Fastly, Inc. (NYSE:FSLY) Q3 2023 Earnings Call Transcript

Fastly, Inc. (NYSE:FSLY) Q3 2023 Earnings Call Transcript November 1, 2023

Fastly, Inc. beats earnings expectations. Reported EPS is $-0.06, expectations were $-0.07.

– : Will Power – Baird Tim Horan – Oppenheimer Rudy Kessinger – D.A. Davidson Fatima Boolani – Citi Tom Blakey – KeyBanc Capital Markets Madeline Brooks – Bank of America

Operator: Ladies and gentlemen, good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fastly Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. And I’d now like to turn the conference over to Vernon Essi, Investor Relations at Fastly. Please go ahead.

Vernon Essi: Thank you, and welcome, everyone, to our third quarter 2023 earnings conference call. We have Fastly’s CEO, Todd Nightingale; and CFO, Ron Kisling, with us today. The webcast of this call can be accessed through our website, fastly.com and will be archived for one year. Also, a replay will be available by dialing 800-770-2030 and referencing conference ID number 754-3239, shortly after the conclusion of today’s call. A copy of today’s earnings press release, related financial tables and investor supplement, all of which are furnished in our 8-K filing today, can be found in the Investor Relations portion of Fastly’s website. During this call, we will make forward-looking statements, including statements related to the expected performance of our business, future financial results, product sales, strategy, long-term growth and overall future prospects.

These statements are subject to known and unknown risks, uncertainties and assumptions that could cause actual results to differ materially from those projected or implied during the call. For further information regarding risk factors for our business, please refer to our most recent Form 10-K and Form 10-Q filed with the SEC and our third quarter 2023 earnings release and supplement for a discussion of factors that could cause our results to differ. Please refer in particular to the sections entitled Risk Factors. We encourage you to read these documents. Also note that the forward-looking statements on this call are based on information available to us as of today’s date. We undertake no obligation to update any forward-looking statements, except as required by law.

Also during this call, we will discuss certain non-GAAP financial measures. Unless otherwise noted, all numbers we discuss today other than revenue will be on an adjusted non-GAAP basis. Reconciliations to the most directly comparable GAAP financial measures are provided in the earnings release and supplement on our Investor Relations website. These non-GAAP measures are not intended to be a substitute for our GAAP results. Before we begin our prepared comments, please note that we will be attending three conferences in the fourth quarter. The RBC Capital Markets 2023 TIMT conference in New York City on November 15th. The D.A. Davidson Technology Summit in New York City on November 16th and the UBS Global Technology Conference in Scottsdale Arizona on November 29th.

With that, I’ll turn the call over to Todd. Todd?

Todd Nightingale: Thanks Vern. Hi everyone and thanks so much for joining us today. First, I will give a quick summary of our financial results and third quarter highlights. And then I will provide an update on our product strategy, go to market and internal transformation before I hand or call off to Ron to discuss our third quarter financial results and guidance in detail. We reported record third quarter revenue of $127.8 million, which grew 18% year-over-year and 4$ quarter-over-quarter. This came in at the very high end of our guidance range driven by strong international traffic. This demonstrates continued momentum in our enterprise customer motion, as we continue to benefit from vendor consolidation and seasonal strengths in streaming activity.

Our customer retention efforts, a hallmark of our customer satisfaction were favorable in the third quarter, Our LTM, and NRR was a 114%, down slightly from Q2. Our DBNER was a 120% in the third quarter down from 123% in Q2 and also slightly down from 122% in Q3 of last year. Our DBNER continues to demonstrate healthy wallet share gains in our customers as we continue to cross-sell more functionality and grow with our customers’ ongoing edge traffic requirements. We’re starting to see some effects of budget tightening by our customers, but we continue to see strength in customer expansion, especially cross product expansion across the board. Our total customer count at third quarter was 3,102 which increased by 30 customers, compared to Q2 and 63 year-over-year.

