DKosig
I last wrote about Fastly (NYSE:FSLY) in November, suggesting that the company continued to face demand issues, customer concentration and an unfavorable cost structure. The stock is down close to 50% since then, with Fastly reporting poor results in Q4 2023 and Q1 2024.
Fastly’s share price is again approaching levels where it could be considered attractive from a valuation perspective. It remains difficult to get excited about the opportunity though, as Fastly’s business has a relatively narrow scope and is competing in a commoditized space.
Market Conditions
In early 2023, it appeared that pandemic related demand headwinds were moving into the rearview mirror. Recent soft results and conservative guidance suggest that either market conditions have weakened again, or that Fastly is facing competitive pressures.
Fastly has suggested that there has been some demand variability internationally and that pricing continues to present a headwind, particularly amongst larger customers. This situation could worsen, as Akamai (AKAM) has stated that it is worthwhile discounting delivery in order to attract compute to its platform. Fastly believes that its delivery technology (serverless compute, edge storage, etc.) will protect it in this scenario, but I’m not sure that this is the case.
Internet traffic growth should be supporting Fastly’s business, and there remains a large opportunity to drive adoption of security solutions across content delivery customers. Fastly’s inability to drive strong growth in this environment calls into question its competitive positioning.
Fastly Business Updates
Fastly claims to offer a unified platform for content delivery, security, compute, storage and observability. Fastly’s product portfolio has expanded over the past few years, but the platform still appears to only really appeal to large companies with high performance delivery requirements.
Recent updates include simplified product bundles, which aim to encourage adoption of more products. Fastly also continues to upgrade its security solutions (bot management, WAF) and recently introduced edge observability. Fastly’s success outside of delivery has been limited so far though. Compute and observability revenue is still minimal and security growth has fallen off quickly.
Financial Analysis
Fastly generated 133.5 million USD revenue in the first quarter, a 14% increase YoY. Network Services revenue increased 12% YoY to 106 million USD and Security revenue was up 16% to 24.6 million USD. Fastly saw lower traffic at its largest customers in Q1, which was largely held responsible for the weak first quarter performance. The company’s top 10 customers only contributed 38% of total revenue in Q1, compared to 40% in the fourth quarter. Fastly has suggested that it has not lost any of its large customers, but there has been pricing pressure and a reversal of some of the vendor consolidation from last year.
Second quarter revenue is expected to be 130-134 million USD, up 6-9% YoY. For the full year, revenue is expected to be 555-565 million USD, an increase of 11% at the midpoint.
Figure 1: Fastly Revenue Growth (source: Created by author using data from Fastly)
Network services continue to dominate Fastly’s revenue. While there was a large amount of hype around edge compute prior to its launch, it is still not a material contributor and growth is only modest. Security revenue growth is also relatively poor, although some of this is due to a decline in legacy WAF revenue.
Table 1: Fastly Revenue by Segment (source: Created by author using data from Fastly)
Fastly’s customer count increased 6% YoY in Q1 to 3,290 and the company’s enterprise customer count was 577, down one sequentially. Fastly attributed the enterprise customer decline to seasonality, dropping some customers below the 100,000 USD threshold. Fastly reportedly added two large new logos in Q1, which are expected to move into the company’s top 10 customers over the course of the year. Enterprise customers accounted for 91% of total revenue in Q1, and average enterprise customer average spend was up 6% YoY. The company’s net retention rate has been fairly consistent in recent quarters at 114%.
Figure 2: Fastly Customers (source: Created by author using data from Fastly)
Fastly’s gross profit margins continue to improve, driven by growth of its higher margin segments, along with scale-based benefits in peering, infrastructure investments and contracts. Progress in this area has been limited by ongoing pricing pressure though.
Fastly’s operating profit margin was approximately -35% in Q1, with the improvement due to increased gross profit margins, operating leverage and operating expense control. Fastly generated 3.7 million USD adjusted EBITDA and 11.1 million USD cash flow from operations in the first quarter. While the business has problems, consistent growth and positive cash flows will likely begin to matter at some point.
Figure 3: Fastly Profit Margins (source: Created by author using data from Fastly)
Figure 4: Fastly Operating Expenses (source: Created by author using data from Fastly)
Conclusion
Fastly’s stock may appear attractively priced, particularly after the Q1 earnings drop, but there is a high probability that Fastly turns out to be a value trap. The convergence of delivery with compute and security are changing competitive dynamics. Companies like Akamai and Cloudflare (NET) are taking an all-encompassing approach to the market, making delivery a relatively small part of their businesses. In comparison, Fastly is more focused on delivery and will suffer if delivery just becomes a tool to help attract security and compute customers. This will make profitable growth difficult to achieve, even if Fastly has a leading technology stack for delivery.
Figure 5: Fastly EV/S Ratio (source: Seeking Alpha)
