Markets

I Almost Never Buy the Dip, But Here's Why I Just Doubled Down on Fastly Stock.

Fastly (NYSE: FSLY) has been all the rage this year. The content delivery network (CDN) and edge computing specialist has been on a tear, with its stock gaining more than 500%. Earlier this month, the company released preliminary third-quarter results that were lower than anticipated, sending the stock into a tailspin. Since that ill-fated announcement on Oct. 14, the stock has tumbled more than 40%.

As a general rule, I avoid buying stocks when they're down, but in Fastly's case, I've made an exception. In fact, I just doubled down on my original investment. Let's see why investors punished Fastly stock and why I think they have gone too far.

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Trouble in paradise?

When Fastly issued the preliminary results for its third quarter, the company said it now expects revenue in a range of $70 million to $71 million, down about 5% from its initial guidance of between $73.5 million and $75.5 million. At first glance, that hardly seems worth a 40% haircut.

Management cited a couple of factors that led to the revision. First, the company said usage by its largest customer -- TikTok parent ByteDance -- wasn't as much as expected, the result of the "uncertain geopolitical environment." Second, Fastly said that late in the quarter, "a few customers had lower usage" than management estimated.

It's important to remember that Fastly operates its CDN on a usage-based model. In other words, customers pay based on what they use. When traffic is higher, customers pay more. Conversely, when traffic is lower, they pay less. There are any number of reasons clients can experience a slowdown in the Web traffic that Fastly accelerates. In the case of this quarter, a number of Fastly's customers experienced a modest decline in traffic, leading to the aforementioned 5% decline in revenue.

Given the dynamic nature of attempting to estimate usage in unprecedented times, its hardly surprising that the company would occasionally get the forecast wrong.

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Image source: Getty Images.

The TikTok factor

ByteDance is Fastly's largest customer, representing about 12% of revenue during the first six months of 2020. ByteDance has been in a standoff with the Trump administration, which had threatened to ban the app from operating in the U.S. because of concerns over the security of user data. That led to a potential divestiture, with Oracle (NYSE: ORCL) and Walmart (NYSE: WMT) inking a deal to take a stake in the business. President Trump has blessed the deal "in concept," but questions remain.

Here's what CEO Joshua Bixby had to say about TikTok's impact on Fastly:

Any ban of the TikTok app by the U.S. would create uncertainty around our ability to support this customer. While we believe we are in a position to backfill the majority of this traffic in case they are no longer able to operate in the U.S., the loss of this customer's traffic would have an impact on our business.

This leaves investors wondering if Fastly's growth is permanently stunted, causing the sell-off.

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Image source: Getty Images.

A bit of perspective is required

At the midpoint of management's guidance, Fastly expects third-quarter revenue growth of 42% year over year. While it's quite a decline from the 62% growth it delivered in the second quarter, it's still an acceleration from the 35% growth in the prior-year quarter, placing it squarely in growth stock territory. It's also worth noting the Q3 is historically slower.

Given the stock's meteoric rise this year, its valuation had gotten a bit stretched as well. Just prior to the announcement, Fastly was selling at 50 times sales, when a price-to-sales ratio of between 1 and 2 is considered reasonable. Even after its recent plummet, the stock still sports a valuation of 30. While investors were willing to pay up for Fastly's superb topline growth rate, some may have gotten a bit skittish regarding the TikTok situation.

Since TikTok represents just 12% of Fastly's revenue, and management has stated that it could make up for the majority of the traffic, I would argue that a 40% stock decline is clearly overdone. That's why I view the recent drubbing as a buying opportunity and why I just doubled down on Fastly.

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Danny Vena owns shares of Fastly. The Motley Fool owns shares of and recommends Fastly. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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