Enterprise customers totaled 547 in the quarter, a decrease of four from Q2 and an increase of 36 year-over-year. We have four new customers make the enterprise $25,000 threshold in the quarter, number dropped to reflect a sequential decline. As we discussed during our Q1 earnings, our newer enterprise customer count methodology will be slightly more volatile. Our average enterprise customer spend was $858,000, up $40,000 quarter-over-quarter, representing a 5% increase as well as an 11% increase year-over-year. These results point to continued wallet share expansion, as we’ve aligned our customer success teams to be more focused on cross-product adoption. Also, as we work towards platform unification, we begun focusing on our goal of making customer cross-selling, and onboarding as simple as a single click for existing customers.

This will be a huge shift in the usability and the expandability of our platform and help drive customer retention, as well as expansion. I’m excited to share with you that in the third quarter, we acquired Domainr a real-time, DNS API provider. We’ve run on board a small team of highly respected DNS experts and paired with the general availability of Certainly, our certificate authority, we have the opportunity to greatly simplify on boarding to the Fastly platform with security and simplification. In the third quarter, we landed key new logo wins in highly competitive deals. I am personally very excited about Wendy’s a true White House account in a new vertical for Fastly that opens up a major market opportunity As our success in e-commerce grows to include more and more adjacent verticals such as food delivery, travel, and leisure and consumer brands, we see significant potential to accelerate customer acquisition.

Continuing our success in security and privacy proxy implementations, we are excited that Mozilla, adapted Fastly’s oblivious HTTP relay, Fastly now serves three of the top four internet browsers worldwide. On thought leadership, we published our first threat intelligence report, featuring data and insights from Fastly’s network learning exchange, as well as continued posts on Fastly’s technical leadership in the constantly evolving world of DDOS experts. As some of you are aware, a couple of CDM providers are in the process of winding on their services and have sold their remaining customer contracts to our competition. This has created disruptive environment that Fastly is poised to capitalize on, especially as those contracts come up for renewal.

Digital Turbine, a leading digital ad provider is a great example and there are many others already engage Fastly to find higher levels of service and performance at competitive rates. We are committed to helping them find their next strategic partner. If anyone listening recently had their contract sold, please feel free to reach out. We’re seeing this e-commerce expansion internationally as well, closing a top New Zealand grocer and an omni-channel retail fashion house in UK. We saw continued customer acquisition in the travel leisure segment and in the healthcare life sciences. We anticipate continued momentum in these expansion verticals as our sales team is now armed with more reference accounts and pre-built use cases. This momentum significantly tilts the win probability to Fastly and gives us a considerable edge of new customers.

As these new verticals ramp, a diversified traffic load will provide Fastly with smoother network and compute demand, providing better infrastructure utilization, leading to future margin improvements. Our gross margin was 55.9% for the third quarter, representing a 17 basis point decline, quarter-over-quarter, but a 230 basis point increase year-over-year. I am pleased with the team’s efforts controlling our variable cost of revenue and continuing to get more from our infrastructure footprint. For the second quarter in the row, we saw outsize increases in international traffic, which did cause a short-term margin headwind. As with last quarter, these will open up opportunities for us to peer more and negotiate a bandwidth cost to lower our total cost of revenue for the future.

Our operating expenses were $84 million in the quarter, coming in lower than anticipated. Financial discipline and rigor continues to have behavioral results here. Note this result also reflects heavy sales and marketing spend due to one-time events and fees. I’m also pleased that we posted another positive adjusted EBITDA quarter making this our second quarter in a row. Positive EBITDA should be a normal occurrence moving forward, but you’ll excuse my enthusiasm just this one last time. Ron will explain our outlook and guidance in more detail. But as you can tell from our OpEx spend, we are readying our model to leverage revenue growth and improve our cash flow for next year. During the quarter, we continued to drive our durable innovation engine strategy and have delivered several key pieces of functionality in the market.

You can see these in our supplement including KV Store, Shipping GA, which enables more powerful edge applications through very high performance of reads and writes of key data at the edge. GraphQL inspection expands Fatly’s API security offering. Certainly going GA establishes, a Fastly certificate authority to provide domain validated TLF certificates and improve the security, and reliability of our customer sites. And our Goal Compiler SDK provides edge compute developers with a key capability for a highly requested language. During the quarter, we hosted Altitude, our user conference in New York City drawing hundreds of worldwide attendees. Most attendees were customers and prospects, but there were also industry and investor analysts in attendance.

