Fastly, Inc. Q3 FY2021 Earnings Call

Good evening. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Fastly Third Quarter 2021 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. Thank you. I would like to turn the conference over to Stefany Flegel, Investor Relations at Fastly. Please go ahead.

Hi everyone. Thank you for joining our third quarter 2021 earnings call. We have Fastly CEO, Joshua Bixby, and CFO, Ron Kisling with us today. Before we start, I want to remind everyone about the usual format of our call. We published a shareholder letter on our Investor Relations website with the SEC about an hour ago. Since the letter provides a lot of detail, we'll make some brief opening remarks and reserve the rest of the time for your questions. During this call, we will make forward-looking statements, including statements related to the expected performance of our business, future financial results, 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, please take a look at our filing with the SEC and our third quarter 2021 shareholder letter for a discussion of the factors that could cause our results to differ. Also know that the forward-looking statements on this call are based on information available to us as of today's date; we disclaim any obligation to update any forward-looking statements except as required by law. Also, during this call, we will discuss certain non-GAAP financial measures reconciliations. The most directly comparable GAAP financial measures are provided in the shareholder letter on our investor relations website. These non-GAAP measures are not intended to be a substitute for GAAP results. Finally, this call is being webcast and will be archived on our website shortly afterwards. With that, I'll turn the call over to Joshua.

Thanks, Stefany. Hi everyone. And thanks for joining us today. A particular welcome to Ron, who has been on board since August, and I can truly say he's hit the ground running. We are thrilled to have him on board. I hope you've all had a chance to read this quarter's shareholder letter. Before we jump into our results for the quarter, I want to take a step back and discuss where the business is today in the context of our long-term goals. With so many factors affecting Fastly in recent quarters, we thought it would be helpful to refresh everyone on the big picture. We have faced some unique tailwinds and challenges and navigated ever-changing market conditions over the past two years, so our trajectory has not been linear. Today though, we are extremely confident that our edge cloud network is going to be the future of how content is created, secured, and delivered on the internet. Our compute edge platform continues to provide mission-critical stability and support to the companies fueling our digital lives, including news, e-commerce, entertainment, and many more verticals for billions of users globally. We continue to investigate these opportunities and believe that successful execution will lead to a billion-dollar business by 2025. The $1 billion in revenue by 2025 will be one of our primary business goals as we head into our next phase of growth. With our new CRO, Brett Shirk, now fully on board, we are aggressively accelerating our customer acquisition through clarity of direction, accountability, and unrelenting focus. To drive success, we've defined three key priorities and outlined additional key goals. First, increase our edge computing platform usage by 50X from current levels by the end of 2022. Second, reduce friction for developer-led enterprise adoption and secure 100,000 enterprise developers on our platform by 2023. And third, 10X revenue for our security business by 2025. We believe that the market is shifting, as enterprise developers are increasingly playing a critical role, delivering always-on instant experiences with security and privacy embedded into all aspects of the user experience. During the quarter, we reached an important milestone for processing over a trillion requests on compute edge, but this is just a start, and we will continue to invest in new products and capabilities within our platform to win over developers. In order to remove barriers and accelerate adoption for enterprise developers, we introduced the start of a much broader incentive and brand program. We're offering customers that are willing to build on compute edge nearly a million dollars in credits. We also launched our fully functional trial version of compute edge. We know from our self-service experience that rapid developer success and self-reinforcing positive experiences are critical to driving enterprise-wide adoption. Customers and developers can now explore and experiment on compute edge. Alongside delivering compute, we want to accelerate the success of our security-led go-to-market motion. The strong pipeline of new products that we will introduce in the coming quarters will further fuel that strategy and lead to further growth from new and existing customers. Moving forward, we are focused on execution, bringing lasting growth to our business and delivering the value to our shareholders that we outlined from the very beginning. Now that you have context for our path forward, let me walk you through our third-quarter results. Following the average in Q2, and over the course of Q3, our top customers returned traffic and continued to ramp, showing significant stability and resiliency in the work for our infrastructure and engineering teams. Alongside this return, we successfully executed our go-to-market motion and had the largest organic quarter-over-quarter increase in single enterprise and total customers since our IPO. We saw great traction in edge computing and security over the quarter with broader customer adoption across all geographies and industries; their innovative use of our security edge computing platform is defining the future. I'd like to highlight three of our customers—EdgeMesh, an online e-commerce acceleration company, rewrote their e-commerce acceleration stack onto compute edge and saw a 5X performance improvement; a current Japanese consumer-to-consumer company leveraged compute edge to preprocess data from their iOS apps before sending it on to their central warehouse; and Flow, the leading visual development platform for websites, chose to double down on Fastly's security offering through the next phase of their growth. I would encourage you to read our shareholder letter where we outline additional exciting customer use cases. We know there is more work to be done, and we are confident in our ability to continue to execute against the plan we have laid out. Lastly, I am thrilled to welcome Vanessa Smith and Richard Daniel to our board of directors. They bring vast experience across security, healthcare, and digital transformation, which makes them extraordinarily qualified to help us accelerate our leadership in edge computing and security. I'd also like to thank Kelly Wright and Sunil Daliwal for their incredible work. With that, I'll turn it over to Ron to go over the financial results for the quarter.

