Fastly (FSLY) delivered numbers that were mostly in line with reduced guidance for the third quarter. But what really matters to investors are the fundamental drivers behind those numbers and the company's potential over the middle and long term.
It looks like Fastly is losing TikTok, which is having a material negative impact on revenue. But this is only a one-time event and it has nothing to do with the company's ability to deliver the best solutions in the industry. In any case, this is already incorporated into expectations at this point in time.
Moving beyond TikTiok, the fundamental drivers of the business remain as strong as ever, and the company is offering enormous room for growth in main areas such as security and cloud computing over the years ahead.
The Context
Fastly stock has been spectacularly volatile in 2020. As of the time of this writing, Fastly is down by a staggering 47% from its highs of the year, but it has also gained almost 265% year to date, even accounting for this sharp decline from the highs in recent weeks.
Data by YCharts
The big reason why the stock is down so much in the short term is that the company announced on October 15 a 5% reduction in revenue guidance for the third quarter. The company provided two main reasons for this negative development in the press release:
- Due to the impacts of the uncertain geopolitical environment, usage of Fastly’s platform by its previously disclosed largest customer - TikTok - did not meet expectations, resulting in a corresponding significant reduction in revenue from this customer.
- During the latter part of the third quarter, a few customers had lower usage than Fastly had estimated.
In a nutshell, the company was seeing a material decline in usage from TikTok, and there was also some kind of slowdown in usage from other clients. The first factor was the one with the larger short-term impact on revenue, but the second one could be more concerning due to its forward-looking implications.
Representing 12% of total revenue, TikTok is Fastly's biggest client, so losing it is more than relevant. But it is still a one-time event, and it is due to the geopolitical uncertainty surrounding the U.S. and China relations, it has nothing to do with Fastly's ability to deliver the best technologies to customers.
On the other hand, if the company is losing other clients versus the competition, this could be a reflection of far more serious problems.
As I wrote in my previous article on Fastly:
I am certainly not going to sell Fastly on a weak quarter, driven mostly by a slowdown in TikTok usage. On the other hand, I will be closely watching the company in the coming quarters to see if there are any signs that Fastly is falling behind the competition. The comments from management regarding lower-than-expected usage from other clients certainly require more scrutiny in the near term.
Providing More Clarity
Management provided some clarification in the recent shareholder letter. The bad news is that TikTok reduced most of its traffic with Fastly due to the potential of a prohibition of U.S. companies being able to work with TikTok.
Management expects this reduction to continue into the fourth quarter, and this is being reflected in the company's guidance. There is always the chance that this traffic could come back to some degree in the future, and Fastly specifically said that it can re-allocate that capacity with a mix of other clients over the medium and long-term, generating a traffic mix that is consistent with the company's gross margin objectives. However, it is what it is right now, and it makes sense to assume that this traffic is not coming back in the near term.
The good news is that the TikTok drama is already in the past for Fastly and any surprises regarding TikTok will probably be positive surprises going forward. About the slowdown in usage from other customers, management said that this was mostly a timing issue that has now been solved, and this traffic is now coming back to the network.
From a forward-looking perspective, this is much more important than the TikTok situation because it has bigger implications from a competitive point of view. Seeing that things are back to normal with other clients is dissipating some major uncertainties around Fastly stock.
The Business Fundamentals
Revenue during the quarter came in at $71 million, at the high end of revised guidance and representing a 42% increase year over year. More importantly, the company performed very well in terms of both new customers and dollar-based retention rates.
Total customer count increased to 2,047 from 1,951 in the second quarter. Total enterprise customer count also increased to 313 from 304 and it now accounts for 88% of total revenue.
The Dollar-Based Net Expansion Rate (DBNER) reached 147% during the quarter, a big increase from 137% in the prior quarter, and 132% two quarters ago. If you are looking to assess the fundamental strength of the business with or without TikTok, this number is clearly showing that Fastly remains at the top of its game.
Guidance for the fourth quarter is now at $82 million and it includes $8 million in additional revenue from the Signal Sciences acquisition. This is a 39% increase versus the same period in the prior year. Nearly 8.7% of the total revenue guidance is the Signal Sciences acquisition, but TikTok is probably assumed at zero, and TikTok represents nearly 12% of total revenue for Fastly.
All in all, it seems like Fastly is growing at more than 40% excluding the one-time loss of revenue from TikTok and the $8 million in added revenue from the Signal Sciences acquisition. The guidance is healthy but not too impressive for a high growth business such as Fastly.
Then again, there is a good chance that management is being conservative with guidance after the recent experience with reducing guidance and the particularly uncertain economic environment that the business is facing.
In terms of future growth opportunities, things look really exciting for Fastly. The Signal Sciences acquisition is providing plenty of opportunities for cross-selling and upselling, and management is "very optimistic about the immediate opportunities" in this area.
An even larger opportunity is edge computing, and Fastly announced that Compute@Edge has moved out of beta into limited availability, with customers now running production traffic on the environment.
According to the company:
Feedback from customers, including Vox Media, HashiCorp, and loveholidays, is that Fastly’s deep investments in Compute@Edge are delivering on the promise of serverless with rock-solid performance and features, allowing developers to create with enhanced speed, agility, and security
Gartner estimates that by 2025 nearly 75% of enterprise-generated data will be created and processed outside a traditional centralized data center or cloud. This trend will create massive opportunities for the leading players in edge computing, and Fastly is in the right position to benefit from the edge computing boom in the years ahead.
The Bottom Line
It looks like Fastly is losing TikTok, and we have to assume that this could be permanent, even if there is always a chance that it may not be so. Losing your biggest customer is a material setback, but it is still a one-time event for a high growth company that can easily replace such a client over time. Besides, expectations regarding TikTok have already been reset.
The rest of the business is performing very well, and an exceptionally high DBNER number is a major piece of good news for investors in Fastly. Moving forward, the company has enormous potential in security and edge computing, and the bullish thesis for Fastly is looking much stronger after the recent earnings report from the company.
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