Fastly (FSLY) Q2 2022 Earnings Review

Continuing my series of looping back on a few companies that I had held previously, I thought it would be instructive to revisit Fastly (FSLY). I had owned Fastly stock during its heyday in 2020, entering in early 2020 and ramping up my position after their strong Q1 2020 results and initial guide for Q2. By May 2020, FSLY was one of my largest positions with a cost basis of $32. The stock took off over the summer, jumping from the low $20 range in May to break $100 by August.

It eventually reached a peak of $128, before pre-announcing weak Q3 results, stunning the market. Yet, FSLY still managed to break $100 again in early 2021, as investors assumed it might recapture its prior momentum. Unfortunately, it didn’t, delivering one poor quarterly report after another. Following the disappointing Q3 2020 earnings, I began reducing my allocation in the $80-$90 price range and still managed to capture a favorable upside. I finally closed my position in early 2021.

In 2020, Fastly’s trajectory appeared promising, with a thoughtful product strategy focused on harnessing trends in edge computing and advanced application security. Revenue growth shot up to 62% y/y in Q2 2020 from 38% in Q1 and 34% a year prior. Additionally, operating margin quickly passed break-even on a non-GAAP basis and gross margin improved 600 bps year/year to 62%, both reflecting improving operating leverage. Fastly’s other favorable growth indicator was their customer spend expansion rate, which was over 130%. The enterprise customer list represented a Who’s Who of Internet innovators, like TikTok, Shopify, Stripe, Spotify, Pinterest, GitHub, Twitter and more.

Fastly’s acquisition of Signal Sciences in August 2020 appeared perfectly timed as well, rapidly accelerating their application security capabilities and bootstrapping a new product offering. Fastly had already built a fairly advanced edge compute product, called Compute@Edge. The Signal Sciences acquisition would be packaged into an adjacent market offering labeled Secure@Edge, which effectively doubled their TAM.

Signal Sciences was already highly rated for their WAF and RASP offerings, and had a stable of marquee customers as well, including Under Armor, Datadog, Duo, One Medical, DoorDash, Onelogin, Airtable, Postmates and Procore. The opportunity to cross-sell between Fastly’s and Signal Sciences’ enterprise customers appeared significant. Signal Sciences also brought $28M of ARR, higher revenue growth than Fastly’s 62% and gross margins in the 80% range.

This excitement was compounded by an ambitious product development plan presented at their Altitude User Conference in November 2020. In addition to Compute@Edgd and Secure@Edge, Fastly leadership teased two more product categories, expanding their planned market penetration even further. These were Perform@Edge, which would enhance their existing content delivery offerings, and Observe@Edge, which promised new capabilities for application tracing, advanced analytics and alerting. Finally, they had been hinting at a broad expansion of their data storage capabilities (referred to as Data@Edge), moving far beyond the rudimentary key-value store in Edge Dictionaries to a full-featured distributed data store with a SQL-like interface.

There were cracks in the armor, however, that started becoming increasingly evident as 2020 proceeded. Some savvy analysts questioned how Fastly’s growth could be booming with such marginal increases in enterprise customer counts (defined as spend over $100k in prior year). Enterprise customers were growing in the single digits for all three quarters of 2020, finishing up just 14% y/y in Q3. This contrasted with 52% y/y growth for Datadog and 63% for Cloudflare. Also, while Fastly’s large customer spend expansion was over 130%, they had to roll out a new measure to account for customer churn. The new Net Retention Rate included churn, but also the impact of billing overages. Both of these masked what was happening under the surface.

The issue was that the surge in revenue growth in Q2-Q3 of 2020 was largely the result of contributions from a couple of large customers (TikTok in particular) and billing overages. As this pull-forward subsided, Fastly’s growth rates plummeted. To be fair, the TikTok drop-off was exacerbated by political undercurrents in late 2020, but the exposure existed nonetheless. And customers were not happy about additional surcharges during usage spikes due to Covid shutdowns, likely causing heightened churn.

