Summary
- Fastly's lackluster execution continues, as revenue slowed down considerably if we take into account the easy comp in 2Q21 and the struggle to acquire new customers.
- Slow revenue growth coupled with poor sales efficiency and declining gross margin caused operating losses to widen. There is no clear path to profitability.
- With that, I deem the company a hold for now unless there is clear visibility of a turnaround.
Investment Thesis
Back in COVID, Fastly's ( FSLY ) content delivery network ('CDN') was thriving as many people had to restrict themselves at home and internet consumption accelerated. In 2Q20 , its revenue growth peaked at 62% YoY.
However, it was not until 3Q20 that things started going south. Revenue growth began to decelerate quarter-after-quarter, reaching a new low of 3% in 2Q21 . At that point in time, it was apparent that the management had to resolve its sales execution issue, and they embarked on a turnaround by implementing several leadership changes - hiring CRO Brett Shirk in 1Q21 , CFO Ron Kisling in 2Q21 , CMO Margaret Arakaw and CPO Lakshmi Sharma in 4Q21 .
Despite these changes, its turnaround continues to drag as there is no meaningful recovery in its revenue growth and the customer acquisition rate slowed down. Its most recent 2Q22 earnings result , which I will be diving into later, in my view, continues to be disappointing. I deem Fastly as a hold for now, and I will refrain from entering unless the visibility of a turnaround is clear.
Just recently, Todd Nightingale was announced as the new CEO to succeed Joshua Bixby, in which he will continue to serve as Fastly's advisor. As of today, this is a complete revamp of the entire management team. The question that most of us have is, can Todd Nightingale be the final piece to the puzzle? Or will Fastly's poor run continue?
I will be sharing my thoughts along the way, but first, let's head into the article for a more in-depth analysis of its 2Q22 result.
Disappointing Revenue Growth
(Source: Image created by the author from Fastly's Quarterly Report)
(Source: Image created by the author from Fastly's Quarterly Report)
(Source: Image created by the author from Fastly's Quarterly Report)
In this portion, I will be breaking down revenue into two separate segments - its core business, and Signal Science, which was acquired back in 4Q20 as part of its security product portfolio.
Its core business revenue grew by 16.6% YoY to $89 million, which in my view, is yet another disappointing quarter. While it may seem that its revenue is recovering as it went from 2.5% in 2Q21 to 16.6% this quarter, this isn't the case. Recall that in 2Q21 , there was a one-time outage that occurred, causing many customers such as Amazon ( AMZN ) and Bytedance's TikTok to pause their spending or churn, and revenue fell as a result. These are customers that account for a sizeable chunk of its revenue. And let's think about this for a minute - they are effectively growing off an easy comp. And if an outage had not occurred, this quarter's revenue growth was likely to be much lower.
However, unlike its core business, Signal Science's strong growth momentum continues as revenue grew by 56.7% YoY, and it is increasingly making up a bigger pie of its total revenue.
It has been 8 quarters since the turnaround began, and sales execution continues to be lackluster. Investors are increasingly worried about whether they are going to turn around in the near future. If you think this is all, not yet.
Awful Customers Growth
(Source: Image created by the author from Fastly's Quarterly Report)
(Source: Image created by the author from Fastly's Quarterly Report)
Similar to its revenue, I will be breaking down its total customers into two segments - enterprise, and non-enterprise customers. Enterprise customers are those who spend more than $100,000 a year.
This quarter, they added a total of 14 enterprise customers, and shockingly, 0 non-enterprise customers. And to quote the management from the earnings call :
"Our total customer count increased by 14 in Q2, down from 76 in Q1…impacted by higher churn at the low end of our customer base, which we believe was impacted by the uncertain macro environment impacting smaller customers…continue to focus on landing new enterprise and large customers…enterprise customer count increased by 14 compared to 12 in the first quarter…validates our efforts in sales and marketing to retain and expand our customers' revenue…"
While the rationale to focus on enterprises may make a lot of sense as it makes up 88% of its overall revenue, I personally disagree. Here is why.
