AKAM - Fastly: Fairly Valued After Recent Share Price Appreciation
2023-04-24 11:29:34 ET
Summary
- Investor sentiment towards Fastly has shifted in recent months as post-pandemic headwinds have begun to recede.
- Fastly now appears to be valued in line with peers, although the stock could outperform in the long-run if Fastly can continue to pick up market share.
- Fastly's hyper focus on content delivery will likely limit the stock's potential upside though.
Fastly's ( FSLY ) stock has rebounded significantly in 2023, but despite this, the company is still modestly valued. A return to pre-COVID internet traffic patterns and easier comparable periods are helping Fastly's growth to normalize. This, along with a change in management, has shifted investor sentiment and helped drive recent returns. Fastly remains focused on content delivery, a competitive market with price sensitive buyers. As a result, Fastly will need to take share from incumbents, like Akamai ( AKAM ), to create value for shareholders, and even then the upside may be limited.
Market
The CDN market is now offering modest growth, after pandemic induced internet traffic distortions have largely disappeared. Fastly's growth is primarily the result of market share gains and Fastly is still relatively small, meaning there is still significant opportunity for expansion.
Figure 1: Fastly Revenue (source: Created by author using data from company reports)
Pricing pressure is generally an issue in the content delivery market, although Fastly's management recently stated that pricing has stabilized over the last 18 months. Small decreases have typically been occurring when customers renew annual contracts, but these are basically in line with Fastly's cost declines (reduced hardware and bandwidth costs etc.). While Fastly has a premium service, they compete in a fairly commoditized market and have limited pricing power. As a result, efficiency gains largely pass through to customers rather than accruing to Fastly's margins. This is an important point, as driving higher gross profit margins is a large objective for Fastly's management team.
Fastly
Fastly started with a software-first approach to managing traffic, which enables content delivery with less hardware. It also enables real-time global upgrades, rather than having to physically swap out hardware, and enables new customers to be rapidly onboarded. The focus on software also reduces hardware costs. In comparison, legacy vendors like Akamai built hardware-centric networks, which potentially puts them at a competitive disadvantage that will likely compound over time as the functionality of edge networks expands.
Providing delivery, security, compute and observability on a unified platform is a large part of Fastly's vision. Fastly's management continues to focus on the user experience and latency for their programmable edge product. Management believes that by pushing a small portion of latency sensitive workloads and storage to the edge, the user experience can be improved. Use cases specifically mentioned include recommendation engines, e-commerce, media, gaming and observability.
Fastly just launched a JavaScript SDK for Compute@Edge, which offers unmatched initialization performance, supporting Fastly's focus on latency. Management believes this introduction could accelerate developer adoption. In addition to prioritizing language support, Fastly is also focused on distributed edge storage technology.
Glitch is a developer community based around education and developer awareness which Fastly acquired less than 12 months ago . The Glitch community has over two million developers. Glitch could help to encourage adoption of Compute@Edge and Fastly is reportedly using the Glitch community to guide its product roadmap. Developer adoption is a potential issue for Fastly as Cloudflare ( NET ) is achieving far greater traction with its edge compute product.
Fastly is focused on the security needs of an edge cloud provider, which includes areas like web application firewall, DDoS, and bot protection. This is aligned with the company's focus on content delivery, but could be a weakness as security products are coalescing into a small number of platforms.
Fastly's web application firewall is reportedly best in class. It is possibly the only web application firewall that is run more than 90% of the time in blocking mode, not just reporting mode, indicating a low false positive rate. Fastly's Next-Gen WAF also now supports automated provisioning and management via Terraform for cloud based deployment options.
Future investment areas within security are likely to include API security, DDoS, anti-bot and web-application protection. Fastly believes it has a quality DDoS product but that it needs to be packaged in a way that makes it easier for customers to deploy. Fastly also offers bot protection, although the company is actively working to improve this product, indicating it is currently lacking.