Thank you, Josh, and good afternoon, everyone. It's great to be on board, and I look forward to continuing to build relationships with each of you on the call today. In the first couple of months, I've had the opportunity to observe, listen, and learn with this talented team. This has only reinforced my excitement for Fastly's potential. It is clear that digital transformation is here to stay. As I get into the numbers, I want to remind everyone that the contribution of Signal Sciences was consolidated into our third-quarter financial results, as well as our key metrics. In Q3, we generated $87 million of revenue, including $900,000 of deferred revenue tied to the acquisition of Signal Sciences, representing a 23% year-over-year top line growth in Q3. Our net revenue retention was 112%, up compared to 93% from the prior quarter. Our LTM remains strong at 114%, and our dollar-based net expansion rate was 118%. Our GAAP gross margin was 52.4% for the quarter compared to 58.5% in the same quarter a year ago. Our non-GAAP gross margin, which excludes stock-based compensation and intangible amortization expenses, was 57.5% for the quarter compared to 59.8% in the same quarter last year. This decline in non-GAAP gross margin primarily reflects the return to traditional seasonal usage patterns as opposed to the increased traffic we experienced in the prior year due to the onset of the COVID pandemic, which positively impacted gross margins in 2020. As we previously outlined, we have a tremendous opportunity to invest in our edge cloud network and plan to do so to position Fastly for future growth. Our operating expenses were down $3.8 million, largely due to increased capitalization of internal-use software. The amount of capitalization of internal-use software fluctuates on a quarter-to-quarter basis based on the stage of development of certain projects. Turning to the balance sheet, we ended the quarter with $1.1 billion in cash, restricted cash, and investments. We remain well capitalized to invest in the future growth of Fastly. Now, on the guidance for the fourth quarter, we expect revenue in the range of $90 million to $93 million, a non-GAAP operating loss in the range of $18 million to $15 million, and a non-GAAP net loss per share in the range of $0.19 to $0.16. For the full year 2021, we have raised the low end and the midpoint of guidance to align with our Q4 guidance outlook and expect revenue in the range of $347 million to $350 million. We expect non-GAAP operating loss in the range of $63 million to $60 million and a non-GAAP net loss per share in the range of $0.58 to $0.55. We will invest in our network given the large opportunity in front of us. We expect our gross margin to be relatively flat, to down slightly in the short to medium term, and capital expenditures as a percentage of revenue to be at the high end of our previously disclosed range of 12% to 14% for the full year. As Joshua described, we have seen some ups and downs over the past few quarters due to both challenges and some big successes, but as I stand here, the new person in the room, I am extremely confident in our ability to execute and believe we are well positioned to achieve the goals we have laid out for you today. With that, I'll turn the call back over to the operator to take your questions.

Our first question is from Will Power with Baird. Your line is open. Please go ahead.