(Source: Image created by the author from Fastly's Quarterly Report)
(Source: Image created by the author from Fastly's Quarterly Report)
Most software companies that I have come across typically grow in 2 ways:
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Kingpin strategy - landing enterprises such as Fortune 500 companies. These are harder to acquire but provide strong and sticky recurring revenue. More importantly, they provide credibility, which helps to speed up customer acquisition.
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Land-and-expand strategy - Tackling customers with basic use cases, and hopefully, growing them over time into enterprise customers as they adopt more use cases. This should be easier since these are basic needs.
However, this is not the case for Fastly today as clearly evident that they are struggling to acquire new customers. Let's compare this quarter's result to the previous quarters. They were adding enterprise customers at similar or if not faster rates than the current quarter. For instance, 17, 22, and 15 enterprises were added in 1Q21 , 3Q21, and 4Q21 , respectively. Moreover, they managed to onboard non-enterprise customers, but at a slower pace over time. And they spent less on S&M expenses in those quarters to land significantly more customers. For comparison sake again, Cloudflare ( NET ) brought on 212 large customers (i.e. spent more than $100,000 per year) while increasing its non-enterprise customers at the same time. This is a vast difference in execution.
This then begs the question - how is landing 14 enterprises and 0 non-enterprises a "validation" of its S&M efforts? Its sales efficiency worsens as S&M is increasingly making up a bigger portion of its total revenue despite not seeing material growth in revenue and customer acquisitions. This, in my opinion, is poor execution at best.
Deteriorating Profitability
(Source: Image created by the author from Fastly's Quarterly Report)
(Source: Image created by the author from Fastly's Quarterly Report)
Its operating losses continue to widen as it grew by -67% YoY, reaching a record high of -$68 million during the quarter. This is in part because of its poor sales efficiency, and also its deteriorating gross margin as it went from 60.2% in 2Q20, to 52.6% (-7.6%) in 2Q21 to 44.9% (-7.7%) this quarter. This decline in gross margin is due to the quick deceleration in revenue and its investments in the new architecture, which it is expected to drive up gross margin over time.
With its total cash (i.e. cash and marketable securities) of $482 million, this means that they have roughly 7 quarters runway of cash (i.e. total cash of $482m / $68m of operating losses). If losses widen, cash will deplete quicker, and sustaining the business will be incredibly difficult. And this is not factoring in that they still have $703 million of convertible notes maturing on Mar 15, 2026.
This lack of profitability is an increased risk for the business, and this may call the need to raise capital at a low valuation, which is not favorable to shareholders.
New CEO, Todd Nightingale
Todd Nightingale came from Cisco ( CSCO ), a $187 billion market cap company, substantially larger than Fastly. At the top of my mind, he comes off as a better fit than former CEO, Joshua Bixby as he had experience in growing a multi-billion conglomerate company. On a side note, I find it appalling that Fastly has decided to keep Joshua Bixby as an advisor considering how he ran the company.
We are likely to see a newly revised guidance in the upcoming investor day which has been postponed for a few months. Most interestingly, Cisco is also an acquirer as they mainly grow through acquisitions , which raises the question if Fastly is a potential acquisition.
Concluding Thoughts
It has been over 2 years since Fastly began its turnaround, and unfortunately, its poor run continues. This quarter's revenue growth and customer acquisition rate have been extremely disappointing and coupled with its declining gross margin, losses widened with increasingly no clear path to profitability.
Whether the decision to appoint CEO Todd Nightingale is a good or a poor one, at the very least, he is a far better pick than having former CEO Joshua Bixby at the helm, in my opinion. Currently, the visibility of a turnaround happening is incredibly low and I deem Fastly is a hold for now.
What are your thoughts on the quarter? Do let me know in the comment section below.
For further details see:
Fastly's Poor Performance Continues