Additionally, while the product roadmap seemed very promising in the second half of 2020, little of it materialized within a reasonable timeframe. Compute@Edge remained in beta for an inordinate amount of time, finally going GA in November 2021. Secure@Edge and other @Edge products were never launched in the form described during the 2020 user conference. The full integration of Signal Sciences WAF and Compute@Edge was delivered in Q1 2022. A review of their quarterly release notes is pretty underwhelming.

The result was a rapid slowdown in all growth metrics through 2021 and a drop in stock price. At this point, the company is struggling with worsening gross margins, middling revenue growth, backsliding on profitability and an uninspiring product roadmap (largely the same as presented in 2020). Meanwhile, rival Cloudflare has significantly expanded their product footprint, maintained high revenue growth through the period and increased gross margins. Fortunately, I shifted most of my Fastly position into NET stock in late 2020.

Looking back, I think one of the biggest take-aways for me is the impact of leadership. In parallel to all this in 2020, Fastly replaced its founder with a new, untested CEO. I think this contributed to the stumble in execution, as the company transitioned from reasonably consistent delivery to constantly missing expectations. Fast forward to this quarter (August 2022) and a new CEO has been finally brought in. But 2+ years have passed treading water, likely resulting in a permanent loss of momentum.

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Q2 Earnings Results

With that background, let’s take a look at the Q2 2022 results to see if the story has changed. Revenue was $102.5M, up 20.6% year/year but roughly even with Q1 revenue of $102.4M. This slightly beat analyst estimates for $101.6M and the company’s prior guidance for $99M – $102M. For Q3, they estimate revenue of $102M – $105M, representing annual growth of 20.0% at the midpoint. They also raised the full year revenue target range to $415M – $425M, up from $405M – $415M issued with the Q1 report.

In spite of the full year revenue raise, Fastly leadership lowered profitability targets. Non-GAAP gross margin dropped to 50.4% in Q2, down from 57.6% a year ago and 52.6% in Q1. On a GAAP basis, the performance was worse at 44.9%. Leadership attributed the lower gross margin to issues in bringing on sufficient network utilization in advance of build-out for new customers. This is perplexing, as other distributed network service providers (like Cloudflare) have been gradually increasing their gross margins and don’t experience these issues with “reserving capacity”. I think this illustrates Fastly’s dependency on CDN traffic and variable video delivery in particular. This quandary first surfaced during the TikTok debacle in 2020, when Fastly was holding network capacity for TikTok in hopes that they would return to the platform.

The worsening gross margins and other unanticipated expenses impacted operating income. For Q2, Fastly generated a $26.9M loss from operations for an operating margin of -26.2%. This compares to an operating loss of $17.6M a year ago for an operating margin of -20.7%. The Q2 result also missed their previous target set in Q1’s report for an operating loss of $20M at the midpoint. On a per share basis, net loss was $(0.23), compared to $(0.15) a year ago and their prior guidance for $(0.18) – $(0.15).

Going forward, the profitability picture worsens. For Q3, Fastly is projecting an operating loss in the range of $21.5M – $18.5M (same as for Q2) and net loss per share of ($0.18) – ($0.15). This missed analyst estimates for ($0.14). For the full year 2022, they lowered the range of projected operating loss from $60M – $70M to a loss of $72M – $78M. This translated into net loss per share of ($0.68) – ($0.63), missing analyst projections for ($0.56), which was based on the company’s prior range.

This backwards movement on profitability represents a real problem and demonstrates that Fastly is not realizing any operating leverage as they are growing. While they increased the full year 2022 revenue range by $10M, they lowered the operating loss by $10M. Analysts called this out during the Q&A portion of the earnings call. Management attributed the worse than expected performance on profitability to a few factors, including lower gross margin, more T&E and increased staffing expenses, including higher salaries than anticipated for new hires. They also referenced expenses allocated to GTM activities, which included an announcement that Fastly is now an official global sponsor of the Mercedes AMG Petronas Formula One Team. I am really surprised that they think this is a good idea.