Okay. Cool. Great. Thanks for taking the question. Good afternoon. Yeah, let me, I guess, try to sneak in a couple of questions here. Ron, I guess on the guidance commentary, would love to get some perspective on the drivers of the flat or slightly down gross margins in the higher capital expenditures. It sounds like that's probably success-based driven or driven by the growth opportunities, but I'd love to better understand the key drivers there. And then I have a second question.

Okay. So I think the declining gross margin that we saw primarily reflects the return to traditional seasonal usage patterns as compared to the increased traffic we experienced in the prior year due to the onset of the COVID pandemic, which favorably impacted gross margins in 2020. I think as we talked about previously, we see a great opportunity to invest in the edge cloud network this year, and we intend to do that to be well positioned for growth. We're continuously leveraging our investments in infrastructure capacity and customer mix to build a long tradition of gross margin accretion with products like our security unit. But we intend to invest in our infrastructure. We do expect some fluctuations going into Q4. One of the drivers is particularly as we expand internationally. A lot of that capacity and bandwidth needs to be brought online and in place ahead of traffic. So you do see a little bit of that buy-ahead affecting our gross margins as we do this investment.

Okay. And then maybe just to follow up on the success you're seeing in compute edge. I mean, I think you referenced the trillion requests—it seems like you're seeing, and you alluded to some of the early customer use cases. Is there any way to kind of frame revenue contribution or growth rate from that segment? Where do we stand today—quantitatively or qualitatively? I guess it would be the same question for security, just trying to better understand the growth rates and the magnitude of those key pieces of the business.

Yeah. So I think security is probably the first one to talk about because it's been a big contributor since the acquisition of Signal Sciences back in Q4 2020. In Q3, Signal Sciences contributed about 11% of our revenues, which is up from 8% in Q4 of last year, which was the first combined quarter. And I think, importantly, when we look at the growth rates we're seeing out of quarters, we are seeing a 12% growth rate. So we're seeing healthy growth that I think is important to customers, and there's cross-selling and upselling that is an opportunity to drive that and see it contributing a bigger piece of our revenues over time. I think on the compute edge, it's still nascent; it's early days, and it's not a material amount of revenue thus far. We believe it has a great opportunity as we attract developers and add more applications to the edge compute network.

Our next question is from James Fish with Piper Sandler. Your line is open.

Hey guys, thanks for the questions here. I guess maybe starting on the Signal Sciences side, how's the integration of Signal Sciences and Fastly going? Is the security edge now generally available, or what's left to integrate still to make it more broadly available? And I guess, why the confidence in going up 10X here reaching about $400 million in four years? Because really when you think about it, very few companies have actually been able to have that growth rate in security, and usually they're in the big endpoint or network markets compared to where you're at today. So trying to understand also how much of that is going to come from inorganic opportunities, as well as where these new products are being launched.

Sure. Hey, Jim, it's Josh here. Let me start on the integration side. So it's been three quarters, as Ron talked about earlier. We had really strong success. We have launched the first phase of having the security edge available at the edge, and that has gone well, and we're going to continue to invest there. We haven't fully completed that plan. We're looking at a target in the Q2 range to have that ready for broader availability. I think the important aspect when you actually look at Signal Sciences is one of the things that attracted us to the company was the variability of implementation options. This can be implemented on-premise; it can be implemented in the cloud; it can be implemented through a variety of ways. I think the success that we've seen in that revenue growth and what we have, as you can tell from our ambitious goals, speaks to the continued broad adoption. We think that that's one of the assets. We're not stalled here. We're seeing that growth. We definitely want to get something that's at the edge that is in general availability, but it also has to meet the requirements that we have, which has massive scale. We need to ensure that it fits in with the portfolio. So I tell you there's some work to do. We're making good progress. I think we all wish it would be faster, but we're seeing that progress. If we step back here a little bit, we see ourselves beginning at the start of this journey. We don't talk about 400 on enterprise customers. If you just go and look at our largest direct competitor, they have 8,000 to 10,000. But if you cast your eye over the legacy software and appliance vendors, you're talking about companies that have 20, 30, 40,000 enterprise customers. So when we look at the position that we're in today and we look at the trends, all of these security components, appliances, and legacy infrastructure are all disappearing. It's all coming to the edge cloud. We feel extremely confident; we are at the dawning of this new era where every appliance we believe, over the next few years, is going to be replaced. We believe that this idea of having this proliferation of many appliances, all with specialized workloads, is something our customers don't want. We are looking at billions of dollars in revenue that we feel is up for grabs. Although the 10X target is ambitious, we feel we're well situated for it; this is all coming to the cloud.

