Fastly, Inc. Q1 FY2022 Earnings Call

Good afternoon. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fastly First Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. I would now like to turn the conference over to Mr. Vern Essi, Investor Relations at Fastly. Please go ahead, sir.

Thank you, and welcome, everyone, to our first quarter 2022 earnings conference call. We have Fastly’s CEO, Joshua Bixby; and CFO, Ron Kisling, with us today. The webcast of this call can be accessed through our website, fastly.com, and will be archived for one year. Also, a replay will be available by dialing 800-770-2030 and referencing conference ID number 7543239, shortly after the conclusion of today’s call. A copy of today’s earnings press release, related financial tables and investor supplement, all of which are furnished in our 8-K filing today, can be found in the Investor Relations portion of Fastly’s website. 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. For further information regarding risk factors for our business, please refer to our most recent quarterly report, 10-Quarter, filed with the SEC and our first quarter 2022 earnings release and supplement for a discussion of the factors that could cause our results to differ. Please refer in particular to the sections entitled Risk Factors. We encourage you to read these documents. Also, note that the forward-looking statements on this call are based on information available to us as of today’s date. We undertake no obligation to update any forward-looking statements, except as required by law. Also, during this call, we will discuss certain non-GAAP financial measures. Unless otherwise noted, all numbers we discuss today other than revenue will be on an adjusted non-GAAP basis. Reconciliations to the most directly comparable GAAP financial measures are provided in the earnings release and supplement on our Investor Relations website. These non-GAAP measures are not intended to be a substitute for our GAAP results. Before we begin our prepared comments, please note that we will be hosting our Investor Day next week at New York Stock Exchange on Thursday, May 12th. We’ll also be attending three conferences in the second quarter. The virtual Craig-Hallum Institutional Investor Conference on June 1st, the Bank of America 2022 Global Technology Conference in San Francisco on June 7th, and the William Blair Growth Stock Conference in Chicago on June 8. We will be releasing further details regarding these events in the coming weeks. With that, I’ll turn the call over to Joshua.

