Fastly: +30% Upside Exists, But So Do Significant Challenges (NYSE:FSLY)

Investment Thesis

Fastly (NYSE:FSLY) has been in transition mode for more than a couple of years, which has dampened investor sentiment around the company. The company’s edge computing platform business had a feeble year in 2023, as reflected by its full year FY23 report, overshadowed by its largest competitors in the same arena. To make matters worse, the company guided for a softer FY24 under consensus expectations.

My model suggests there is an upside of at least 30% if Fastly continues to post growth rates consistent with its current growth levels. This upside represents a significant increase in Fastly’s market cap. However, I see some significant challenges for Fastly to overcome as it moves through the year. A skewed customer-mix and lagging product adoption are just some of the issues that I can see that Fastly needs to change if the company has to take back market share. Too many questions for its management up ahead have led me to view the company in a neutral stance, despite the upside in my valuation.

Skewed customer mix is now Fastly’s Achilles Heel

Fastly ended the year with 3243 customers, up just ~6% y/y as per their FY23 earnings report. Of these 3243 customers, enterprise customers make up 17.8% of their customers, or 578 enterprise customers in total. Fastly’s share of enterprise customers barely moved from 17.4% of its total customer base four quarters ago. But some napkin math suggests to me that the company is facing challenges in getting its enterprise customers to spend more on the platform, as I have illustrated in the chart below.

From the chart above, I see that Average Enterprise Customer Spend grew just 7% y/y far lower than Fastly’s total revenue growth of 16.9% y/y in FY23. Fastly calculates this by taking the annualized current quarter revenue contributed by enterprise customers existing as of the current period and dividing that by the number of enterprise customers as of the current period. Fastly’s Average Enterprise Customer Spend slowed to 7% from the 9.5% y/y growth it saw in the same quarter last year.

These trends portend a problem for Fastly, in my opinion. The reason being that the company inherently depends on its enterprise customers for recognizing its revenue. While for other companies, that is actually a good thing, as I have covered in previous research on Datadog (DDOG) or Akamai (AKAM), which either operate in the same or in similar markets, because enterprise spending continues to remain strong, in Fastly’s case, this looks to be the opposite, as enterprise spend looks weak on Fastly’s platform. This is an important observation, in my opinion, because a review of Fastly’s 2023 10-K shows that the company has consistently depended on enterprise customers for its revenue growth. Here is an excerpt from its 10-K.

Our future success also depends in part on our ability to expand our existing customer relationships, in particular, with enterprise customers, by increasing their usage of our platform, selling them additional products and upgrading their existing products.

If our efforts to increase usage of our platform by, or sell new and additional products to, our enterprise customers are not successful, our business would be harmed.

The company is also known to have a large portion of its customer base skewed towards the media and entertainment industries. TikTok was an example a few years ago, but the company has other companies, such as the new-age social media company BeReal. I believe the skewed mix towards media and entertainment poses its own challenges in terms of predictability because Fastly’s revenue model is based on consumption. If content distributed by media and entertainment companies trends among its user base, consumption goes up, which increases revenue collected by Fastly because of its consumption model.

However, the reverse also applies, which can create meaningful declarations for Fastly’s revenue. In the Institutional Conference last month, Fastly’s CFO Ron Kisling made some comments about one of his enterprise customers about this, which I think augments my point of view here:

We had a single global customer that in one of their markets, there’s a handful of markets in the world where our pricing as well as our cost are orders of magnitude higher than what we see across the rest of the world, think north of 10 times, where really small changes in traffic can drive a big impact on revenue. In Q3, this customer launched some content that was wildly popular. It drove an increase in traffic and revenue, also some headwinds to gross margin. We got into late Q4. That traffic and then the popularity dropped on that content. And it had a sort of an outsized impact on revenue relative to expectations. So that variability particularly in some of these markets, as we scale some of that goes away.

In my opinion, there are elevated levels of unpredictability in Fastly’s business, which the company must work towards improving, and so far, management has not shown to work on these initiatives yet. In fact, management has moved to provide what it calls “conservative guidance” to offer a stable path towards forecasting rather than working on improving its customer metrics.

Management has been making some improvements in their expense profile, as can be seen below, but I believe these improvements are not enough to move the needle on their overall performance. With the lack of any meaningful changes in its customer mix or customer adoption, I see the company getting cornered into improving profitability without sustainable growth.

Fastly’s valuation shows upside

Fastly’s management is guiding revenue to rise ~15.7% in FY24 to $585 million at the midpoint of its guidance range for this year. That represents a 19% growth in revenue on a compound basis from FY20 to FY23. But with recent growth trends slowing coupled with the relative unpredictability of their consumption-based revenue, I have factored in future growth rates for the company, as seen in the valuation table below, which is under what consensus expectations are.

Therefore, I expect growth rates to considerably slow down to 12.5% over the next four years, from FY23 to FY27. Moreover, with the lack of outlook on profitability, I will be using revenue estimates to arrive at Fastly’s target price. With the unpredictability of the company’s business, I see elevated levels of risk, and I will assume a discount rate of 12%.

In addition, I also expect the company’s share dilution trajectory to slow to 5% CAGR over the same time period, leading me to assume 150 million shares outstanding. I have also assumed a forward sales multiple of 5, given that it is growing its revenue faster than the S&P 500.

The assumptions driven into my model imply at least 30% upside in the stock, suggesting the math behind the current numbers supports upside. However, there is significant pessimism in the stock today, which is warranted because of issues I pointed out earlier in the company.

This can also be seen when comparing the forward sales multiples of some of its competitors, which are able to generate superior gross margins as compared to Fastly, as I have noted in the charts below.

Risks and other factors to look for

Apart from the customer trends that I highlighted earlier as some internal issues for the company to work on, Fastly is also ceding market share to its competitors. The company operates in edge computing markets such as CDNs (Content Delivery Networks) and other markets such as cloud security, which are hotly contested by its competitors.

In the CDN space, it competes directly with Cloudflare, Amazon’s AWS CloudFront, and Akamai. The market leaders in this space with the most market share are Cloudflare and AWS, as per this research. In addition, these companies also compete with Fastly’ serverless CDN products.

Moreover, most of these companies are also involved in the cloud security markets that Fastly operates in via its Bot Management and WAF (Web-based Firewall) solutions. According to its Investor Day presentation last year, the company highlighted cloud security as its growth initiative. To add to this mix are WAF solutions from the much larger hyperscalers, such as Google’s WAF capabilities (GOOG) or Microsoft’s WAF products for its Azure cloud (MSFT).

The company may become a target for being bought out by its rivals, as was rumored months ago. With the arrival of their new CPO hire, I don’t see the prospect of this yet, as I believe the company may focus their attention on launching new cloud security products aligned with their growth vision, as highlighted in the Investor Day presentation.

Takeaway

After reviewing the company, I believe 2023 was a lost year for Fastly. The company has scope to make changes, but management’s efforts have so far been underwhelming, in my opinion, and the company needs to do more to prove itself to its investors. While my model suggests significant upside, I believe the company’s current transitory phase will play out amidst volatility throughout the year, pushing down any optimism for this stock.

A Hold rating is warranted at best, in my opinion, until the company demonstrates its ability to grow the company again sustainably.