I was extremely pleased with the event. It was very well received. Some of the sessions have been viewed thousands of times online following our social media coverage. One of the highlights was a demo of simplified service creation, our new onboarding workflow and dashboard. This demo was so powerful because it showcased Fastly’s new ability to provision a global website for best-in-class low latency user experience worldwide, all in 90 seconds. This combination of power and simplicity is near and dear to my heart. And I believe it’s key to rapidly increasing customer acquisition at Fastly. Please give it a look if you have a chance. It’s bookmarked in our Events page and in our supplement. There’s also been great progress with our packaging motion.

We initiate this motion a little less than a year ago and closed our first handful of packaging customers in the first quarter of 2023. Since then, the growth has accelerated and in the third quarter the number of customers that signed packaging deals more than doubled quarter-over-quarter. Almost half the package is sold to-date have been computing related with almost a third of the customers buying a standalone compute-only package. In terms of the overall number of packages sold, more than 25% of our package deals are platform wins with multiple product lines included demonstrating the ability for packaging to help us drive our platform strategy and expand our offerings beyond CDN. This data gives us great insight into where we can see our efforts and we plan to continue to drive a single platform cross-selling motion across our customer base.

I first thought about this opportunity as Ron will explain in just a moment this is having a favorable impact on our RPO as well. Moving on to our channel partner development, we are seeing great progress here. Our 2023 deal registration is already triple that of 2022. You’ll recall that during our Investor Day in late June, Brett shared with you that we had 33 partners globally engaged. Today that number totals 55. Our revenue contribution has grown more than 50% in 2023 year-to-date, when compared to all of 2022. And we expect to see this trend continue into 2024. So far, I’m pleased with the progress we’re making in 2023. And this is reflected in our updated projections for the year. We raised our annual guidance for both revenue and operating margin and we’ll strive to find ways to outperform that guidance through strong innovation velocity, strategically lowering the friction of our go to market efforts and streamlining our employee experience.

Fastly partners with our customers to deliver the best possible end-user experience. This focus uniquely positions us where these market needs intersect the edge cloud. And there is an enormous opportunity in that intersection. The future user experience is fast, safe and engaging without compromise. Organizations been too much time building best-in-class digital experiences only to see the value of that effort lost by having to compromise between performance, safety and personalization. This represents a clear architectural opportunity for Fastly. The solution has to be built on the edge and it has to leverage all the benefits of a best-in-class edge cloud platform, fast, safe and engaging without compromise. This is Fastly. Thank you so much.

And now to discuss the financial details of the quarter and guidance, I’ll turn the call over the Ron. Ron?

Ron Kisling: Thank you, Todd, and thanks everyone for joining us today. I’ll discuss our business metric and financial results and then review our forward guidance. Note that unless otherwise stated, all financial results in my discussion are non-GAAP based. Total revenue for the third quarter increased 18% year-over-year to $127.8 million, coming in at the top end of our guidance of $125 million to $128 million. Revenue from Signal Sciences products was 14% of revenue, a 33% year-over-year increase or a 31% increase, excluding the impact of purchase price adjustments related to deferred revenue. Also, note that we calculate growth rate off of the actual results with the percentage of revenue rounded to the nearest whole percent.

In the third quarter, we saw traffic expansion at our major customers, as well as strong upsell and cross-sell activity. Our trailing 12-month net retention rate was 114%, down from 116% in the prior quarter and 118% in the year ago quarter. We continue to experience very low turn and our customer retention dynamics remained strong. Turning to RPO, as I discussed last quarter, our consumption-based revenue model is now being augmented with predictable revenue packages. For the third quarter, our RPO was $248 million, up 7% from $231 million in the second quarter of 2023 and up 43% from $173 million in the third quarter of 2022. As Todd shared, we had 3,102 customers at the end of Q3, of which 547 were classified as enterprise, a net, decrease of 4 compared to an increase of 11 in the second quarter.