Thank you, Vern. Hi, everyone, and thanks for joining us today. Before we jump into the quarter, I want to address another announcement we made this afternoon. As you may have seen, I will be stepping down from my role as CEO and from the Board after a successor is appointed. The Board has begun a search for my successor, and I will do whatever I can to ensure a smooth transition. I’m extremely proud of everything that we have accomplished, including enabling the best of the web, taking Fastly public, executing our acquisition of Signal Sciences, and positioning ourselves for long-term success. It has been an incredible journey, but I know that there is much more to come and much more to be achieved in the next phase of the business. As I reflect on this time and where we are in Fastly’s history as well as my own journey and desires and through my discussions with my fellow Board members about where we want to take Fastly in the future, it became clear that now is a natural time for me to step back and let someone else take the reins, someone that can lead the Company through the next phase of the business. Fastly has a large enterprise customer base, a world-class experienced leadership team, and a robust product roadmap. We are differentiated by a delivery business that is one of the fastest in the world, an award-winning security business, and an edge cloud platform with unrivaled flexibility and programmability. It sounds simple to say, but in reality, Fastly is where it is because of our differentiated approach. We have built a platform that is highly programmable, agile, secure, and fast, empowering our developers to innovate with ease and scalability. This, in turn, translates to performance, a critical indicator for our customers. As the Board searches for Fastly’s next leader, a process that, as I mentioned, has begun, we are committed to finding a candidate that can help build upon this solid foundation. As you may have seen from the press release we issued this afternoon, I will remain in my role until my successor has been brought in to ensure a smooth transition. Positioning Fastly for long-term success is my number one goal throughout this process. With that, I will move on to talk about the quarter, and then will invite Ron to provide some more color on this quarter’s results. Then, we will take some questions, which due to the limited time we have, we ask that you focus on the results and the outlook. In the first quarter of 2022, we reported record revenue of $102.3 million, representing a 5% quarter-over-quarter organic growth. Not only did this exceed the top end of our guidance range of $97 million to $100 million, but was also our first quarter revenue in excess of $100 million. I’d like to congratulate the Fastly team on this exciting milestone. Our customer retention and growth engine remains strong. Our LTM, NRR was 115%, and our DBNER was 118% in the first quarter. Our average enterprise customer spend was $722,000, representing a 3% quarter-over-quarter increase. Our total customer count in the first quarter was 2,880, of which, 457 were enterprise customers. We made good progress on our total customer count, adding 76 customers in Q1, up from 56 customers in Q4. One of the key initiatives we have undertaken in 2022 is the deployment of our new architecture for key metro regions. As previously discussed, this will greatly increase our storage capabilities by merging entire regions into one storage unit, thus cutting duplication. This does require the duplication of new sites with new architecture over the year. One of the areas where we can gain gross margin leverage is doubling down on our efforts on server efficiency with this new architecture. We have always prided ourselves on how closely we have tied hardware and software together, and we believe it is a key differentiator for us. Artur Bergman, our Founder and Chief Architect, will speak more to our plans at our Investor Day scheduled next week. It is important to note that the pandemic has altered the landscape for hardware procurement and the availability of the types of data centers we rely on. It is not uncommon to have lead times in excess of 80 weeks for key components, to have orders cut or canceled, and to have long wait times to get into the most connected data centers in the world. We made the decision to get ahead of these constraints by prebuying and deploying capacity in key markets. This has left us with some underutilized capacity in some markets. And as we have discussed previously, this has had a drag on gross margin. With no end in sight to constraints on the hardware and data center side, we feel it is prudent to take these steps, and we’re trying to minimize the short-term impact they’re having by redeploying assets where possible. The team at Fastly remains united in our common mission, which is to fuel the next modern digital experience by providing developers with a programmable, secure, and reliable edge cloud network that they adopt as their own. Central to this common mission is the key role developers play in our journey and the new and expanding power of distributed edge compute and security. As they use our trusted platform, they become more interested in its features, and that keeps them engaged and retained as customers as they scale. To reinforce this