A reader sent me a question on a topic that interest me, and he referenced a teaser pitch from Justin Spittler for his IPO Insider ($2,997/yr), so that caught my interest…

His actual words were, “any chance of sleuthing these 2 edge computing companies?” … so that’s the goal today, but I’ll also try to go into some detail about these firms. Ready?

The email pitch from the RiskHedge folks is headlined, “America’s Most Critical Industry is Being Eaten Alive” … and while you think maybe he’s talking about real estate, since much of the intro is about how offices are now sitting empty, it’s really a pitch about “edge computing” is going to eat “cloud computing.”

That’s probably more of an evolution than a dramatic “Edge eats Cloud” statement implies, and most of the businesses you might imagine are tied in to both of these trends, but let’s dig into the opportunity he sees in these “work from home” days…

“I’m not referring to Zoom Video (ZM) or any other “work from home” stock you’ve probably read about. This opportunity is much bigger. In fact, early investors who recognize this shift stand to collect +1,000% in coming years….

“Twenty years ago, this would have been impossible. Companies didn’t have the tools to allow thousands of employees to work from home.

“We’re only able to do this today because of ‘the cloud.'”

And he goes through a long list of the big winners, talking up now the cloud has been the primary driver of success for so many companies for 15 years as enterprise software shifts to internet-based software and services, but he indicates that the big cloud gains are over, and we’re on the verge of that next big jump…

“The easy money in cloud computing has already been made…

“Amazon, Salesforce, and Microsoft (MSFT) already dominate the cloud computing market.

“So, if it’s 10X or 20X gains you’re after, I suggest focusing on the next evolution in computing.
I’m talking about ‘edge computing.'”

There’s a fair amount of exaggeration here in how important “the edge” is to all kinds of new innovations, but here’s how he puts it in the email:

“Edge computing makes the ‘impossible’ possible…

“Technologies like self-driving cars, IoT, AR, and the commercialization of 5G will never get off the ground without it.

“But you shouldn’t wait until these technologies go mainstream to invest in edge computing.

“Big money is already pouring into edge computing. According to the global research firm Analysys Mason, 30% of its IT budget over the next three years will be spent on edge cloud computing!….

“Other experts believe edge computing will end cloud computing as we know it. Peter Levine—partner at Andreessen Horowitz—thinks edge computing will ‘obviate cloud computing.’ The research firm Gartner Group shares a similar view. In 2017, it predicted that ‘the edge will eat the cloud.'”

And then we finally get to the tease our reader mentioned about two edge computing stocks…

“The opportunity is so big that I recently ‘doubled down’ on edge computing.

“I added a second edge computing stock in my advisory, IPO Insider.

“One of these companies has quietly built out one of the world’s largest edge computing networks. The other has partnered with Microsoft to help it build out its edge computing capabilities.”

Any other clues? Just this…

“In fact, one of my edge stocks has raced 57% higher since I recommended it late last year. The other has spiked 67% since I added it to the portfolio just three weeks ago.”

So can we answer those questions? Not definitively, since those clues are a little sparse when it comes to offering 100% confirmation… but the very likely solutions for this teaser are the two most obvious recent IPOs in the “edge computing” space: Cloudflare (NET) and Fastly (FSLY).

Those clues don’t get us enough specific fuel for the Thinkolator, but it’s a fairly small sector when it comes to public companies… so here’s my guess: Spittler probably recommended Cloudflare in November or December, there are plenty of days on which you could have picked the stock at that time and be sitting on roughly a 57% gain today. And he probably recommended Fastly at the end of April or beginning of May — depending on the specific moment of recommendation, you would have had 67% gains on May 19 (when this email ad is dated) if you had bought on April 27 or thereabouts (or, really, anytime before May 7, when the stock shot up following its big earnings report).

Fastly went public about a year ago, and Cloudflare went public back in September of 2019. And while I’ve actually been a Cloudflare customer and have never used Fastly, I prefer FSLY by a small margin and have owned FSLY shares since January — mostly because the valuation is more compelling. Cloudflare is a bit over twice the size of FSLY, and is growing revenue a bit more quickly, which is presumably why investors have bid it up to 22X sales (FSLY’s valuation was appealing to me mostly because it was at “only” about 10X sales in January when I first bought the stock, but that has now bumped up to about 15X).

And Fastly has collaborated pretty closely with Microsoft to embed its Fastly edge cloud into Microsoft’s Azure cloud services. Cloudflare partners with Microsoft as well on many projects, as well, so that “clue” could really match either. And yes, either one could really claim to have built “one of the world’s largest edge computing networks” (and both do claim something similar to that, in not so many words).