As a reminder, we changed our calculation of enterprise customers this year to customers with an annualized revenue run rate of $100,000 or $25,000 in the current quarter, which results in more quarter-to-quarter volatility than the previous 12 months trailing $100,000 definition. Using our prior methodology, enterprise customer count increase by 10 customers in the third quarter to 530, compared to an increase of six in the prior quarter. Enterprise customers accounted for 92% of total revenue on an annualized basis in both Q3 and Q2 and enterprise customer average spend was 858,000, up 5% from 818,000 in the previous quarter and up 11% from 771,000 in Q3 of last year. Our top 10 customers comprise 40% of our total revenues in the third quarter of 2023, an increase from the 37% contribution in Q2 2023, reflecting in part the impact of vendor consolidation and expansion of our traffic at some of our largest customers, which also drove one customer to account for 12% of revenue in the third quarter.

I’ll now turn to the rest of our financial results for the third quarter. Our gross margin was 55.9%, compared to 56.6% in the second quarter of 2023, slightly above our expectation of 100 basis point sequential decline. We saw increased bandwidth costs from higher than expected growth in traffic from customers outside the US and EU, which was partially offset by reductions in our other variable and fixed cost of revenue. As we’ve discussed in 2022, we implemented new and more robust network capacity planning to better align network capacity investments with our expected traffic demands. These steps have driven significant reductions to our cash CapEx investment as a percentage of revenue, which declined from 14% in 2021 to a current range of 6% to 8%.

As part of this capacity planning, we identified approximately $4.3 million of hardware, software and related commitment, primarily acquired or committed to in 2021 that are in excess of our requirements. We recorded an impairment charge for $4.3 million in Q3 to reserve for this excess equipment and commitment. We excluded the impact of this charge in our non-GAAP results. Operating expenses were $84 million in the third quarter, an 8% increase compared to Q3 2022 and up 9% sequentially from the second quarter. A portion of this growth was a tax benefit of $3.4 million recorded in the second quarter that did not recur in Q3 and one-time marketing expenses related to events and fees in addition to our normal investments in R&D and sales and marketing.

The benefits from our continued focus on cost discipline and financial rigor offset these investments resulting in OpEx coming in slightly below our expectations. This favorability, combined with revenue at the upper end of our guidance range and gross margin slightly ahead of expectations resulted in an operating loss of $12.6 million, exceeding the high end of our operating loss guidance range of $15 million to 13 million. Our net loss in the third quarter was $8 million, or a $0.06 loss per basic and diluted share, compared to a net loss of $16.8 million and $0.14 loss per basic and diluted share in Q3 2022. I am pleased to report that our adjusted EBITDA was positive in the third quarter coming in at $0.7 million, compared to negative $9.1 million in Q3 2022.

Turning to the balance sheet, we ended the quarter with approximately $461 million in cash, cash equivalents, marketable securities and investments, including those classified as long term. Our free cash flow for the third quarter was negative $19 million from positive $7.8 million in the second quarter. This decrease was primarily driven by changes in working capital and lower operating margins as compared to Q2, which benefited from the aforementioned non-recurring sales and use tax refund of $3.4 million. Our cash capital expenditures were approximately 4% of revenue in the third quarter below the low end of our outlook of 6% to 8% of revenue for 2023. We expect to accelerate the purchase of certain hardware in the fourth quarter for deployment in 2024, which will drive our annual CapEx for 2023 as a percentage of revenue to the high end of our 6% to 8% range.

As this demonstrates, we expect to continue to see quarterly fluctuations in the timing of our capital expenditures, but for them to align with our range on an annual basis. As a reminder, our cash capital expenditures include capitalized internal use software. I will now discuss our outlook for the fourth quarter and full year 2023. I’d like to remind everyone again that the following statements are based on current expectations as of today and include forward-looking statements. Actual results may differ material. We undertake no obligation to update these forward looking statements in the future except as required by law. Our fourth quarter and full year 2023 outlook reflects our continued ability to deliver strong top-line growth via improved customer acquisition, upsell and cross-sell expansion in our existing customers driven in part by new and enhanced products.

Our revenue guidance is based on the visibility that we have today. Historically, our revenue experience is sequential growth in the second half that accelerates into the fourth quarter. For the fourth quarter, we expect revenue in the range of $137 million to $141 million, representing 16% annual growth and 9% sequential growth at the midpoint. As we shared on our previous calls, we saw some increase in price declines in the first half as a result of winning additional traffic from a major customer. As we entered the second half of 2023, we experienced increased traffic in the international markets where we saw favorable pricing. As a result, our pricing trajectory was more favorable than this normal course and we expect that to continue to the remainder of 2023.