effort, we’ve acquired Fanout, announced in late Q1, a platform that creates a frictionless environment to build and scale real-time and streaming APIs. We will be integrating the Fanout technology into our Compute@Edge platform and launching a beta soon. Compute@Edge allows us to acquire technology and rapidly release it. Our delivery products, which are part of our network services portfolio, also received strong analyst validation. Fastly was recognized as a leader in the first quarter by IDC MarketScape for the worldwide content delivery network services. We earned recognition due to our network size and scale, our comprehensive product portfolio, excellent customer service, and our modern network offerings. Reinforcing these efforts in the first quarter, we announced our new Compute@Edge partner ecosystem designed to help customers build a variety of edge computing use cases. Partnerships include marquee integrations with the top three cloud providers. Margaret Arakawa, our Chief Marketing Officer, will be sharing more details at our Investor Day. We are accelerating Fastly’s product delivery. In the first quarter, we had 11 releases in total compared to 3 in the fourth quarter of 2021. We’ve launched our new global persistent Object Store for compute functions. With fast reads and writes from both the edge or via API, developers can store, control, and cash data to reduce origin dependency and unlock new use cases. Also, in the quarter, we deployed HTTP/3 and QUIC, which are now available to our customer base. QUIC, the technology behind HTTP/3, is a new latency-reducing, reliable, and secure internet transport protocol. It offers modern web performance with low latency, built-in encryption, and seamless developer platform integration. We also launched the Observability dashboard, which will bring delivery, security, and application metrics into one interactive window. The dashboard provides per second visibility and historical reporting on the performance and activity of our customer services and applications in a single customizable dashboard. Each of these releases also represents another touchpoint with our developer base and another opportunity for revenue growth. Lakshmi Sharma, our Chief Product and Strategy Officer, will be providing you more details on our product roadmap next week at our Investor Day. All of these new features would never reach our enterprise developers without our network services business fueled by our lightning-fast delivery network. Since the beginning of the year, our worldwide network remains consistently faster in the U.S. and Europe than our largest competitor in most countries and regions as measured by independent real user data. Our significant advantage in performance validates our unique architecture. Performance paired with security is one of the most critical decision-making metrics for our customers. That is why you will see us winning business with highly regulated customers, like a digital lending platform for Fortune 100 financial institutions. They need configurability at a per endpoint basis for highly regulated multi-tenant customers who demand speed while maintaining stringent security requirements. The size of our network matters as it opens up opportunities to us that are closed to others. In the first quarter, we signed a Fortune 1000 multinational mass media and entertainment conglomerate by working closely with our partners at Google Cloud. They ultimately chose Fastly for our token authentication while further improving their performance across Latin America. The first quarter also brought strong analyst validation for our security product portfolio. For the fourth consecutive year, Fastly was recognized as the only vendor named by Gartner Peer Insights Customer Choice for web application and API protection. Fastly’s Next-Gen WAF received an overall exceptional rating for web application firewall solutions among customers that have purchased, implemented, and used a WAF. Last quarter, we deployed the industry’s first and only unified WAF built on the Compute@Edge platform. This quarter, we are thrilled to continue our momentum in security. We announced support for arm-based environments at scale. We are the first and only WAF that enables customers to quickly secure their apps and APIs using any combination of ARM and other processors. This is a major step forward in securing multi-cloud environments. We have also introduced GraphQL inspection. With API attacks becoming the most frequent attack vectors, we wanted to provide a customized and out-of-the-box GraphQL inspection that will detect, inspect and block attacks that can target GraphQL APIs. Developers can now customize this tool or choose a simple out-of-the-box option with no additional configuration on their part. Our security business continues to shine. A publicly traded identity and access management application with a global presence adopted our next-generation WAF for its ability to offer isolated environments. They wanted to provide customized security for both their platform and their customers. The team is excited about the opportunity that lies ahead of us in 2022. We look forward to sharing with you further updates on our success at our Investor Day. To discuss the financial details of the quarter and guidance, I will now turn the call over to Ron.

