Fastly Delivers a Harsh Lesson on Software’s Valuation Excesses

(Bloomberg) -- Software stocks have been among the best performers of 2020, juiced by revenue growth related to stay-at-home measures and lofty expectations for future gains. But a blowup at cloud provider Fastly Inc. served as a stark reminder of how some of those hopes may prove misguided.

Fastly plummeted as much as 31%, its worst session on record, after a revenue warning for the third quarter rebutted a growth narrative that had made the company the fifth-best performer in the Russell 1000 Index this year. While some of the weakness was related to geopolitical tensions and its exposure to TikTok owner ByteDance, Fastly also warned of reduced revenue from other customers.

Fastly’s slowdown highlights the precariousness of lofty software valuations. Massive share plunges are the price paid when these businesses fall short of perfection. Software stocks have been among the year’s leaders, with an S&P index of software makers up more than 43% in 2020, topping even the 31% gain of the S&P 500’s tech index.

This “dramatic outperformance” is creating some valuation risks, according to Mizuho Securities, which recommended clients take “a more surgical approach to stock selection.”

Many cloud-based software makers, including Zoom Video Communications Inc., Twilio Inc. and Okta Inc., saw product usage spike when businesses moved to work remotely at the start of the pandemic. But many companies haven’t seen enduring demand surges to match Zoom’s, where quarterly revenue jumped 355% in the period ended in July, the second consecutive period of triple-digit sales growth.

Some cloud companies are balancing a pickup in demand from large enterprise clients that are insulated from the pandemic against a drop-off in purchases from cash-starved small- and mid-sized business that have reduced spending. Disclosing even mixed results, let alone a miss, usually means paying a steep price. Slack Technologies Inc. shares lost 14% of their value the day after reporting disappointing quarterly billings in September. PagerDuty Inc. plunged about 26% one day last month after projecting revenue that fell short of Wall Street estimates.

Among Fastly peers, Limelight Networks dropped 5.1% on Thursday while Akamai Technologies was off 4%. B Riley said that Fastly’s issues were unlikely to be seen across the sector.

Walter Pritchard, an analyst at Citi, noted that even with Fastly’s sell-off, shares were trading at a multiple he called “unsustainable, especially with reduction in growth rate.” In a bear-case scenario for Fastly and other content-delivery networks, “even 10x sales could be hard to justify.”

Fastly’s price-to-sales ratio of 35 stands out even in the software industry. The ratio is more than three times the average in the S&P North American Expanded Technology Software Index. By comparison, the S&P Information Technology sells for about 6.5 times sales, while the Nasdaq 100 is at 5.1.

While many Fastly analysts continue to see rosy long-term prospects, especially as the pandemic accelerates the use of cloud computing and streaming video, they were caught off guard by the latest warning. At least two firms downgraded the stock, including Stifel, which wrote that due to Fastly’s “premium valuation and uncertain core organic growth, we expect the stock to meander in coming quarters.”

©2020 Bloomberg L.P.