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Motley Fool Issues Rare “All In” Buy Alert
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Cloudflare (NET 0.09%) and Fastly (FSLY 0.23%) both operate cloud-based content delivery networks (CDN), which accelerate the delivery of digital media from websites to their visitors. CDNs accomplish this by storing cached copies of all that content on their “edge” servers, which are often located physically closer to the visitor than the “origin” server.
CDNs also integrate bot blockers and other security tools into their platforms. If you’ve ever been prompted to prove that you’re a human while browsing the web, you’ve likely encountered Cloudflare or Fastly’s defenses. Rising internet usage rates, media-intensive websites, and bot-based cyberattacks are all generating robust demand for these services.
Image source: Getty Images.
But this year, Cloudflare and Fastly lost roughly 64% and 76% of their market value, respectively, as rising interest rates crushed higher-growth tech stocks. Should investors invest in either of these beaten-down CDN plays today?
Cloudflare generated 85% more revenue than Fastly in 2021, yet it has consistently grown at a much faster rate than its smaller competitor:
Company
2020
2021
Q1 2022
Q2 2022
Q3 2022
Cloudflare Revenue Growth (YOY)
50%
52%
54%
54%
47%
Fastly Revenue Growth (YOY)
45%
22%
21%
21%
25%
Data source: Company earnings reports. YOY = Year-over-year.
For the full year, Cloudflare expects its revenue to rise 48% to 49%, while Fastly anticipates just 20% to 21% growth. It’s generally a bright red flag when an underdog is growing much slower than a market leader, but Fastly’s accelerating growth in the third quarter is a positive sign, since it surpassed its own guidance and coincided with Cloudflare’s slowdown.
Some of Fastly’s deceleration over the past two years can be attributed to competitive headwinds, but some of its wounds were also self-inflicted. It suffered a major service outage last June, which drove away some of its large customers, and it has been led by three different CEOs over the past three years. Cloudflare has had the same CEO for the past 13 years.
Cloudflare also beats Fastly in terms of retention and gross margins. Cloudflare ended the third quarter with a dollar-based net revenue retention rate of 124%, which stayed flat year over year, and it expects that metric to surpass 130% over the long term. Fastly’s comparable trailing 12-month net retention rate came in at 118% in the third quarter, which represented a four percentage increase from a year earlier. Unlike Cloudflare, it didn’t provide a long-term outlook for its net retention rates.
Cloudflare’s adjusted gross margin declined by 110 basis points year over year to 78.1% in the third quarter. It mainly attributed that compression to inflationary headwinds, but it also noted that the metric remained above its long-term target range of 75% to 77%. Fastly’s adjusted gross margin declined 390 basis points year over year to 53.6% in the third quarter. It blamed most of that decline on higher costs related to the expansion of its network infrastructure, and it expects its adjusted gross margin to hold steady in the low- to mid-50s for the rest of the year.
Fastly insists its gross margins aren’t being squeezed by a loss of pricing power against its larger competitors, but it’s still a red flag when an underdog generates much lower gross margins than the market leader.
Cloudflare and Fastly are both unprofitable by GAAP (generally accepted accounting principles) measures due to their heavy dependence on stock-based compensation to subsidize their salaries. On a non-GAAP basis, which excludes those charges and other one-time items, Cloudflare turned profitable this year and but Fastly remains in the red.
Cloudflare expects to generate a non-GAAP net profit of $0.11 to $0.12 per share this year, compared to a net loss of $0.05 in 2021. Fastly expects its non-GAAP net loss to widen from from $0.48 per share in 2021 to $0.63 to $0.67 in 2022.
Cloudflare’s business looks healthier than Fastly’s, but the valuations already reflect that gap. Cloudflare’s stock trades at 12 times next year’s sales, while Fastly trades at just two times next year’s sales. Cloudflare’s stock isn’t cheap, but I’d still buy it instead of Fastly. Fastly isn’t doomed, but it will struggle to grow in the shadow of better-run competitors like Cloudflare.
Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Cloudflare, Inc. and Fastly. The Motley Fool has a disclosure policy.
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