Fastly, Inc. (FSLY) Morgan Stanley Technology, Media & Telecom Conference (Transcript)

Fastly, Inc. (NYSE:FSLY) Morgan Stanley Technology, Media & Telecom Conference Call March 6, 2024 12:30 PM ET

Company Participants

Todd Nightingale - Chief Executive Officer

Ron Kisling - Chief Financial Officer

Conference Call Participants

Sanjit Singh - Morgan Stanely

Sanjit Singh

All right. I'm Sanjit Singh. I'm the Infrastructure Software analyst on the Morgan Stanley Software Research team. We are super thrilled to have the management team from Fastly, Todd Nightingale, CEO; and Chief Financial Officer, Ron Kisling. Todd and Ron, thank you for joining us for the conference once again this year.

Todd Nightingale

Thanks so much.

Ron Kisling

Thank you.

Sanjit Singh

Just to go over disclosures. I don't have my little readout, but if you want to see important disclosures, go to www.morganstanley.com/researchdisclosures, or ask your Morgan Stanley representative.

Question-and-Answer Session

Q - Sanjit Singh

With that, let's kick off the conversation, Todd. You guys have been having a decent year. You just reported your Q4 results, which were generally solid, but a little light on revenues and the outlook was a little bit light. The stock reaction has been quite severe. It's been almost down 40%. From your perspective, Todd, what do you think is going on with -- in terms of the market reaction to the recent results?

Todd Nightingale

Yeah, and I think you nailed it. Revenue result was a little lighter than we wanted to be. And we always want to be above the midpoint of our guide and above consensus, obviously, and we didn't quite get there that quarter. And I think we're seeing the results of that. It was relatively small miss, but still below the midpoint, it's not a good feeling.

I do worry a little bit that some of the company transformation that's happened over the last year was a little bit lost in the shuffle. The gross margin correction that we saw and that the team has worked so hard to realize was really significant. And bringing the gross margins all the way back to north of 59%, like striking distance to 60%, I think really gives us the ability to fuel

The other thing though, and maybe the signal that I think the strategy that we've had around packaging and channel transformation and channel investment, et cetera, all of the kind of focused platform unification. We saw the largest increase in enterprise customers that we've seen for years, in fact, I think since 2020. And the focus on customer acquisition is really what drives growth for the company in '24 and '25 and beyond. And we're starting to see a real change in trajectory there, which is super important. Again, I'm just a little worried that some of those signals, some of that positive transformation was lost in the revenue top-line number.

Sanjit Singh

Yeah, that makes a lot of sense. I actually want to go -- I was going to ask this later, but I want to go to the gross margin point because I think for me, following the company, that's been something that I've been kind of squarely focused on. And I think, the message coming out of Q4 earnings on the gross margin side was actually quite constructive. Gross margins expanded by 250 basis points in 2023. In 2024, the guidance suggests another 200 basis points of improvement. Ron, as you scale and the network gets more efficient over time, how should investors think about getting to that -- the magical threshold of 60% gross margin, which you're all waiting for?

Ron Kisling

Yeah. I think a couple of things. I think we ended the year, I think it was in striking distance of 60%, which we set out at the beginning of the year to do. And I think we'll continue to see margin. I think one way to look at it is in terms of incremental gross margins, that we expect to see incremental gross margins at 80%. And so, you build that into the revenue growth rates. And you see us getting into that 60% gross margin in 2024 and further expansion beyond that as we see growth from our higher-margin segments of our product, security and Compute@Edge continue to see the benefits of scale that peering and our contracts and aligning our hardware investments along with our traffic expectations within that 6% to 8% of revenue, which is kind of the go-forward alignment on CapEx.

Todd Nightingale

Just to add one thing there, and this is an important issue for us, not just in how we post the numbers, but how we operate internally. Gross margin is what fuels growth for the company. It's what funds all of our team expansion, et cetera. Fastly's infrastructure is fundamentally software-defined infrastructure. And our edge is very uniform. All of our different product lines, compute, content delivery, network services, security, observability, they all run across our entire edge, every single POP, every single machine. We don't have to deploy specific infrastructure for any piece of that. And that allows us to upgrade the efficiency of our infrastructure through software.