And recall that normal reductions in our bandwidth cost and ongoing network optimization, combined with increasing traffic into our fixed cost base typically offset our pricing declines. Looking more closely into these dynamics on the cost side. In the second half of 2023, we saw a larger increase than previously expected in traffic from customers outside the US and EU markets. Within these markets, our bandwidth cost today are higher than those in the US and EU markets and it had a modest adverse impact on our gross margins. While this increased traffic gives us the opportunity to renegotiate our bandwidth rate and increase peering reducing costs for all customers in these regions, it will have a modest near-term impact on growth margins while we complete these negotiations.

We continue to be very disciplined in our network investment and cost of revenues, which contributed to our third quarter gross margins being approximately 30 basis points better than we initially expected. For the fourth quarter, we now anticipate, our gross margins will increase approximately 100 basis points relative to the third quarter, plus or minus 50 basis points. As we mentioned previously, our Q3 operating loss was moderately better than our earlier expectations, as our continued cost controls offset increased seasonal spending in marketing. For the fourth quarter, we will see the benefit of increased revenue as we continue our cost control efforts. As a result, for the force quarter, we expect our non-GAAP operating loss to decrease by approximately $3 million to $7 million to $10 million to $6 million and our non-GAAP loss to be $0.5 to $0.01 per share.

We reported nominally positive EBITDA in our third quarter and expect our adjusted EBITDA creating positive and to improve materially in the fourth quarter. For calendar year 2023, we are raising the midpoint of our revenue guidance from a range of $500 million to $510 million to a range of $505 million to $509 million. This increase represents 17% annual growth at the midpoint. We expect our non-GAAP operating loss to improve to a range a $44 million to $40 million, reflecting an operating margin of negative 8% at the midpoint, which compares favorably to our prior guide of negative 9% at the midpoint and our operating margin of negative 18% in 2022. We expect our non-GAAP net loss per share to improve to $0.23 to $0.19, reflecting the improvement in our operating loss expectations, compared to our prior range of a net loss per share of $0.27 to $0.21 and we expect our adjusted EBITDA for calendar year 2023 to be positive, compared to negative $32.9 million in 2022.

Before we open the line for questions, we’d like to thank you for your interest in your support in Fastly. Operator?

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Q&A Session

Operator: [Operator Instructions] We will take our first question from Frank Louthan with Raymond James. Your line is open.

Frank Louthan: Great. Thank you. Just following up on the guidance, any change to the longer term metrics you gave at the Analyst Day, particularly the free cash flow guide from 2024? And then to follow up on the OpEx declines how much further can that – can we see that decline and what sort of good run rate for that going forward? Thanks.

Todd Nightingale : Yeah. I think if you look at the sort of outlook, particularly with respect to cash flow, that we gave back on the Investor Day that exact – that is still intact if we look toward 2024, our cash flow basis, we would look to be break even-ish on a cash basis.

Ron Kisling: On the OpEx side, I’m pretty happy with the cost control across the company right now. But I’ll tell you, we’ve got, we still have some significant benefits here. I mean, it takes a while to unravel long-term SaaS contracts and commitments. We’re still seeing that. We’re still reaping the benefits there and we’ve done I think a pretty good job of putting business model rubrics in place to control the headcount, that control the operating models for our teams. So that, going forward, we don’t expect OpEx to grow nearly as fast as the top-line. And I think that’s going to be the key for us.

Frank Louthan: All right, great. All right. Thank you.

Operator: And we’ll take our next question From Jonathan Ho with William Blair. Your line is open.

Jonathan Ho: Hi, good morning, good afternoon. Just wanted to get a little bit more color on what you’re seeing in terms of the spending environment and some of the budget tightening? That’s the first question.

Todd Nightingale : Yes, it’s super interesting. We’re seeing we see budget tightening in some of our accounts that leads to that can lead to vendor consolidation. They don’t want to manage as many vendors. That tends to be good news for us, because, as the performance leader in almost all of those deals they tend to want Fastly to be part of their solution even if they stick with a multi-vendor play. There are some cases where we’ve seen deals taking a little longer to close as more approval of our needed. I think that might be the nature of the current economic environment that we’re in and we haven’t seen those deals dissolve. We’ve seen them take a slightly longer than usual. What we’re tracking that very carefully. Kind of, I might have a little bit more interesting information next quarter on it. But we haven’t we haven’t really been too worried about it so far. But we’re noticing something.