Thank you, Joshua, and thanks to everyone for joining us. Today, I’ll discuss our financial results and business metrics and then review our forward guidance. Note that unless otherwise stated, all financial results in my discussion are non-GAAP based. Total revenue for the first quarter increased 21% year-over-year to $102.4 million, exceeding the top end of our guidance of $97 million to $100 million. In the first quarter, revenue from Signal Sciences products was 12% of revenue, a 59% year-over-year increase or a 39% increase after purchase price adjustments related to deferred revenue are reflected. Our dollar-based net expansion rate or DBNER was 118%, down slightly from 121% in Q4 ‘21, and our trailing 12-month net retention rate was 115%, down slightly from 118% in the prior quarter. The majority of this decline was driven by last year’s outage related to the impact from a single customer, which we have previously discussed. As you can see, from a very low churn of less than 1%, our customer retention dynamics remain strong. As of March 31, 2022, we had 2,880 customers, of which 457 were classified as enterprise, those customers with an excess of $100,000 of revenue over the previous 12 months. Our total customer count grew 17% over the year-ago quarter. And in the first quarter, we added 76 net new customers and 12 net new enterprise customers compared to 56 and 15 new customers, respectively, in the prior quarter. Accelerating our customer acquisition is one of our key goals as the sales team continues to ramp and we increase our marketing activities around lead generation and brand awareness. Brett Shirk, our Chief Revenue Officer; and Margaret Arakawa, our Chief Marketing Officer, will share more of our plans at our Investor Day. Enterprise customers accounted for 89% of total revenue on a trailing 12-month basis, in line with their contribution in Q4 and increased their average spend to $722,000 from $704,000 in the previous quarter, representing sequential growth of 3%. This also demonstrated our strong customer retention. Our top 10 customers comprised 33% of our total revenues in the first quarter of 2022, in line with the contribution in Q4 2021. Turning now to gross margin. Our gross margin was 52.6% in the first quarter compared to 55.8% in the fourth quarter of 2021. As we discussed on our Q4 earnings call, we anticipated our gross margin would decline a couple of hundred basis points for the full year 2022 due to the rollout of our next-generation architecture, the continued investment in our network to support growth, and accelerated investments to proactively address supply chain constraints. We will continue to incur costs on the existing sites until the transition is complete. In the first quarter, we transitioned several sites and will transition more sites in the second quarter. We expect the older duplicate sites to be fully decommissioned by the end of the year. As Joshua described, we derisked our network expansion plans by accelerating the purchase and deployment of equipment. Given the volatile dynamics occurring in the semiconductor industry and the supply chain at large, we believe this was a prudent decision. We continue to invest in infrastructure and capacity and expand into new markets to support growth and new customers. In some locations, this has resulted in underutilized capacity. In the quarter, we did not see any acceleration in price compression, and we continue to expect the mix of our product offering in security and compute to be a strong gross margin tailwind in 2023 and beyond. We are very focused on gross margins and the opportunities to drive leverage in our network. We look forward to providing more details on these dynamics and the changes we are making to improve the efficiency of our network investments during our Investor Day. Lastly, looking at full year 2022, we still expect gross margins to be down a couple of hundred basis points with Q2 gross margins relatively flat with those in the first quarter and to improve by year-end. Our operating loss and net loss per basic and diluted share for the first quarter of 2022 were in line with our guidance. Operating expenses were $71.6 million in the first quarter, up 12% over Q1 ‘21 due to increased headcount across the organization. While attracting talent has been difficult, we are pleased with our success in attracting high-quality talent. With new leadership in place, we expect expense growth in 2022 will be higher in the first half and growth in operating expenses will be lower in the second half of the year. Our operating loss for the quarter was $17.7 million, and our net loss was $18 million or a $0.15 loss per basic and diluted share compared to $11.7 million and a $0.10 loss per basic and diluted share in Q4 2021. Turning to the balance sheet. We ended the quarter with $1 billion in cash, cash equivalents, marketable securities, and investments, including those classified as long term. Our cash capital expenditures were 6% of revenue in the first quarter. Our capital expenditures include capitalized software. This, along with our foundational technology, drives efficiency and leverage in our network, which is a competitive differentiator. Despite our transition to our next-generation network architecture and acceleration of some investments due to supply chain constraints, we expect our capital expenditures in 2022 to remain at 12% to 14% of revenue. I will now turn to discuss our outlook for the second quarter and the full year 2022. I’d like to remind everyone again that the following statements are based on current expectations as of today and include forward-looking statements. Actual results may differ materially. We undertake no obligation to update these forward-looking statements in the future, except as required by law. Our second quarter and full year 2022 outlook reflects our continued ability to deliver strong top line growth via improved customer acquisition and expansion within our enterprise customers, driven in part by new and enhanced products. Our revenue guidance is based on the visibility that we have today. And given our usage-based business model, we expect to gain additional visibility to our annual guidance as the year progresses. Historically, our first and second quarter revenues are generally flat with revenues increasing in the second half of the year. As a result, for the second quarter, we expect revenue in the range of $99 million to $102 million, representing 18% annual growth at the midpoint. We expect a non-GAAP operating loss of $21.5 million to $18.5 million and the non-GAAP loss per share of $0.18 to $0.15 per share. For the full year 2022, we are increasing our prior guidance by $5 million to a range of $405 million to $415 million. We expect a non-GAAP operating loss of $70 million to $60 million and a non-GAAP net loss of $0.60 to $0.50 per share, unchanged from our prior guidance. Before we open the line for questions, we would like to thank you for your interest and your support in Fastly and look forward to seeing you at our Investor Day.