These are essentially the next evolution of the content delivery network that was pioneered by Akamai more than 20 years ago — the basic idea of a content delivery network (CDN) is that it moves the big files closer to the end customer so they don’t have to travel as far when you’re downloading them… so if you’re downloading a popular movie or video game, for example, it’s far more efficient to download it from a server that’s colocated with a nearby network hub in your city (or even your neighborhood) than it is to have every single customer download that big file from one centralized location. Even with huge and fast data centers, and with fiber-optic connections from coast to coast, distance matters.

And over the past decade, CDNs have evolved to do more than just put static files closer to end customers, they’ve also distributed more complex work to these “edge” computers, with systems in the background that constantly make sure these systems at the edge are talking to each other and are all up to date, both to help with security (there’s no single server to “fail” for everyone, and no single server to “hack”) and to help the more complicated interactions move more smoothly now that we’re not just downloading files from the internet, we’re performing complex work that requires constant back and forth communication with “the cloud.”

So that’s basically the service that Fastly and Cloudflare perform — they operate networks of servers that are “on the edge” and closer to end customers, and they constantly balance the load and the security and the up-to-dateness of all those systems.

Those two companies aren’t the only ones solving this challenge, but in the big picture this is all clearly of growing importance as the internet is taxed in new ways, not just with more reliance on streaming video and video games for entertainment, and with data demand that will only increase as we rely more on mobile networks and 5G is rolled out, but with heavy reliance on distributed cloud systems for millions of workers who are in “work from home mode.”

And while “work from home” and “please God give me more Netflix” had a big burst of demand in March and April and might come down from those highs a bit as some parts of the world begin to “normalize,” those are also strong long-term trends that aren’t going away. Indeed, some of the coronavirus impact will likely be permanent in the way it changes both consumer behaviors and company policies — we’ve seen headlines for weeks about companies rethinking “work from home” as a permanent strategy, with Facebook talking about the likelihood that at least half of their workers will be remote a decade from now, and Shopify CEO Tobi Lutke announcing that “office centricity is over” as he closed their company offices for the rest of 2020 and noted that most employees will be allowed to work remotely after that. We’ll be going back to work, but not everybody will be going back to the office.

Cloudflare’s “what is Cloudflare” page explains the basics of how their network works in very simple language, so that’s a good place to start if you’re trying to wrap your head around the idea. Fastly has similar descriptions up on their website, though they’re a little less clear for non-tech folks.

Here’s the investor summary of the company from each… Fastly:

“As the consumption of online content continues to grow globally, organizations must keep up with complex and ever-evolving end-user requirements. We help them surpass their end-users’ expectations by powering fast, secure, and scalable digital experiences. With Fastly’s edge cloud platform, our customers are disrupting existing industries and creating new ones. Today, our platform handles hundreds of billions of internet requests a day.”

And Cloudflare:

“Cloudflare, Inc. (NYSE: NET) is on a mission to help build a better Internet. We have built a global cloud platform that delivers a broad range of network services to businesses of all sizes around the world—making them more secure, enhancing the performance of their business-critical applications, and eliminating the cost and complexity of managing and integrating individual network hardware. Today, approximately 13% of the Fortune 1,000 are paying Cloudflare customers.”

My impression (and it may be wrong) is that Fastly provides a faster updating platform for edge computing, with more of the processing power distributed to the edge for application processing, and that Cloudflare offers an easier setup and a powerful security defense against large-scale attacks like DDoS (which is why we used Cloudflare a few years ago, when somebody tried to take down StockGumshoe.com). A lot of companies use services from both for somewhat different purposes, so they’re not direct competitors in all things, but there is some overlap in various CDN and “edge computing” use cases. As there is with the older wave of CDN companies, like video streaming-focused Limelight Networks (LLNW) and the grandpappy of the sector, Akamai (AKAM).

There are also lots of private companies in this space, including startups like Vapor IO and EdgeMicro, and there’s some degree of competition with major cloud players and other providers, including both big services like Amazon AWS and Microsoft Azure as well as a bunch of cybersecurity firms who compete in parts of this business, and there are other legacy providers like F5 Networks (FFIV) and other networking names who can do some similar things for some customers… but AKAM, LLNW, FSLY and CDN would make up most of the list for the “pure play” CDN-type companies who are available for investment right now.

