Fastly: There's Opportunity In This Crash

In an incredibly difficult operating environment for small and mid-cap stocks, Fastly (NYSE:FSLY) has seen a world of hurt. The content delivery network (CDN) platform, once one of the hottest trades on Wall Street during the pandemic when it commanded double-digit revenue valuation multiples, has seen its share price slide nearly 60% year to date. And relative to pandemic-era highs that briefly went above $100 per share, Fastly has wiped off billions in market value over the past few years.

The company recently released Q1 earnings alongside a deep revenue guidance cut for the current year, which caused the stock to plunge even further.

Fastly is lowering expectations now to leave room to beat in the near future

I last wrote a bullish article on Fastly in April, prior to the company's Q1 earnings fiasco. While I admit now that my buy call was premature, after observing the wreckage of the company's Q1 print, I do think there is plenty of salvage value that investors should recognize in this stock.

Let's cover the elephant in the room first: the company cut its full-year guidance outlook from a prior viewpoint of $580-$590 million (15-17% y/y growth) to just $555-$565 million (10-12% y/y growth).

Needless to say, a five-point cut to growth expectations is a big swing. But we do note that it's not rare for companies to take a single "big bath" quarter to reset expectations very low, and then to chart a course to beating from there on. We also note that Fastly's share price has dropped ~40% since the earnings outlook (or a loss of more than $600 million in market cap) for a ~$30 million cut in revenue outlook for the current year - which looks to be an overreaction.

Fastly is attributing the slowdown to lower traffic trends at the company's largest enterprise customers. Traffic, meanwhile, is largely an input that's outside of Fastly's control - it relies on users like you and I clicking through sites and sending content requests to be processed through Fastly's network. In my view, this weaker traffic appears to be more seasonal and macro-driven in nature, rather than a failure of execution on Fastly's part.

But that doesn't mean that Fastly isn't taking steps to right the ship. Fastly is undergoing a wholesale leadership change-up, including searching for a new CEO. We note as well that the company just appointed a new Chief Revenue Officer, a long-time software industry executive with thirty years of experience primarily in cybersecurity, to demonstrate its commitment to rectifying its sales processes.

Beyond the short-term volatility, here is a reminder as to my long-term bull case for Fastly:

• Usage-based pricing may be hurting Fastly now amid weaker traffic, but it also allows for expansion when traffic recovers. Because Fastly's pricing is based on volumes of content delivered, as the underlying customers continue to grow their websites and traffic, Fastly's revenue will also grow proportionally. Amid NRR deterioration for many of its tech peers, and even amid the company's reports to traffic slowdowns, we like that Fastly's trailing NRR has remained above 110%.
• Customer growth and diversification - The company now has a base of approximately 3,000 total customers, with about ~500 enterprise customers between them. It no longer has reliance on single large customers (prior to 2020, TikTok was a major driver of revenue for the company).
• Economies of scale and just now eking a positive adjusted EBITDA profit. As Fastly grows, it achieves economies of scale on its CDN network. It has already started to pare down hardware spend in an effort to improve gross margins. Capex spend as a percentage of revenue is also expected to continue trending downward. As Fastly's existing customer base continues to boost usage, margins will continue to expand.

Stay long here: in my view, a lot of risk has already come out of Fastly's share price, and it has more opportunity than downside.

Q1 download

Let's now go through Fastly's latest quarterly results in greater detail. The Q1 earnings summary is shown below:

Revenue in the first quarter grew 14% y/y to $133.5 million, slightly missing Wall Street's expectations of $133.8 million but barely decelerating from Q4's 15% y/y growth pace.

Top-line weakness in the quarter was, as previously mentioned, dominated by weaker traffic trends at the company's largest enterprise customers. Per CEO Todd Nightingale's remarks on the Q1 earnings call:

There are a few factors that contributed to a challenging short-term environment. The biggest factor is a reduction of revenue from a small number of our largest customers. The first-quarter revenue from our top 10 customers dropped from 40% to 38%.

Many of the top 10 accounts run a multi-vendor strategy. And we did see significant volatility here. And there are a few reasons for that. Firstly, historically, Fastly has gradually won greater traffic share in our largest accounts. But with the timing of rate and volume changes, we saw increased volatility this quarter. To be clear, we have not been removed from any of our largest customers and we remain in a strong strategic position, each of them long term.

Secondly, in some accounts, we did see an addition of CDN vendors or reversal of the vendor consolidation we saw last year. And thirdly, we are seeing a slight uptick from the typical level of rerates with our largest customers, but we have not yet seen the commensurate traffic expansion usually associated with this motion.

Very positively, we are seeing continued success with new customer acquisition motions, and notably, added two very large new logos in Q1, one of which will move into the top 10 over the course of the year. We aim to see the long-term results of our new customer acquisition motion having an increasing effect on our revenue as the year goes on."

The last points that Nightingale mentions above are critical. While traffic has dropped in the existing customer base, the company continues to see better-than-expected new customer acquisition - which, over time as these customers fully onboard, will help to offset weaker trends in the existing base. The company noted adding 18 new enterprise customers in the quarter (including the "two very large new logos" mentioned above) as well as 47 net-new customers overall in the quarter, bringing the customer count up to 3,290.

Second: we note as well that trailing dollar-based retention rates clocked in at 114% in Q1, indicating that in spite of all this traffic weakness, the average customer is still expanding by ~14%. This even improved slightly from 113% in Q4.

We note as well that profitability is on the cusp of turning around.

As shown in the chart above, adjusted EBITDA cranked out to a positive $3.7 million in the quarter, representing a 3% adjusted EBITDA margin, versus a -2% adjusted EBITDA loss in the year-ago Q1.

Risks, valuation and key takeaways

At current post-earnings share prices near $8, Fastly trades at a market cap of just $1.04 billion; and after we net off the $329.5 million of cash and $343.8 million of debt on Fastly's most recent balance sheet, the company's resulting enterprise value is $1.05 billion.

This puts Fastly's valuation at 1.9x EV/FY24 revenue. Even amid a lowered growth outlook, with Fastly just beginning to turn a positive adjusted EBITDA plus achieving strong new logo wins, I'd say this is quite a low multiple.

There are a plethora of risks here, of course - and that's exactly why the stock has fallen so harshly. New logo wins could slow down, and new processes implemented by the new Chief Revenue Officer could fizzle. Competition versus other CDNs could cause Fastly to lose more share and suffer deeper traffic declines.

But in my view, all of this is already priced into Fastly's bargain-basement price post-earnings. In my view, it's time to pick up the pieces here.