We will take our first question from Frank Louthan at Raymond James.

Great. Thank you. Maybe just walk us through a couple of the puts and takes in the gross margins and how we should expect that to progress to only be down a couple of hundred basis points for the year? And then, secondly, you had a competitor state recently that the rate of growth and traffic growth has slowed that they’re seeing. Are you seeing anything like that? What are sort of the traffic trends that you’re seeing? Thanks.

Hey Frank, it’s Joshua here. Let me take the traffic question. I’ll hand it over to Ron for the gross margin side. I think, like we are seeing across the prints that are happening on the street, we are definitely seeing a change in growth rates. For some industries, it’s going up, for some, it’s going down. And I think that thankfully for us, we’re exposed to both sides of it. In general, the industries that we’re hearing our competitors talk about slowing down are industries we don’t have a lot of exposure to. So on the streaming side, as you know, we’ve talked about this many times, we don’t take the commodity stream business, in the areas of streaming that we do work in, those are the high growth areas, the high-value areas, and we don’t have a lot of exposure. You’re rarely going to see us as sort of the number one or number two provider. There are some exceptions. But in general, we have a tremendous amount of room to grow in that because we’ve been picky, we’ve been selective about who we work with, and we don’t work across the board. So in general, I wouldn’t see Fastly as a good proxy for some of the overall trends in the industry because of how selective we’ve been in some of those industries. But unquestionably, in industries, for example, like travel, we’re absolutely seeing an uptick. So, I would say we are seeing both sides of the coin, but we have much less exposure, I think, to the generally commoditized side of the business, which is what a lot of the other vendors are speaking to. Ron, why don’t you take the gross margin question?

Yes. So, I think, let me start with kind of how we see the year, and then I’ll talk about the dynamics driving it. So, I think as we said, we expect for the full year still to be down a couple of hundred basis points. That plays out over the course of the year with Q2 being relatively flat with those in the first quarter. And then, we see improvement in gross margins in the second half toward the end of the year. The biggest driver to the change in dynamics really is that rollout of the next-generation architecture. As we talked about in the past, as part of this rollout, we continue to incur costs on the existing sites. So, in the first quarter, we transitioned several sites. We’ll transition a few more in the second quarter. And then, as you get into the second half, we expect the older duplicate sites to be fully decommissioned by the end of the year. So, that’s going to drive some reduction in our cost of revenues in that second half. The other driver, if you just look at historically kind of how our revenue plays out, we typically see an acceleration in revenue in the second half that drives an increase in utilization. And so, we typically see an increase in network utilization, and that also drives an improvement in gross margin. So, those are the two biggest drivers. I think the other drivers that we’ve seen is we haven’t seen, as Joshua said, any acceleration in price compression. Our mix product didn’t really change materially from quarter-to-quarter.

Next, we’ll take a question from Sanjit Singh, Morgan Stanley.

I wanted to revisit the gross margin topic once more if I could. I guess, in some sense, I’m trying to understand maybe just the magnitude of the sequential decline in the sense that if I look at sort of the second growth on the network of capacity, that seems like that’s slowing or starting to improve on the network capacity side? On the expansion rate side, in the in-quarter net revenue retention improved decently versus the prior quarter, your sequential revenue growth improved versus last year, your year-over-year growth improved versus last quarter. So it would seem to me that like there’ll be more sort of utilization or more absorption of some of the sort of stale capacity. So, I’m just trying to understand, like the magnitude on the gross margins of this quarter versus prior?

Sure, let me handle the first part and then I'll pass it to Ron. Generally, the growth in our customer base and network expansion is positive, and we're also expanding the network. Ron will elaborate on these aspects further. As I mentioned earlier, we believe we're in a fortunate position regarding our access, which we anticipate will be very beneficial in the latter half of the year. However, we're seeing two areas of growth, with one outpacing the other. If there were changes in the pricing environment or mix, that would present a different scenario. But that's the main driver. Ron, could you provide more details on that?

Yes. The only thing I would expand on that thing, Joshua, is in addition to what we saw around the new architecture is we did accelerate some of the purchase and some deployment of equipment, given kind of the volatile dynamics we saw in the supply chain at large. And so some of that deployment that we did actually increased capacity ahead of the demand. And so, we did see in some locations, some underutilized capacity as a result of accelerating some of the deployment in response to the supply chain. So, that’s probably the additional factor on top of the other drivers that we spoke about earlier.

Next, we’ll take a question from James Fish, Piper Sandler.

I wanted to inquire about the non-top 10 enterprise customers, really good strength with top 10, but it looks like the non-top 10 only grew like 3% year-on-year. And I get it was a tough compare, but what’s going on with that lower end kind of customer base that aren’t growing as fast? And underneath your guideline, Ron, it looks like it implies a relatively flat net retention rate compared to what we saw in Q1, despite easier compares coming, just being conservative and prudent, given some of the macro stuff going on or how should we think about net retention for the rest of the year?