You don't see us disclosing special infrastructure deployments for particular product lines or in particular regions. And that's because our infrastructure is designed to be a single-edge platform that can support all of this. And it means through software, we can gain efficiencies in that infrastructure. And we've done that this year. We see that in the results, and we have the potential to continue to do that to yield better efficiency and more revenue through the exact same hardware we already have deployed.

Sanjit Singh

Awesome. Let's talk a little bit about some of -- to wrap up the conversation on sort of the near-term debate, let's tackle the guidance, particularly on the top-line side. So, what were sort of the trend lines coming out of Q4, Ron? And then, what are the assumptions that underpin the outlook? And if you can sort of map it to how you're thinking about some of the cohorts behaving in 2024?

Ron Kisling

Yes, certainly. I think as we talked about in Q4, we kind of came in below the midpoint of our guidance. We always want to be kind of above the midpoint, between the midpoint and the high end. We saw some variability in international. In some of the markets where we have small presence, we see greater variability. And so, as we look forward to guidance and taking that into account, we assume that a very low level of traffic. We wouldn't see the peaks in that, with a very conservative view given that into our guidance.

I think there's a number of other opportunities in terms of how customers ramp. We've taken a very conservative view in terms of how quickly they ramp. And in terms of new customer acquisition, certainly taking into account what we saw in Q4, but if we continue to see that acceleration, those are all opportunities for -- to beat where we are in guidance. Certainly, our internal goals are to do much better than that and to come in well within the range that we shared at Investor Day, closer to 17% to 21%, and a lot closer to that 20%.

Sanjit Singh

As a part of that conversation, there has been, Todd, a number of executive changes, including Kip Compton as your new Chief Product Officer. You got Peter Alexander as your Chief Marketing Officer. You're adding more talent to the team, Brett Shirk, your prior Chief Revenue Officer has left. How are these executive changes impacting or not impacting your ability to execute?

Todd Nightingale

Yeah. It's been incredibly successful so far. The first big move that we made after I joined, actually, is to bring Puja Jaspal in as the Head of our People Team and HR. And I think that gave us the ability to build an employee experience that's been very successful. We've had great retention up and down the org and to do it in a more cost-effective way, and we're seeing the results of that. And she's also been instrumental in the senior staff transformation. And really, being able to ensure that we have the right leaders for each functional team across my senior staff and the next move being in marketing. Peter has been remarkable. Not only does he care deeply about the efficiency, but he's been able to really pivot the company towards customer acquisition.

Obviously, marketing is part of how we grow all of our existing accounts, but their impact on customer acquisition is first and foremost, and we're seeing the results here in Q4, and I think it's largely due to that real shift in the way we're spending money in marketing and the way that we're really targeting bringing people onto the platform. It also takes some trust, because we know that the power of Fastly's platform tends to grow and expand accounts very efficiently, and we're really leaning into that by focusing our go-to-market teams on customer acquisition.

With Kip, that's a real long-term move. Obviously, he's a very senior and tenured executive coming out of Cisco. And probably no one has greater long-term product vision in this space. He's even built out -- early in his career, built out one of the first CDNs in the media space, doing real media streaming, which is awesome. And part of laying down the foundation, delivering the kind of results Ron is talking about, not just in '24, but into '25 and '26 is about this massive shift towards being a true platform with multiple product lines, delivering value on equal footing in content delivery and security and compute and observability. And beyond that, in storage, in AI, in edge product lines yet to come, and Kip brings the maturity and the scale to be able to do that. We're so excited about that.

Sanjit Singh

That's -- I'm sorry, continue.

Todd Nightingale

I want to say, Brett left the company, obviously, now, it's very public, he went to CrowdStrike. Great job. I would have loved to keep Brett around, but that's an amazing opportunity for him. We're excited. I think it does give us an interesting opportunity to bring someone with Brett's skill set, that large enterprise sales leadership, but also someone who is comfortable in the scaling phase and this growth phase. And we're excited about that opportunity. We're deep in the process right now, bringing on a world-class CRO.