Here’s an excerpt from my Friday File a couple weeks ago, when I wrote about Fastly for the Irregulars following their blowout earnings report:

Fastly (FSLY) reported one of the more dramatic beat-and-raise quarters I’ve seen in a while (investor letter here), right up there with Shopify — they surprised with a profit (of six cents/share) when a loss (of 12 cents) was expected, and they upgraded their guidance for the year by bumping up the revenue number by about 10% above what had been expected, so the midpoint of the revenue guidance for 2020 is now $285 million, which means revenue growth would be about 43% (it was 38% in the first quarter). That represents accelerating growth over the prior year, and accelerating revenue growth can have a pretty extraordinary impact on a company (revenue growth was about 38% in both 2019 and 2018) — so it’s no surprise that they’re also moving up their progress toward profitability, with the second quarter also expected to be roughly flat (maybe a two cent loss) and the full year now anticipated to have a loss of 8-15 cents per share, versus the analyst prediction of 40 cents.

If they can keep these new customers and sustain the increased volume of business from those customers that they’ve enjoyed during this coronavirus work-from-home shutdown (and boom in online entertainment and shopping), then things could get exciting pretty quickly — though that is, of course, an “if,” just like it is for Shopify and Amazon and the video game companies and Zoom Video and all the other “winners” of coronavirus, we don’t know whether they’ll be able to keep up the business momentum in whatever the “normal” world is next year and into the future. But man, it looks good so far — FSLY popped up by 25% or so after hours on the news, but is still well below its highs of last year (FSLY only went public about a year ago, but the shares peaked around $35 last Fall).

Here’s an excerpt from what I wrote about this one back in January, when I first picked up shares:

“At 9X forward sales, Fastly looks downright cheap compared to other cloud services companies, and it’s still quite small, with a market cap of only $2.3 billion and a market that they’ve barely begun to penetrate… though it’s true that growth, recently at 35% on the top line, is also a little lighter than many. This has the flavor of one that could really take off over a few years if they can get some bigger contracts, and they have plenty of cash from the IPO to try to get growth accelerated… but it could also fall apart quickly, this is a high-risk speculation.”

It’s still at a little less than 10X 2020 sales, even after the big pop, so even though one hesitates to chase performance I do still think Fastly is a worthy speculation here… as I’ve noted before with companies like Roku (ROKU) in quarters past, accelerating growth really stands out. It will be interesting to see how the 2021 estimates start moving, since 35-40% growth from $285 million would mean that the 2021 revenue estimate has to go up by 15% from the current $335 estimate (that’s if they can sustain that revenue growth pace — a big “if” but certainly possible, largely because of their growing appeal to larger customers).

That growth hasn’t come for free, their operating expenses increased by about $14 million in order to support the growth in gross profit of about $10 million, though scale is worth paying for with a recurring revenue company like this that can continue to get more and more business from its large customers (the net retention of revenues was about 130%, meaning, to oversimplify, that their renewing customers are spending 30% more than last year)… and on a cash basis, things looked a little better (about $5 million of the increased operating expense was through share-based compensation). This is a company that still has fewer than 300 major customers (297 “enterprise” customers, meaning those who spend at least $100,000 a year, and though they have more than 1,000 other customers those big guys generate the lion’s share of Fastly’s revenue), and has been growing that number very steadily (it was 243 a year ago), so it’s impossible to be certain of the pace of growth, or whether or not they’ll have more slipups along the way (they probably will), but the market that’s available to them is gigantic and they’ve hardly begun to tap into it. I really like the way the new CEO took the reins right before the coronavirus hit and managed them through this first quarter, so I’m hopeful that they’ll be able to continue to impress — this strikes me as a strong enough growth story that it deserves some extra slack in the leash.

I didn’t catch the “bottom” in Fastly, I bought all of my previous shares between $20 and $22 before I added more at $30 yesterday (taking profits on part of my options position to help pay for that), but aside from being mindful of not exposing too large a position to this young and volatile small growth company I still think it’s worth a speculative spot in the portfolio, even after this big jump.

And that jumping bean kept jumping — the 20% pop after earnings turned into another 20% rise over the next ten days or so, and the stock is now in the low $40s. It is no longer drastically undervalued relative to similarly positioned “cloud” growth stocks, but it’s still on the cheaper side, relatively speaking… and it’s still very small and growing fast, with that key phrase “accelerating growth” to pique our interest, so it’s quite possible that the upside potential remains largely untapped.

Which doesn’t mean it can’t fall back to $20 a share in a bad quarter, to be clear, but I really have been impressed with management, and I really like how they’re positioned, and in a world of expensive growth stocks Fastly stands out as still arguably being a relative value, with a business boost from the coronavirus that is unlikely to recede quickly (the valuation may come back down after the coronavirus “story” stocks become less popular, but the actual sales are very unlikely to drop just because fewer people begin working from home… I think they are a beneficiary of a strong trend that was in place before the coronavirus, it just got accelerated a little bit).