Sure. Ron, why don’t you take the top 10 and the guide question?

We experienced a customer count increase of about 3.4% to 3%. This is a rise from the previous quarter, although that growth was modest. Our priority is to accelerate customer acquisition across both enterprise and smaller businesses. We are taking several actions to boost market activities, lead generation, and brand awareness. At our Investor Day, Brett Shirk, our Chief Revenue Officer, and Margaret will outline specific strategies aimed at enhancing customer acquisition as we enter the second half of the year. Regarding guidance, the metrics like LTM NRR and DBNER reflect a 12-month period and still show some influence from the outage we encountered in June 2021. We will likely continue to feel the effects of reduced traffic until the impact of that outage fades from these metrics. Most of our customers returned within a week or two, but one significant client took a couple of quarters to recover to pre-outage levels. Although we have seen positive growth in that area, it will still act as a minor drag on the LTM metrics until the outage effects are eliminated from the figures.

Up next is Will Power from Baird.

This is Charlie Erlikh on for Will. Just first, I wanted to ask about the Fanout acquisition and maybe just get a little bit more detail on what that gives you and the path forward on that?

This is an exciting development for us. Our customers have been requesting this for a long time. It requires significant effort from them to unlock real-time app development and everything that entails. For instance, consider live chat support or gaming, which our customers frequently handle on their own. With this acquisition, we are well-positioned to assist these use cases, allowing them to move away from complicated existing in-house web socket stacks without needing to build it themselves. This has been a top priority for a long time, and when we observed Fanout's accomplishments and market perception, it became a clear and exciting acquisition for us.

Great. And if I could just squeeze one more in. How are you guys thinking about profitability timing in the future, balancing a lot of growth initiatives you want to invest in, but also keeping an eye on profitability, of course? So, how should we think about just the timing around that?

Sure. I mean, we’re certainly going to talk more about that at our Investor Day, but Ron, I don’t know what you want to share before that. Ron, you there?

Sorry about that. Yes. I think we’re certainly starting to spend more time about it. And I think there is an opportunity to drive growth. We’ve talked about growth and increased investment business to grow both security and managed computing platform, those are accretive to gross margin. And we believe that drives long-term margin as we see that growth play out and the accretion we see in gross margins. In terms of the long-term model and getting to profitability, we plan to share kind of our view on what that long-term model looks like at our Investor Day.

Yes. Charlie, what I can tell you is it’s a high priority for us. We believe that there’s a tremendous amount of leverage as we talked about just briefly on the gross margin side in the call and in the script, and we believe that across the business. So it’s a priority, and it’s something that you’ll hear a lot more from us about at Investor Day.

Our next question is from Philip Rigby, RBC Capital Markets.

Just one for me, following up on the idea of traffic, traffic growth in streaming. Can you just remind us sort of what those higher-quality streaming businesses you’re in that you have a higher mix to? Like, is that all just more of capacity and increases, is there potential to sort of go into the lower, call it, more commoditized business to kind of maintain utilization? You talked before about how important video is to kind of max out utilization and lower times. Any color there would be really helpful?

Thanks, Phil. That's a great question. I believe the importance of video is often misunderstood in terms of our long-term success. As for the second part of your question, we have no plans to enter the commoditized side of this market meaningfully. Our focus is on building a profitable business, which is incredibly challenging, if not impossible, at the lower end of this market. That segment does not appeal to us. Our emphasis has always been on quality and the ability to monetize content. Traditionally, this began with live events. When significant events like a live sports game or major broadcasts occur, the advertising revenue is substantial, and quality is critical. Over the past three years, we’ve seen that video on demand has similar traits. For instance, when a major show like Game of Thrones is released, quality issues generate a significant consumer response, just as they do during live events. Major shows from platforms like Netflix or Disney are key drivers for new subscriptions, and we've noticed that. The dynamics are shifting toward those who prioritize quality and can monetize effectively, and we don’t plan to shift focus toward those who do not. Our involvement with high-quality challenges is still limited, indicating considerable growth potential in that valuable segment. The importance of video is immense. Our aim has always been efficiency, utilizing all aspects of our network and servers, which helps us manage bandwidth when delivering content. Looking forward, who controls the majority of content will be significant, as those will be the providers engaged in crucial markets like satellite and cruise ship entertainment. We regard this as a critical strategic aspect, and at present, we have no intentions of entering the commodities portion of this business.