Sanjit Singh

Awesome. Let's take a step back and we've tackled some of the near-term tactical debates. But you've been now CEO for over a year. At your Analyst Day, you have this One Fastly platform [indiscernible], which seemed a lot more than just product. It seems pretty impacting all areas of the business, including sales and product engineering. What are the milestones and -- what are some of the milestones that have been achieved thus far? And what are you excited about going into 2024 in terms of executing that vision?

Todd Nightingale

Yeah. One Fastly, yes, that's great. I'm so glad to hear that question because it's probably the first thing that employees will talk about in terms of the focus of the company shifting. Platform unification being the first. The Signal Sciences acquisition a few years ago brought really key and core intellectual property and products into Fastly with the Next-Gen WAF. And that strategic move was so important because it laid the groundwork for Fastly to truly be a full service edge platform, content delivery, security, compute, storage, observability, all of these things.

And we're seeing that more and more customers are really focused on one strategic partner, one platform. In the market, we've seen point players like StackPath or Lumen falling out of the space because being just a player in just one of these spaces is really insufficient. The buyer, our customers are looking for a strategic partner, someone who can deliver an edge platform solution, just like the kind of convergence we saw in central cloud a decade ago. And that transition to One Fastly, where we are delivering all of these options on one unified platform, it's what drives the land-and-expand motion that our sales team is starting to run to really drive that one cohesive platform experience for customers, how the customer wants to buy, the kind of partner that they want and now it's really what we're delivering.

So, platform unification and ensuring that we're delivering one cohesive platform has just lowered the friction of customer acquisition, customer expansion and really the user experience.

The second one is making our teams more efficient. As we show up to customers, if we have a separate team bringing the security technology to customers and a different team bringing content delivery to customers, that's just deeply inefficient, and both in our customer support and customer success teams, we've unified those teams on our go-to-market side as well, and that has just been extremely effective. It's a better user experience for the customer, and it's a more efficient use of our resources, and we're seeing that across the board.

Sanjit Singh

Yeah, that's great. When I think about -- in terms of our framework, and thinking about some of the value drivers, there's multiple, but the ones I've been focused on, we talked about gross margins. And to me, security, if that starts to inflect and scale, I think, that makes growth and margins a lot easier for the company. So, talk to us where you are in the state of the security portfolio in terms of the check of items that customers expect from a provider like Fastly, and where you are in terms of delivering those capabilities?

And the second part of that question, Signal Sciences, I think it's been okay, but potentially could be better. When do you think that becomes a bigger driver of expansion within the customer base going forward?

Todd Nightingale

Yeah, it's a great question. Ron will tell us, we're very excited to start disclosing -- instead of legacy Signal Science revenue, start disclosing security revenue holistically for Fastly so that people are going to start to see our revenue split by product lines. And I think that will give investors a lot more insight into how the business is continuing to evolve.

Our security business, it's really been an awesome addition to Fastly, and it's been driving growth, like you said. We had a good '23, I think we can accelerate growth in '24 there, which I'm excited about. There's two pieces to it. One is this is a platform play. And we have still an enormous amount of opportunity to take content delivery customers and expand their footprint into security. And that's a very efficient expand motion, it's a very efficient cost of sales, it's a very efficient way of increasing revenue and increasing stickiness for the customer. So, we're super excited about that. And it comes from what you said, like completeness of the platform, making sure we're delivering everything customers expect.

On the security front, that tends to be DDoS prevention and mitigation, which Fastly has really always been best in class. Ever since the content delivery gains scaled, six or seven years ago, we've been running some of the most sophisticated DDoS prevention in the world. Next-Gen WAF, we feel like we have a significant technology lead here with the Signal Science intellectual property now -- especially now that, that's embedded into the Fastly edge around the world.