Jonathan Ho: Got it. And just as a follow-up, how should we think about where you’re growing in terms of the international markets? Is there a way for you to maybe help us understand what markets these are, these are specific vertical that you’re seeing traction internationally? And how long is it sort of takes for some of these contracting negotiations to take? Thank you.

Todd Nightingale : Sure. We see – we’ve been pushing on our international go to market for sure, and that drives local business with local traffic in those expanding regions for us. But what is interesting and what is causing some of our model to shift a tiny bit, is we’ve got large multinationals who are successfully penetrating new regions themselves, and they’re using Fastly to partner to deliver that that content. We see it in media largely. And I think it’s really good news. It’s helping us grow into those markets and modernize our infrastructure and our or I should say, mature our infrastructure and that’s what these to those contract negotiations. Because with more traffic, we’re able to negotiate and peer more effectively in those regions and then improves the margin for all of our traffic in that region not just the multinationals, but the local traffic, as well.

It can take us a little bit quarter, but more likely probably six months. It doesn’t take a full year generally speaking because those contracts have a much tighter turning on renegotiations.

Operator: We will take our next question from James Fish with Piper Sandler. Your line is open.

James Fish: Hey guys. Nice quarter here. Todd, maybe for you, channel partner deal registration of three times year-to-date. Can you just talk about what those channel partners are leading with between delivery that tends to be more self-serve versus security understanding? You gave some of those metrics there and really the crux is kind of what kind of economics you’re seeing versus the traditional Fastly model? And then I’ve got a follow-up for Ron.

Todd Nightingale : Yes, no worries. Our partner community has largely, historically been around the security business and we’re starting to see that branch out from just security to them being able to operate across the portfolio, which is awesome. And that’s been a big help, especially new partners that we’re bringing on board, they are capable of operating and in some cases have much broader expertise. And that’s why for me, the jump of partners in the program up to 55 really matters. I think that is a broadening of the expertise of our partner community. And I think will also help customers to engage with those partners on board faster which is an important metric to our business. And the other thing is just on the geographic side.

We’ve got our traditional partner program for the revamp was really heavily focused in the US. We are seeing it start to ramp up outside of the US and that’s helping quite a bit. And I should say the partnership with the cloud providers helps that move a little faster. In some cases, it’s easier for partners to onboard because they’re all the operating to a cloud marketplace, and that is a nice synergy for them. And it’s valuable for us, as well as it lowers our operating costs it.

James Fish: Got it. I am not surprised to see the top 10 up, just you guys own the relationships with those top 10 customers and it’s a bit of double-edged sword especially as you think about the history of this space. So I guess how are you guys trying to mitigate some of that risk around those top 10 customers? Are you looking to sign those customers for longer contracts? And also Ron, any puts and takes on ‘24 to think about understanding, you’re not going to guide Q4 for specifically, but especially as we start to think about how this packing can kind of impact growth rates moving forward? Thanks.

Ron Kisling : Yeah, I’d say, I’m proud with the growth in the top 10 accounts. And we take that very seriously as the largest, the most sophisticated users of this tech they trust Fastly and they’re leaning into the platform more and more strategically, which is a good thing. The only way that I look to combat that is through enterprise customer acquisition, and especially large strategic customers. I have, we love engaging with those large customers. I’ve no interest in doing anything, but growing those accounts as fast as we can, and adding more and more technology to those partnerships. But it’s a long-term litigation that has to come through customer acquisition especially differentiated vertical customer acquisition, and that’s why we’re so focused on that.

That’s why we mentioned some of the expansion verticals especially e-commerce expansion verticals that we’re focused on. I think, looking into ‘24 and we haven’t really shared our ‘24 guidance. We talked a little bit about some of the cash flow expectations at our investor Day. We will share that as we’ve historically done on our Q4 call in February. I think what I would say is I think we’re excited about the progress to-date. We continue to believe on our ability to outperform the market continuing into 2024.