Our next question is from Rudy Kessinger at D.A. Davidson. It’s going to matter who has the majority of the content because those will be the suppliers invited into satellites and cruise ships. They will be the suppliers present at key points where content is consumed. We view this as essential and strategic to our narrative, but we currently have no plans to enter this part of the business, especially the commodities aspect.

This is Nima on for Rudy. I just had a question on an update. You guys said last quarter that you had 40 sign-ups for the three credit program on Compute@Edge. I was just wondering where you guys are at on this quarter and how many you guys have converted to paying customers at this point?

Hey Nima, it’s Joshua here. One of the things that we’re going to be sharing is a comprehensive view of this at Investor Day. I can tell you that we’ve had growth, we’ve had conversion, but we’re going to share that in sort of when we have a little bit more time to walk through those, the nuances of that. I have been very happy with those programs, including how many enterprise developers around the platform. So, a little wait and see on that because I’d like to give you all the context all at the same time. But we’ve seen progress, and it’s Compute@Edge remains, I think, the most exciting, if not one of the most exciting opportunities that we have here for really significant growth.

And now, we’ll hear from Fatima Boolani, Citi.

Josh, it was nice working with you and good luck on your next ventures. The question is just around your security momentum. I know you sort of spoke to it at a high level, but I’m curious about how that business is trending. If you can sort of quantify for us some of the year-over-year and quarter-on-quarter momentum within that specific side of the house in your portfolio? And then, as an extension, Josh, you had talked about security and compute being pricing accretive, right? You have a lot more pricing power. These are very important challenges you’re helping solve customers. So, I was curious if you can help reconcile that with the average enterprise customer spend only up 3%. So, hoping you can sort of bridge some of that gap from vis-à-vis the pricing power on the security side and maybe a lighter wallet share growth on some of your larger enterprise customers?

Sure. Let me address a couple of those and I'll pass a few on to Ron. Generally speaking, we've talked about the contribution of the legacy SigSci product line, but we haven't yet compiled and published the details of our entire security portfolio, which goes far beyond that. Before we acquired Signal Science, we already offered a WAF, had a DDoS business, a TLS business, and were developing a bot business. Ron will discuss the SigSci business, which he already touched on, but that's just part of the picture. Overall, I've provided some insight into the entire portfolio, which continues to experience significant growth. As we've mentioned before, we also maintain a strong margin profile for this business as well as the compute business. So, Ron, could you share some statistics on this? And regarding the wallet share and growth question, could you also address that?

In the fourth quarter, revenue from Signal Sciences was 11.9%, an increase from 10.9%, reflecting approximately a 15% growth rate. On a year-over-year basis, Signal Sciences revenues increased about 59% when considering purchase price adjustments, and around 38% growth year-over-year overall. We are seeing strong growth in this area. As mentioned, Signal Sciences is just a part of our security business and does not include other Fastly products like DDoS TLS. Over time, as we introduce more security products, we expect to see further growth in our overall security portfolio. This aligns with our long-term goal of achieving significant growth in security. Security is a critical aspect of our delivery discussions, and we see opportunities for expansion. Regarding margins, the gross margins for our security business are significantly higher than for delivery since security products require less bandwidth and are primarily sold on a SaaS basis, making them less volatile compared to traffic or volume-based sales. This highlights the distinction between our security offerings and our delivery products.

Fair enough. If I may ask you a follow-up on the delivery side of the house. I think you sort of characterized the quality of the traffic on the network has not been commodity, right? So I’m hoping if you can take a step back, if you can help us appreciate the composition of the estate in terms of your traffic and traffic volumes on the network, whether that’s across very premium high-end video, streaming VOD, gaming, software downloads, social media, anything to help us sort of think about that pie of traffic on your platform to give us a maybe more crisper understanding of why it isn’t necessarily the commoditized trends that some of your peers maybe are seeing?

