Summary
- The COVID boom and bust now appear to be in the rearview mirror, with a range of indicators showing improving demand for Fastly's services.
- A change in sales strategy could accelerate customer acquisitions, which continue to be low.
- Fastly's stock is inexpensive, meaning a shift in sentiment could move the stock significantly higher, but the company has large cost problems which will not be easily resolved.
Fastly ( FSLY ) is emerging from a tumultuous 3-year period and appears set to start realizing more stable growth going forward. Despite this, expenses remain high and growth modest, meaning that profitability is not on the horizon. The stock is relatively inexpensive, and as a result consistent growth and progress towards profitability may be enough to shift investor sentiment.
Network services and content delivery continue to be the core of the business, with security driving growth. Edge compute and observability are currently nascent, but potential growth engines in the future. Compute is currently not a large contributor, but by 2025 Fastly expects their non-delivery businesses to be contributing around a third .
Even though their platform has enormous potential, Fastly has quite a narrow vision, with their edge compute strategy focused on content delivery, aiming to provide dynamic content with low latency. Within security, Fastly is not really looking beyond web application security. This could result in Fastly having a highly competitive product within their niche, but significantly limits their addressable market.
Innovation could be considered a problem for Fastly given their relatively high R&D budget and the large range of end markets their platform could potentially address. The new CEO believes innovation is better than what he thought from the outside though. This appears to be a focus area for management and while the company continues to introduce new functionality, this is primarily focused on adding to the core business rather than extending their platform into new areas. For example, recent product improvements help customers meet data sovereignty requirements and provide real-time low latency solutions for content delivery.
Demand Environment
The demand environment for tech in general is quite weak at the moment, but demand drivers can vary significantly across companies. Fastly may actually be in a position of strength relative to many companies in 2023 due to the nature of their business. Fastly's performance over the last few years has largely been dictated by COVID and the large swings this caused in internet traffic. With fluctuations caused by lockdowns now largely in the past, it appears that there is a return to more stable and increasing demand for content delivery.
Search interest for Fastly pricing is trending up after bottoming in late 2021. Internet traffic appears to have returned to growth in the middle of 2022, which should be supportive of growth for Fastly due to their consumption-based pricing model. Similarly, Netflix subscriber growth appears to have stabilized in recent months, further indicating a normalization of internet usage trends.
Figure 1: "Fastly Pricing" Search Interest (source: Created by author using data from Google Trends) Figure 2: 2022 Internet Traffic Growth (source: Cloudflare Radar) Figure 3: Netflix Subscribers (source: Created by author using data from company reports)
Streaming of live sports is also potentially a tailwind for Fastly as they believe they are the best CDN for live sports . While this is likely to take time to play out, streaming is making large strides towards capturing the TV market and sports is likely to eventually become a part of this.
Go-to-Market Strategy
Fastly has traditionally focused on large customers within publishing, media and entertainment, which has shaped their pricing model and sales strategy. While a consumption model aligns with customers within media, many other customers prefer more stable costs and this has created friction for Fastly. In an effort to expand their customer base, Fastly has introduced simpler product packaging and pricing, which could alleviate some of this friction and attract more mid-market customers.
Fastly also appears set to utilize channel partners more, with the new CEO stating that systems integrators have the expertise to rapidly onboard and create value for customers.
Financial Analysis
Fastly's revenue growth has rebounded somewhat in recent quarters, which is not surprising given that demand is likely to be stabilizing and Fastly should be gaining market share over time. Management has stated that they are not immune to macro headwinds, but they are seeing traffic expansion from their enterprise customers.
Security is an area of strength, with Signal Sciences products contributing 13% of revenue and growing much faster than the core business. Going forward, the delivery business is expected to grow in the high teens and the security business around 30%, suggesting headline growth of around 20%. Revenue growth is expected to be approximately 17% YoY in the fourth quarter , although this appears to be a conservative estimate based on recent performance and demand indicators.
Figure 4: Fastly Revenue Growth (source: Created by author using data from Fastly)
Enterprise customers accounted for 89% of revenue over the past 12 months, and on average enterprise customers spend 759,000 USD. Fastly's top 10 customers contribute around 35% of revenue , but no single customer contributes more than 10%. Customer concentration is an ongoing risk for Fastly shareholders, as highlighted by TikTok in 2020.
Fastly is attempting to reduce concentration by accelerating new customer acquisition, but the success of this initiative remains to be seen. Weak customer growth is likely one of the factors holding Fastly's stock back, and if their shift in sales strategy can accelerate customer acquisition it could improve sentiment significantly.
Figure 5: Fastly Customers (source: Created by author using data from Fastly)
Gross margins are an ongoing issue for Fastly, but they now appear to be making progress towards a more normal range. Gross margin declines in 2021 and 2022 were largely due to overbuilding network capacity and some international expansion. As network utilization improves, gross margins are beginning to bounce back, improving 3% in the third quarter and an expected ~2% in the fourth quarter.
In addition to this, Fastly has renegotiated some of their bandwidth costs, removed duplicate site costs and is increasing its use of peering networks. Fastly believes that as their scale increases, they become a more attractive peering partner, which allows them to offload more traffic to low-cost lines. While costs are improving, there is also pricing pressure which naturally offsets some of this.
Fastly believes that gross margins will return to near 60% by the end of 2023 and is eventually targeting margins in the mid to high 60s range. This is a big ask from past levels and will likely require a substantial shift in product mix.
Figure 6: Fastly Profit Margins (source: Created by author using data from Fastly)
The biggest concern for Fastly is its high operating expenses, which cannot be easily rationalized. In particular, general and administrative expenses are extremely high and suggest bloat in the company that needs to be addressed. The return on R&D investments is also questionable as there appears to be a lack of new products which are driving meaningful revenue growth. Despite an increased focus on profitability, Fastly accelerated sales and marketing investments in the third quarter to better position the company for 2023.
If Fastly can rein in spending, there is no reason the company can't be profitable though. Churn continues to be less than 1%, which should eventually result in relatively low sales and marketing expenses. Fastly has suggested that breakeven adjusted EBITDA is feasible by the end of 2023, although this is a fairly meaningless metric given the company's high reliance on SBC and the relatively capital-intensive nature of the business. Given Fastly's relatively low growth rate and high-cost base, it will take time for the company to achieve genuine profitability.
Figure 7: Fastly Operating Expenses (source: Created by author using data from Fastly)
Hiring declined significantly in 2022 and appears to have stabilized at pre-COVID levels. Despite this, employee costs remain elevated due to lower than anticipated attrition during the third quarter. For a company with Fastly's gross margin structure, employee costs are far too high, and driving improved productivity will be a key part of achieving profitability.
Figure 8: Fastly Revenue per Employee (source: Created by author using data from Fastly)
Conclusion
Fastly's stock continues to trade near all-time lows, despite the company beginning to resolve some of its issues. A stronger demand environment in 2023, along with accelerated customer acquisitions and margin improvements, could improve investor sentiment significantly. While the risk/reward balance for Fastly's stock is currently favorable, the company continues to be a high-performance CDN which caps the upside.
For further details see:
Fastly: Early Signs Of A Turnaround