But what about Cloudflare, a company I’ve covered much less closely? It’s about twice the size of Fastly, and carries a more challenging valuation… but that size also helps with efficiency, and their margins are a little better at this point. NET stock has been far less explosive and volatile than FSLY this year, but, coincidentally, they’re actually both showing the same return since the NET IPO at this point…

Here are the charts of both stocks since the FSLY IPO about a year ago:

And here’s the more direct comparison since the NET IPO in September:

Cloudflare positions itself as offering a wider variety of services through its network, though perhaps Fastly would object to that characterization, but what really stands out with Cloudflare is the stronger growth, at least recently, in their number of large customers. Both companies are primarily reliant on these big customers, who Fastly calls “Enterprise” customers and Cloudflare just calls “Large” — they’re the customers who spend at least $100,000 a year on these CDN and “Edge” services, and though both companies offer their services for easy adoption by the smallest businesses, it’s the higher-touch relationship with the big guys that pays the bills.

So what makes me still consider Cloudflare, despite the generally more compelling valuation and likely faster growth at Fastly (that’s my judgement call, the growth is very similar right now), is the rapid climb in large customer accounts that should make it a steadier business (these customers don’t opt in and out of services willy-nilly, once committed they tend to stick around and keep spending more).

These are the numbers for that: Cloudflare went from 336 $100K+ customers one year ago to 556 in this latest quarter, which is remarkable growth of 65% for that metric. Fastly, which is younger and smaller despite being public for six months longer than NET, comes up far short of that kind of “whale recruiting” — they had 262 $100K+ customers in the second quarter of 2019, and that rose to 297 three quarters later, which is only 13% growth (I haven’t seen any disclosure of what the March 2019 count was, for direct comparison, but it was somewhere between the 227 they reported in their S-1 at Dec. 31, 2018 and the 262 at June 30, 2019… if you split the difference, that’s 245ish in March 2019 and 21% growth in the number of enterprise customers, either way it’s far slower than Cloudflare has been piling them up).

That’s just one data point, and even though it’s an important one it obviously doesn’t tell the full story — clearly the amount that customers spend is important, as is the increase in sales per customer over time, to say nothing of expenses and margins and all that other good stuff… but it’s one indicator of the relative strength and maturity that Cloudflare has in the enterprise space, having gone public with a larger stable of large customers.

Both stocks will probably be quite volatile, not just with variation in the actual numbers the companies report but, because they’re richly valued growth stocks, with the likelihood that investor sentiment about these stocks will rise and fall sharply as news changes. That’s the nature of a future-focused growth stock, particularly one that’s unprofitable — most of the valuation is based on what investors think the future will look like. While the numbers don’t usually change all that fast, the sentiment of investors about that future can change overnight if the company stumbles for a quarter, say, or if there’s a scary headline… like maybe Amazon is reported to be about to launch a competing CDN within Amazon Web Services, at far lower cost, and we all panic about Amazon eating Fastly or Cloudflare’s lunch. (That’s just an imagined example, but headlines along those lines have crushed other stocks many times in the past… remember when Facebook announced that they were about to offer a dating service in May of 2018, and investors panicked that this would destroy Match.com and Tinder? MTCH lost a quarter of its value in two days just on Mark Zuckerberg’s announcement about the future service, though buying MTCH either before or after the announcement would have let you dramatically beat the market over the subsequent two years, and even to do much better than Facebook investors. So even if the imagined threat doesn’t arise, and the headlines don’t end up meaning anything real for that company’s financials in the longer run, the stock price can take a painful fall on a “Amazon is coming!” or “Microsoft is coming” headline).

But for me, reviewing these two companies again as I researched this topic today led me to take Cloudflare’s potential more seriously than I did last time I checked them out — and I decided to open a small position in NET as I watch to see how it does, though I also opted to add on to my Fastly position today as it lingered around the secondary offering price, so FSLY remains a much larger position for me than Cloudflare.

Your mileage may differ, of course, and I’d be curious to hear what you think — see a lot of potential in these edge networks? Will they be the steady growers as the cloud becomes more complex, or be eaten by someone huge or disrupted by the next unicorn with a better idea? Prefer one over the other? Let us know with a comment below. Thanks for reading!

P.S. Spittler’s IPO Insider newsletter is still quite new, we’ve only covered one other teaser pitch from them (that was Elastic (ESTC) back in November — coincidentally, at the same price today that it carried then), but our readers always want to hear from actual subscribers and we don’t have any subscriber reviews of that letter in our system yet… have you tried out IPO Insider? If so, please click here to share your experience with your fellow investors. Thank you!

Disclosure: Of the companies mentioned above, I am invested through either equity or call options in Amazon, Fastly, Cloudflare, Shopify and Roku. I will not trade in any covered stock for at least three days, per Stock Gumshoe’s trading rules.