All right. And if I can sneak in another one there, talking about compute— you brought up an example with a company pre-processing the data via compute edge, but then it gets sent on to a central data warehouse. Do you guys feel like you need to do more on the storage side at the edge, like some of your competitors have done in the edge space or even kind of a centralized storage environment to really bring on the full developer suite?

Our perspective on storage hasn't changed, which is that our customers are looking for us to provide that high-value service of data manipulation and ensuring and adding value to that data. They want us to offload their origins from as much work as possible. We've got these amazing partnerships with the large clouds and other companies that are really good at storage, and we feel like those, we see an ecosystem of partnerships here. The answer is we will continue to invest in ensuring that we have the data that our customers need us to have, but we also acknowledge and recognize there's a place for the central clouds here. We have a different perspective in terms of looking at it as an ecosystem; it's how we looked at our entire business. If you think about all the partnerships that we have across logging, data, and the broader portfolio that we're doing in compute, we believe in an ecosystem; we do not believe in a walled garden. I think that approach, you will see also on data. We have a job to do, which is to make sure that we have the content that our customers want, and the origins are getting as few requests as possible. We are the best in the world at that, and we intend to stay the best in the world at that.

Our next question is from Phil Rigby with RBC Capital Markets. Your line is open.

Hey guys, thanks for taking the question. I want to start on this promotion you announced for the compute edge. First, I know we're in early days here, but can you give us a sense of what you're seeing in terms of adoption or interest, or maybe your expectations there? And then second, any ideas you can give us on how we should be thinking about this in terms of revenue impact over the next 12 months?

Sure. It's just Josh here. I think on the compute edge motion, our entire company's experience is based on the idea that developers, at the time of inspiration, can use our product, try our product, and they can have this sort of self-referential and self-reinforcing process. They don't have to go through an arduous enterprise sales cycle; they can just try it. That's been the case for our delivery product and the first generation of our compute product. It's now true for the second generation of our compute product. What we know is that that seeds the future of innovation. So I would tell you that the motion we announced recently around trying our product is a significant step for us. This is just the start; you are going to see more and more as we build out these ecosystems in terms of feeding that developer mindset and showing the path for how compute is going to change the world. I would tell you that motion has been something that we've been doing in our own little ecosystem. We believe the next year is a very important year in terms of getting enterprise traction by developer traction. You saw us set some ambitious goals, like getting to 100,000 enterprise developers by 2023. These enterprise developers are really crucial to our work. We're unleashing that capability, and it's something that our customers have been demanding. We're truly excited about it and will certainly report back to you and others on how we're progressing. I'll hand it off to Ron for revenue insights.

From a downside perspective, all of these are new things, and people will be trying these things that they wouldn't have necessarily launched into the network as quickly. Ultimately, as more experimentation happens and these things get built out, they will come into production. We believe this will add traffic and applications to the edge over the course of the year, and it will be good to add revenue as these things get deployed. From a cost perspective, I think the cost of actually supporting this will factor into the period.

We have no further questions at this time. Mr. Bixby, I'll turn the call back over to you.

Great. Thank you. Before we sign off, I want to thank our employees, our customers, our partners, and our investors. We remain as committed as ever to fueling and securing digital experiences. Moving forward, we will remain focused on execution, bringing lasting growth to our business and delivering the value to our shareholders that we outlined from the very beginning, as we continue to execute against our longstanding goal of being a billion-dollar business in 2025. We look forward to connecting with many of you and hope to see many of you at the upcoming Needham, RBC, and Raymond James conferences. Thank you.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.