Don’t Buy Fastly Stock: TikTok’s Demand Will Not Bounce Back

Shares of Fastly, a San Francisco-based Internet-content delivery service, have plunged about 28% since Wednesday.

The reason? Its biggest customer is TikTok owner ByteDance, according to the Wall Street Journal. And TikTok has reduced its use of its service due what Fastly called in a press release “the impacts of the uncertain geopolitical environment.”

Should you buy Fastly on the dip? If you think that TikTok will rise again and boost its use of Fastly’s service, the dip is a buying opportunity.

I do not. The bear case — that slower growth to be reported at the end of the month will send this over-valued stock down further — is a better bet.

(I have no financial interest in the securities mentioned in this post).

Fastly’s Bad News

Fastly increases the speed of content delivery over the internet for customers including TikTok, Vimeo and Pinterest. The pandemic has been kind to Fastly — causing its revenue to pop 62% in the second quarter of 2020.

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The company has benefited during the pandemic from higher demand for online services, with revenue rising 62% in the second quarter.

I don’t think investors should have been too surprised that Fastly’s revenues would be hurt by TikTok’s geopolitical woes.

After all, in August, when Fastly reported second-quarter results, CEO Joshua Bixby told investors that TikTok represented “about 12% of Fastly’s revenue for the first half of the year, with less than 50% of that from the U.S.,” according to the Journal.

On October 14, Fastly announced that revenue for the quarter ending September 30 would be lower than it had previously estimated.

More specifically, Fastly projected revenue growth 5.3% below the midpoints of its previous guidance — from a range of $73 million to $75.5 million to between $70 million and $71 million. Fastly also told investors to “disregard its previous financial guidance for the full year,” reported the Journal.

Will TikTok’s Growth Resume?

TikTok has become hugely popular over the past year, particularly among young people, and its downloads have climbed through the pandemic. TikTok says the app has more than 50 million daily active U.S. users and 100 million monthly users.

TikTok was used to keep seats empty at a rally held in Tulsa, Oklahoma by Donald Trump this June, according to the New York Times NYT . On August 15, he gave ByteDance 90 days to sell TikTok’s U.S. operations to a U.S. company, according to AP. A proposed deal including Oracle and Walmart would give these partners control of those U.S. operations, noted the Journal.

Since September 21 — when the New York Times reported that the deal was tied up in a power struggle between the U.S. and China — not much has been reported about the deal.

Many questions remain unanswered: Will the deal go through before the election? If Trump loses the election will be push for the deal to be completed before he leaves office? If so, will China slow down the deal until the next president takes office? Will Biden abandon Trump’s insistence that TikTok must sell its U.S. operations to an American buyer?

I don’t know what will happen; however, were Biden to win, TikTok could resume its growth unfettered by geopolitical tension — which could benefit Fastly. But even if that were to happen, it might not be enough for Fastly to grow faster.

The Bear Case Against Fastly

Fastly — which had risen 317% in 2020 as of October 15 — is a very expensive stock compared to its peers. While its revenue growth has been high — up at a compound annual rate of 38% between 2017 and 2019, it trades at a price to sales ratio of about 38, according to Morningstar.

Fastly peers — such as Limelight Networks LLNW and Akamai Technologies AKAM  — have grown more slowly, enjoyed more modest share price appreciation, and are less highly valued.

How so? Limelight stock is up 44% in 2020, its revenue has grown at a 6% three year compound annual rate, and it trades at a price to sales ratio of 3.2, according to Morningstar. The comparable figures for Akamai are 24.4%, 7.2%, and 5.9, according to Morningstar.

Some analysts are worried about the slowdown in demand for its services — not solely from TikTok. According to Barron’s, Stifel analyst Brad Reback cut his price target on Fastly from $98 to $77 — expressing surprise that TikTok usage has slowed so much given that it’s fully available in the U.S. Reback questioned whether competition was resulting in slower usage at other large Fastly customers.

Citi analyst Walter Pritchard set a $58 price target on Fastly. As Barron’s noted, Pritchard’s view is that the stock is overvalued and that the company’s removal of guidance suggests that Fastly will deliver investors a negative surprise when it reports its third quarter results on October 28.

The Bullish Case For Fastly

Analysts who remain bullish on Fastly offer a range of hypotheses to explain Fastly’s warning.

Barron’s noted that Raymond James RJF analyst Robert Majek suggested that lower revenue from TikTok might spring from a technical change — more compressed data leading to lower bitrate consumption. Majek sees Fastly’s “’performance and product differentiation” boosting its stock.

If I could see proof that TikTok’s boost in data compression was real and that it would increase Fastly’s revenue — when it seems like it would have the opposite effect — I might be more persuaded by Majek’s optimism.

Jim Cramer blamed ignorant traders for Fastly’s plunge. According to CNBC, “Now the stock has been significantly de-risked, the ignorant money is fleeing like rats on a sinking ship, and I actually like it more.”

If Cramer could provide a list of those rat-like investors who are fleeing Fastly stock and explain their reasons for selling, his words might be a compelling defense of its shares.

On October 28, we’ll learn whether the bearish case prevails for Fastly.

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