Sure. We have previously discussed maintaining a balance between video and non-video content, and this balance has remained fairly consistent. As Ron mentioned, there has not been any significant change from one quarter to the next. The mix has stayed relatively stable over the past 18 to 24 months, and one of our primary goals is to keep it that way. We believe this stability is crucial, and we aim to avoid moving towards commoditized aspects of our business. Overall, we are seeing growth, which is important for our profitability and margin because each segment has varying impacts on our operations. It’s challenging to isolate pricing specifics because, for instance, having a valuable streaming partner may provide us with access to audiences that we would otherwise have to pay to reach. This aspect is quite valuable to our business and is something we continually evaluate. In summary, there hasn’t been a significant change in the past quarter or over the last couple of years.

Next up, we’ll have a question from Tom Blakey at KeyBanc Capital Markets.

I have a couple of questions, starting with Ron, about the gross margin. It appears that we can clearly identify duplicate costs. Can you explain what the impact on gross margin would be as we move into 2023 with those costs reduced? Additionally, regarding utilization, it's difficult to gauge demand accurately, but for every 10-point increase in utilization, what kind of expansion in gross margin should we expect? Lastly, in the long term, how will this new improved network compare? Will it align more with your peers who have significantly higher gross margins, or should we anticipate a different outcome?

As we look ahead to 2023, we anticipate that the challenges associated with the transition to the new architecture will diminish, allowing us to focus on achieving higher utilization across our network. We are implementing several internal initiatives related to traffic forecasting and investment processes to ensure closer alignment between our investments and traffic projections. We will provide more details on this during Investor Day, which should also enhance utilization and lead to increased gross margins. Although we haven't specified the projected gross margin for 2023, we do expect further improvement due to efficiencies in our cost of revenue, the completion of the architecture transition facilitating better utilization, and the growth of our security products, which are becoming a larger part of our offerings and contributing to overall performance. We have multiple favorable factors heading into 2023 that should enhance gross margin beyond what we've experienced this year, and we anticipate this will be evident as we reach the end of the year, although we haven't provided specific figures yet.

That's fair. Let me try one more time. It sounds like if I'm hearing you correctly, Ron, that as we move into 2023, 2024, and 2025, there will be more focus on utilization in relation to the expansion of the gross margin, aiming to return to those rates above 60 percent, rather than dealing with any significant identifiable duplicative cost burdens.

Yes. I think the way I would look at that is, I think we did have a headwind in ‘22 from this transition, and that sort of falls away. And then, as you get into ‘23, ‘24, ‘25, it’s really going to be driven by utilization and efficiency on the network because we build more efficiency, leveraging the new architectures and driving efficiency there and product mix. So, sort of the fundamentals of the business that will be driving ongoing accretion in gross margin.

Great. That’s helpful, and we’ll see going into ‘23 what that looks like. My second question is around security, obviously, and related kind of longer-term strategic vision on adding functionality that’s less bandwidth intensive and more kind of a SaaS like on your platform. Just given - the question here is about, we’ll see about the profitability going forward. So kind of all-in-one question about capital structure and cash usage and what the long-term strategic vision of Fastly is in terms of long-term growth on the non-delivery-related businesses, would that be more organic or inorganic in your kind of intermediate term vision for the Company?

Yes, thanks, Tom. We've mentioned this before; we believe our growth trajectory is primarily organic at this time. We expect security to keep expanding, and we have barely started to tap into that market given our current scale. There are a few areas in our portfolio where we're enhancing our offerings, especially related to bots, but we don’t see large-scale inorganic growth as the way to achieve our long-term objectives. Currently, our teams are diligently working on improving the bot portfolio, and the rest of our offerings are robust and world-class. We compete effectively against others in the market, as evidenced by our growth and positive trajectory. We are very confident in our portfolio and our team. While there may be minor issues, they relate more to talent than to revenue. Thank you. Yes, it’s been a great success.

That does conclude today’s conference. Thank you all for your participation. You may now disconnect.