And the last one, being really table stakes right now is bot mitigation. And bot mitigation, even just a couple of years ago, was something that certain verticals really focused on, certain types of e-commerce, et cetera, but it's becoming much, much more pervasive. And we have been deficient in our bot mitigation offers until recently. We went -- we launched in limited availability right at the end of the year. We actually closed a couple of deals actually in Q4. We are going GA at the end of this quarter. And we're super excited about that offer. We've gotten phenomenal participation in the betas and limited availability, tons of positive customer sentiment around that.

And I think that really is the table stakes offering. We've been talking about that three-legged stool for a while. That being said, for a lot of customers, there's, I think, vision for so much more offering in this space and the opportunity for us to increase wallet share over the next three to five years, API security, and especially security and a performing API gateway is going to be important, antipiracy in the media space, increasingly important, different types of security enhancements around authentication, and the way that applications are delivered. There's a lot of opportunity to continue to grow here. And I think that's why the security space for us is so attractive. Not only do we have this opportunity with what we already have to expand the revenue with existing customers, but there's just a ton of roadmap ahead of us.

Sanjit Singh

And this -- I mean, obviously, there's a big player in this space that's proven you can build a $1 billion-plus business in the space. So, you have like a roadmap to follow. In security, it seems like we usually a pretty bad idea to go it alone, and partners and channel partners, and that's been key to building an ecosystem. So, talk to us a little about the partner channel strategy to drive more security sales. What's the state of the partner program? And what are you looking to evolve over the next couple of years when it comes to partners?

Todd Nightingale

We really took a swing at the beginning of '23 to double down on the partner engagement and partner investment. We saw really remarkable results in that. I think we tripled the deal registration from partners, bringing new logos to Fastly in '23 over '22. We have, I think, a little bit of a unique opportunity here. Our partner community before '22 has really brought into Fastly through Signal Sciences. And what we did is we took the opportunity to reset that expectation and really make the entire platform, the entire offering available to the partners, and we're starting to see some really interesting activity with partners who were traditionally security-only partners, starting to bring us compute business and content delivery business.

And we're also starting to attract partners beyond the security space, some of the more mainstream systems integrators, the WWTs and Presidio's of the world, which is awesome. And that, I think, gives us an opportunity to reach just enormous set of customers that we really haven't had access to in the past. So, the partner motion has been great.

It's also true that the packaging allows that partner community to operate more efficiently. And so, the packaging has kind of two benefits. It's better for end customers who want repeatable, simple onboarding, predictable billing. It is better for us because that predictable billing drives RPO. But it's also better and easier for the partners to transact.

Sanjit Singh

Just a follow-up on the packaging point. Is there a mix of new business that you guys are targeting in terms of getting more and more revenue from these bundles that give you that more predictable revenue outcome? Or how are you thinking about that being a purchasing vehicle for your customer?

Todd Nightingale

Yeah. When I think about it in terms of mix, I actually think about it less in terms of revenue and more in terms of customer acquisition. It's designed to make it easier for customers to onboard onto the platform. They get predictable billing. They can buy all the features they need for a particular product line in one shot. They don't have to worry about getting sort of nickeled and timed. They get the no overages value, et cetera.

When it comes to revenue, there's always going to be large, sophisticated deals. And at the last minute, they might decide to buy one way or the other, and I'll take it anyway. We try to be flexible, especially in large accounts. But when we think -- when we look at customer acquisition, I do think that we're going to see -- and we're going to continue to see this increase in new customers choosing packaging, because it drives just a simpler go-to-market motion, simpler purchasing decision for them. I wouldn't be surprised if that number trends towards 50%.

Sanjit Singh

Awesome. Let's talk a little bit about the delivery business and the dynamics that are going on the delivery business. As you sort of mentioned, you're having players sort of drop out. So maybe like a two-part question. Is that helping unlike the pricing side as the market consolidates? Typically, that's been a more price-sensitive set of a market. And then just more holistically, Todd, what do you see the role of the delivery business as part of the broader portfolio midterm to longer term?

