Fastly’s (NYSE:FSLY) Q2 results were in line with expectations, but soft guidance and management commentary suggest that demand to grow is deteriorating, and competition is increasing. Fastly’s heavy exposure to a handful of large media companies is exacerbating this issue. Fastly still appears to be having some measure of success outside of its largest customers, but results are still disappointing given the upside that the expansion beyond delivery into security and compute should be creating.
I previously suggested that while demand was softening, Fastly’s problems were also due to increasing competition. Despite the scope of Fastly’s business increasing in recent years, the company is still largely a high-performance CDN, making it vulnerable to pricing pressure and the spending patterns of a handful of large customers. I continue to think that Fastly should find support at some point due to its low valuation, although consistently positive cash flows may be required first. There also remains a high probability that Fastly is a value trap, particularly if the company doesn’t attract any M&A attention.
Market Conditions
Fastly is currently facing challenges within its largest customers, with data suggesting roughly a 10% sequential revenue decline from the company’s top 10 customers in the second quarter. Fastly’s business continued to expand, though, driven by 13% YoY revenue growth from the rest of the company’s customer base.
This appears to be due to a combination of pricing pressure, weak traffic growth and the distribution of traffic across multiple vendors. The softness in traffic is primarily coming from large media accounts. There is also a renewed push for profitability within these organizations, creating pricing and vendor deconsolidation headwinds. Fastly reportedly hasn’t lost any accounts, though. These trends are expected to persist throughout Q3 and then begin to moderate in Q4.
Fastly Business Updates
Few updates were given on Fastly’s products or overall strategy in the second quarter. The company continues to expand its security portfolio, with the release of its BOT mitigation solution in Q1. The reception has reportedly been strong, and the product is ramping faster than Fastly expected. The company now has a complete security portfolio (BOT mitigation, WAF, DDoS prevention), providing cross-sell opportunities.
Fastly’s product portfolio is fairly narrow in comparison to companies like Akamai (AKAM) and Cloudflare (NET) though. This leaves Fastly poorly positioned when it comes to customers that aren’t primarily concerned about delivery. It could also mean that Fastly is vulnerable if competitors choose to discount delivery in order to penetrate customers with a broader portfolio of higher margin security and compute solutions.
Fastly also launched a beta version of its AI accelerator in June. This is an AI proxy which provides performance and cost savings to applications leveraging LLMs. Beta testers have reportedly seen impressive performance improvements. Fastly plans on rolling the product more broadly later in the year.
Financial Analysis
Fastly generated 132.4 million USD revenue in the second quarter, an increase of roughly 8% YoY. Network Services revenue was up 6%, while security revenue increased 13%. Weakness was attributed to some of Fastly’s largest customers, partially offset by strength in areas like social media, development platforms and gaming.
Channel partners is one of the few bright spots for Fastly at the moment, with YTD revenue contribution from the channel more than doubling compared to 2023. Fastly expects this to remain an important contributor going forward.
While Q2 revenue was in line with expectations, conditions appear to have deteriorated through the quarter, leading Fastly to materially lower guidance for the remainder of the year. Fastly now expects 130-134 million USD revenue in the third quarter, representing 2-5% YoY growth. For the full year, 530-540 million USD revenue is anticipated, implying a slight YoY revenue decline in the fourth quarter.
Fastly’s TTM net retention rate was 110% in the second quarter, down from 116% in the year ago quarter. Fastly’s NRR has been falling since late 2022, which is disappointing given the cross-sell opportunities the company’s security and compute solutions should have created. The company’s NRR is likely to decline further as headwinds from larger customers continue to impact the business.
Fastly’s customer base continues to expand at a low rate, although there was some strength amongst the enterprise customer cohort in the second quarter. Fastly now has 3,295 customers, up 7% YoY, while the company’s enterprise customer count was 601, up 9% YoY. Enterprise customers accounted for 91% of total revenue in the second quarter, although average enterprise customer spend continues to decline.
Fastly’s gross profit margin was 58.5% in Q2, up roughly 2% YoY, with cost controls helping to offset pricing pressure. Security and compute should also be tailwinds, but modest growth in these areas, coupled with delivery pricing headwinds, are limiting margin gains at the moment. Gross margins are expected to decline around 1.5% in Q3.
Fastly’s operating profitability is generally improving, driven by a combination of revenue growth, improving gross margins and operating cost control. The company is still a long way from GAAP profitability, though, and hasn’t really made any progress in this regard since becoming a public company. Things are less dire from a cash flow perspective, with negative 18.5 million USD free cash flow in Q2.
Given the company’s new revenue outlook, the company’s current structure is no longer considered suitable. As a result, Fastly plans on reducing discretionary spend and reviewing staffing levels, with the company targeting a 14 million USD reduction in operating expenses in the second half of 2024. One third of these savings are expected in the third quarter, with the remaining two thirds occurring in the fourth quarter. This will not be sufficient for Fastly to achieve cash flow breakeven without further revenue growth, though.
Conclusion
I have never been particularly bullish on Fastly’s business but have felt that its differentiated technology was an advantage amongst some customers. It is now looking questionable whether Fastly can build a healthy, albeit small, business based around just this. Larger customers are trying to cut costs, and Fastly’s high-performance network doesn’t appear to be shielding it from pricing pressure. Amongst customers less concerned about delivery performance, Fastly is vulnerable to competitors with larger strategic considerations.
It should be clear at this point that Fastly doesn’t have a particularly strong business. The real questions now are how much of its current struggles are due to macro headwinds, and what is a reasonable valuation. I think further multiple compression from this point is unlikely to be sustained, but Fastly make greater progress towards profitability before valuation becomes a focus for investors. This will take time, particularly while the company’s top-line remains under pressure.
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