Management has stated that the consumption model is often a tough sell in the mid-market, and the company is currently working on a package that will launch in Q2. Fastly wants to package its content delivery and security products in a way that makes it easier for customers to deploy and price compute in a manner that provides a predictable monthly cost. This could help with customer acquisition, particularly amongst smaller organizations.
Financial Analysis
Fastly's revenue grew 20% YoY in the fourth quarter, excluding the impact of non-recurring payments. Traffic from Fastly's enterprise customers continues to expand, and management expects to build on their relatively small market share over time. Security continues to be an area of strength, with revenue from Signal Sciences products contributing 12% of revenue in the fourth quarter, a 37% YoY increase.
In the first quarter of 2023 Fastly expects revenue growth to be approximately 13% YoY at the midpoint. Management is guiding for 16% revenue growth in 2023, which is based on an expectation of Fastly gaining share in a fairly soft market. As an indication of Fastly's ongoing underperformance relative to prior expectations, the company had previously been targeting $1 billion in revenue in 2025, but management is no longer standing behind this target.
Figure 2: Fastly Revenue Growth (source: Created by author using data from Fastly)
Fastly's business continues to be characterized by a small number of large customers, with weak customer acquisition. Fastly's average enterprise customer spend continues to expand, and was 782,000 USD in the fourth quarter. Enterprise customers accounted for 89% of total revenue on a trailing 12-month basis and Fastly's top 10 customers contributed 37% of total revenues in the fourth quarter of 2022. Customer concentration could be an issue for Fastly, but churn currently remains low (less than 1%).
Fastly recently gained six new logos in the travel and leisure vertical, including one of the world's largest corporate travel management platforms, which management believe is becoming more focused on the user experience. Fastly also won four new logos in the healthcare and life sciences vertical, highlighted by McKesson ( MCK ). While new customer wins are a positive, it is somewhat telling that management feels the need to highlight these types of small gains.
Figure 3: Fastly Customers (source: Created by author using data from Fastly)
Search interest for "Fastly Pricing" has continued to strengthen in recent months, which could be interpreted as increasing demand or pricing pressure. Given Fastly's modest growth and gross margin headwinds, there is likely some of both occurring.
Figure 4: "Fastly Pricing" Search Interest (source: Created by author using data from Fastly)
Fastly realized a reduction in bandwidth rates at the end of Q3 (bandwidth represents around one third of costs), which along with an increased percentage of peering traffic and improved network capacity utilization, contributed to higher gross profit margins in the fourth quarter.
Fastly is focused on realizing operating leverage and achieving profitability over the next few years, although it continues to make focused investments in sales and marketing around quota-carrying sales reps. Even absent significant efficiency gains, Fastly's margins should improve just on the back of declining SBC costs as the burden of amortizing SBC from peak pandemic stock prices declines. Given Fastly's modest growth, the company still has a long road ahead to reach GAAP profitability.
Figure 5: Fastly Profit Margins (source: Created by author using data from Fastly) Figure 6: Fastly Operating Expenses (source: Created by author using data from Fastly) Figure 7: Fastly Revenue per Employee (source: Created by author using data from Fastly)
A rebound in job openings at the start of the year was one indicator that Fastly's business had stabilized and was facing a more normal traffic growth environment. Job openings have begun to fall in recent weeks, but so far the decline has been modest. This could indicate that demand has begun to soften again or simply that Fastly's employee count is approaching target levels.
Figure 8: Fastly Job Openings (source: Revealera.com)
Valuation
While Fastly's stock price has appreciated significantly off the lows, its valuation is still fairly modest. Forward revenue multiples for Fastly and Akamai are similar, which demonstrates the extent to which investors are prioritizing current profitability over future prospects. It remains hard to get excited about Fastly though, as the company continues to focus on a market niche, rather than realizing the full potential of its network.
Figure 9: Fastly Relative Valuation (source: Created by author using data from Seeking Alpha)
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Fastly: Fairly Valued After Recent Share Price Appreciation