Customer activity was similarly marginal. Fastly’s total customer count in the second quarter was 2,894, up 12% y/y, of which 471 were enterprise customers. Total customer count increased by 14 in Q2, down from 76 in Q1. They increased enterprise customers by 14 in Q2, versus 12 in Q1, and 13 in Q2 2021. On a year/year basis, enterprise customer count increased by just 15%. These counts have tracked about the same for the past 2 years. By comparison, Cloudflare added 212 large customers in Q2, up 61% from a year ago. Fastly DBNER is holding at about 120%, up slightly from 118% in Q1 and down from 126% a year ago. The trailing 12-month net retention rate (excludes churn) was 117%, up from 115% in Q1 and down from 121% a year ago. The convergence of these two measures at least shows that churn is low, which the company reports as less than 1% of customers at this point.

Looking back, I blame a lot of the execution issues over the past two years on Fastly leadership, and the ill-fated CEO transition in particular. For the software infrastructure companies that I own, the ideal case is to have a founder CEO. The founder CEO brings the unique combination of intimately knowing the business and having a lot of skin in the game. The continued success of the company represents their legacy, so they often go far beyond what would normally be expected to ensure continuity. They can maintain the highest standards for performance, because it is their company. Once the company’s reins are turned over to a non-founder, this extreme personal accountability diminishes.

However, there are circumstances in which the company’s trajectory can surpass the founder’s ability to run it. In these cases, I like to see the founders move into another meaningful role and the Board to bring in a seasoned executive with significant wins under their belt. Ideally, they have already been the CEO of another publicly traded company and have recognized industry chops. For MongoDB, this was Dev Ittycheria. For Snowflake, this was of course Frank Slootman, who also brought in his former CFO.

In retrospect, I don’t think Joshua Bixby was the right choice for CEO. While he had been with the company for several years in senior executive roles, his experience before ascending to the CEO position was limited to a couple of smaller start-up exits. These were acquisitions by larger companies and Bixby subsequently left each to start another company. Coming into Fastly, he lacked the perspective of running a multi-faceted public company. I think the CEO role at Fastly was a bit overwhelming. This was combined with the company’s own execution challenges that I mentioned earlier. In addition, the company kept founder and prior CEO Artur Bergman as Executive Chairperson, meaning that Bixby’s boss was still his former boss and likely tolerated a lot of missteps.

The Fastly Board decided in May 2022 to replace Bixby, coinciding with the Q1 2022 earnings report. In August, they announced that Todd Nightingale will be replacing him, effective September 1, 2022. Nightingale joins Fastly from Cisco, where he leads business strategy and development efforts for Cisco’s multi-billion dollar networking portfolio as Executive Vice President and General Manager of Enterprise Networking and Cloud. He joined Cisco in 2012, through an acquisition. Prior to that, he held leadership roles at Motorola. This should represent an improvement. It may also be positioning Fastly for an acquisition. In the past, Cisco has been floated as a potential acquirer.

Interestingly, in 2021, the company established a goal to reach $1B in revenue by 2025. As we exit 2022 with a targeted revenue of $420M at the midpoint, this implies that Fastly will increase revenue by 33.5% in each of next 3 years. It’s possible they could reach that target, if their execution improves. With a net expansion rate around 120% and customer counts increasing by roughly 15% a year, they could get to 30%+ revenue growth a year. This makes a lot of assumptions, however, and doesn’t take profitability into account. Over the past year, it seems Fastly has had to increase expenses and lower margins in order to reach their current revenue growth. The lack of operating leverage makes it more difficult to increase the revenue growth rate from its current 20% range, as Fastly leadership have already been increasing investment to drive current demand.

Given Fastly’s continued underperformance, I don’t plan to restart a position. If the new CEO focuses on sales and product execution, he may reinvigorate Fastly to achieve at least a reasonable level of consistent performance. To become interesting, the company needs to increase revenue growth over 30%, improve gross margins and get back to break-even on non-GAAP operating margin. This will require increasing the pace of product development and becoming more aggressive in security offerings. In the meantime, I will keep an eye on Fastly’s execution and at least look forward to the potential impact of the new CEO. If he can get the company tracking towards its $1B revenue target, then it would be worth another look.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.