences' lower-value customers) but still improved 3% sequentially. Those numbers suggest that Fastly's growth is gradually stabilizing, but its adjusted gross margins are still crumbling:

Data source: Fastly.

During the conference call, CFO Ron Kisling said Fastly's gross margins contracted as it rolled out its next-generation architecture, expanded its network capacity, and accelerated its investments to "proactively address supply chain constraints." Unfortunately, Kisling expects its gross margins to drop a "couple of hundred basis points" for the full year.

By comparison, Cloudflare's adjusted gross margin rose 110 basis points year over year to 78.7% in the first quarter. Those higher margins -- along with its much stronger revenue growth -- indicate that Cloudflare has significantly more pricing power and scale than Fastly in the CDN market.

Its retention rates are slipping

Fastly gauges the stickiness of its platform with its 12-month net retention rate (NRR) and dollar-based net expansion rate (DBNER). Both metrics exceeded 100% in the first quarter, but they fell sequentially and year over year:

Data source: Fastly.

Kisling admitted that both metrics, which look back over the past 12 months, still "reflect some impact from the outage we saw in June '21." Those metrics might stabilize after it fully laps that outage in the third quarter of the year, but its sluggish growth rates and declining gross margins suggest that its retention rates probably won't improve significantly.

Once again, Fastly can't keep up with Cloudflare -- which increased its DBNER 400 basis points year over year to 127% in its first quarter.

A murky outlook and another CEO departure

For the full year, Fastly expects its revenue to rise 14%-17% as its adjusted operating and net losses widen. That's a grim outlook for a small-cap company in a market which is dominated by large-cap competitors.

To make matters worse, CEO Joshua Bixby -- who took the top job just over two years ago -- announced his upcoming departure. Bixby's predecessor, Artur Bergman, served as Fastly's CEO for less than a year. Bixby will remain on board until a new CEO is hired, but those unstable leadership changes could make it difficult for Fastly to tackle its biggest challenges.

It's cheap for obvious reasons

Fastly might seem like a bargain at four times this year's sales, especially when Cloudflare still trades at 27 times this year's sales.

However, Cloudflare is still firing on all cylinders while Fastly's growth has stalled out. Investors should avoid Fastly and stick with better-run companies in this challenging market for higher-growth tech stocks.