Todd Nightingale

Yeah. I think pricing and pricing pressure, that pendulum swings, and you see the macro affects how tight budgets are and the -- how many players are in the space also, and a couple of competitors leaving the space who, to be honest, to compete primarily on price, I think that certainly helps. And for the next 18 months -- maybe 24 months, we'll see that help support pricing for sure. But when I think about the content delivery space, I think, again, we're seeing this -- we are seeing this transition. I think we're kind of at the beginning of it, but we're seeing a transition towards buyers looking for a platform.

Gartner started referring to this entire space as the edge computing space. And that's holistic of content delivery, edge security, edge compute, storage, observability, et cetera. I think we're going to see that middle of the market, the like profitable enterprise customer, low -- high six-figure, low seven-figure ARR customer. We're going to see them searching for strategic edge partners.

And content delivery is going to be one component of their buying decision, but we're not going to see content delivery purchases separate with a separate decision from edge security or with a separate decision from edge compute. And as we see that trend, we feel pretty good about that. It feels kind of like the market is coming to us. We've been active in edge compute for years. We've done -- had an enormous influx and intellectual property around edge security and our offering is really -- we feel incredibly good about that right now. We see the point players starting to fade away. This sort of platform convergence and content delivery being kind of the most important pillar of that. We feel pretty good about that transition. I feel like it's playing to our strengths.

Sanjit Singh

Yeah. Let's talk about the edge compute opportunity. You guys have been working on Compute@Edge for quite some time now for, obviously, as workers have been talking that for several years. What's going to be the signal? Or what do you think will be the catalyst to actually where developers are building consequential applications? They're rolling on to production and customers are starting to pay for it. Is GenAI the catalyst? Or is it more of this convergence around delivery and sort of minimizing latency at the edge? What's going to get the edge compute to sort of cross the chasm in terms of adoption?

Todd Nightingale

I think it's really focused on user experience, it's going to be the lead there. By moving workloads to the edge, you have the opportunity to deliver deep personalization with no compromising performance. And that is what really delivers a compelling user experience.

The folks that are pushing us hard on edge compute right now are the ones who are the most focused on user experience because it hits their bottom-line. E-commerce players who know that content -- that product recommendation and shopping cart calculation, et cetera, being extremely, extremely -- performance and feeling to the customer like instant, just yields a better financial outcome for them, better basket conversion, better ROI. Those are the people who are the first to move because they have a real deep understanding in the data of how valuable that user experience is. And I think that's just the early adopter.

We're going to start to see more and more people who are focused on user experience. Their app, their website is -- it's driving their business, and they need to deliver the best possible user experience. And by moving a handful of workloads to the edge, they can radically improve that user experience. I think that's going to be driven in part by AI, and we are deeply focused on that. But there's a ton of customers for whom it will be based on, just personalization and recommendation engines and real-time alerting and real-time event management, IoT management, et cetera, at the edge. Whatever that user experience value is delivering it from the edge, that's the, I think, the catalyst right now.

Sanjit Singh

When you think about the portfolio of opportunities that you have in front of you, a delivery business, a security business that has a lot of potential, and then the edge compute piece, from R&D focus, from a sales focus, like how are you thinking about edge compute in terms of allocating resources to that opportunity versus the multiple other opportunities you have in your mind?

Todd Nightingale

Interesting. We invest a ton into edge compute, maybe for two reasons. The first is, I believe the future life there. We are going to see outsized growth in edge compute, not for the next 18 months, but for the next six years. And so, we have a huge amount of investment there, and it is incredibly critical, I think, to the health of our platform and to maintaining sort of mind-share leadership in this space.

Edge compute, and being the most developer-friendly edge compute in particular, that's a big way that we differentiate. You can bring your own language, you can compile into our WASM architecture, et cetera, that differentiation being the most developer-friendly edge compute solution in the world. I believe that's enormously important for the future, the long-term future of the company.

It's also true that more and more of our own infrastructure is built on top of that compute infrastructure. So, I'm investing in it for two reasons: more of my content delivery, more of my security modules are built on top of our own compute. That keeps us honest, right? We are building that compute infrastructure to be useful to engineers, including our own, and that's key.

Sanjit Singh

All right. I'm going to give Todd a break, and maybe we can talk to Ron a little bit. So, at the Analyst Day, you guys unveiled like a three-year sort of target operating model, looking to hit $800 million to $900 million in revenue, gross margins to 65%, which could be very exciting, and operating margins of 7% in calendar '26. Given what you're seeing in the market today and heading into 2024, how achievable is that target operating model? And so, what are sort of the levers to get there?

Ron Kisling

I mean, I think we still see that as a very achievable goal for -- over the next three years. I think the -- some of the dynamics we saw fundamentally in 2023 give us some of that confidence, particularly around the margin accretion we saw in gross margin and operating margin. I think those trends are very strong and intact. The acceleration in new customer acquisition gives us confidence in the medium-term growth rates over that three-year period of seeing an acceleration over that period to achieve those goals. So I'd say we feel very good about those, given the fundamentals that we saw in '23 from those results that are important to achieve those.

Sanjit Singh

Great. I want to see if anyone had a question for the management team? If you just raise your hand, and I will get the mic to you. All right. No questions. So, let's -- Ron, on operating margin side of the house. So, 2024 guidance, I think it was on the other -- we talked about something that was missed, the margin expansion story continues a pace for Fastly. You're targeting 430 basis improvement in operating margins. Where do you expect to show the most leverage? And how you're going to give us those 400-plus basis points?

Ron Kisling

Yes. We embarked on a kind of a strong effort around financial rigor. It was everything, from establishing a purchasing function 1.5 years ago to drive just better negotiate, better tracking of our spending. We have made huge progress in eliminating duplicate SaaS systems. As we build our organization and scale our headcount, we look very much at what is an efficient organization, what is the management level that really allows us to grow, and that efficiency also lets us to be more efficient in terms of adding in resources to go-to-market and engineering.

And so, as we look forward, where we're going to see some of the benefits underlying in terms of our operations, we're going to continue to be more efficient. You're going to see most of that in the G&A function while we invest heavily in go to market, continue to add in engineering. But some of that efficiency does give us the opportunity to sort of redeploy savings, even in go-to-market and engineering toward adding direct salespeople or direct engineers to build the product. And so that motion, I think, is very much intact. We're going to see -- and our outlook for 2024, we're going to bring down our operating losses by more than half again, at the midpoint, 2%, 3%, coming off of 8% in 2023.

Sanjit Singh

Great. And Todd, maybe just to wrap up the conversation, I'd love to get a better sense of how you're thinking about the major cloud providers for the partners or as potential competitors? What's the interplay in that relationship? And how do you decide when you need to lean into partnerships versus becoming, let's say, more paranoid about competition?

Todd Nightingale

Yeah. We really see the hyperscaler central clouds as partners across the board. Our value proposition is based on delivering the fastest, safest, most engaging end user experience as a hybrid cloud architecture. All of our customers use the central clouds. They use Fastly to deliver that user experience. And it's that combination, that multi-cloud architecture that matters. We partner deeply with potential cloud providers. We're on their marketplace. We engage in the go-to-market as well as technology integrations.

I can barely count on one hand how many times I've ever been engaged in a direct competitive effort against the central cloud. I know some of our competition has pivoted their architecture towards more like a central cloud competitive posture. We certainly don't. There's just enormous value to offer as an edge cloud, and we have absolutely focused on that.

That being said, I think the space, the edge computing space, it's mimicking what the market -- the central cloud market went through a decade ago. We're seeing platform convergence, and we're seeing the fact that point solutions can't compete, but a holistic platform can, and we feel really well positioned for that. We're super excited about 2024.

Sanjit Singh

Awesome. We'll leave it there. Thank you so much, Todd and Ron, for joining us at the conference again, and updating us on Fastly's journey. Thank you so much.

Todd Nightingale

Thank you.

Ron Kisling

Thank you.