All right. I'm Sanjit Singh. I am 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 at the conference once again this year.
Thanks so much.
Thank you.
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. With that, let's kick off the conversation, Todd. You guys have been having a decent year. You've 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 in terms of the market reaction to the recent results?
Yeah, and I think you nailed it. Revenue result was a little lighter than we wanted it 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 a 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 teams worked so hard to realize was really significant. And bringing the gross margins all the way back to north of 59%, striking distance of 60, I think really gives us the ability to fuel growth in 2024 and beyond.
Seeing the operating margin improvement across the board, again, restructuring the whole company in order to really drive a result that allows us to use our cash, to use our spend to focus on growth again, and to get the company really refocused on customer acquisition and growth. We saw it on the cash flow side. We even posted a positive EPS, which is really great to see. So I think I worry a little bit that some of that got lost in the shuffle of a $1.5 million revenue miss. 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 focus platform unification, we saw the largest increase in enterprise customers that we've seen for years, in fact, I think since 2020.
The focus on customer acquisition is really what drives growth for the company in 2024 and 2025 and beyond. 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.
Yeah, that makes perfect 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 suggested 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 we're all waiting for?
Yeah. I think a couple of things. I think we ended the year, I think, within 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 attach, 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%-8% of revenue, which is kind of the go-forward alignment on CapEx.
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.
It means through software, we can gain efficiencies in that infrastructure. We've done that this year. We see that in the results. 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.
Awesome. Let's talk a little bit about some things to wrap up the conversation on sort of the near-term debates. 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 then if you could sort of map it to how you're thinking about some of the cohorts behaving in 2024.
Yeah, 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. And 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 assumed that a very low level of traffic, we wouldn't see the peaks in that, which is 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.
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 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%-21% and a lot closer to that 20%.
As a part of that conversation, there has been, Todd, a number of executive changes, including Kip Compton is your new Chief Product Officer. You got Peter Alexander who's 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?
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 in 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 this 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 it'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. We're seeing the results here in Q4. 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. 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. 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 was awesome. Part of laying down the foundation, delivering the kind of results Ron's talking about, not just in 2024 but in 2025 and 2026, 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. Kip brings the maturity and the scale to be able to do that. We're super excited about that.
Oh, sorry. Continue.
I was going to say, Brett left the company, obviously. Now it's very public. But 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 this 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.
Awesome. Let's take a step back. We've tackled some of the near-term tactical debates. You've been now CEO for over a year. At your analyst day, you had this One Fastly platform communication vision, which seems 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?
Yeah, on Fastly. It's great. I'm so glad to hear you ask 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 product into Fastly with the Next-Gen WAF. 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. 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. 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. It's how the customer wants to buy. It's the kind of partner that they want. Now it's really what we're delivering. 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 customers and a different team bringing content delivery to customers, that's just deeply inefficient. Both in our customer support and customer success teams, we've unified those teams on our go-to-market side as well. That has just been extremely effective. It's a better user experience for the customer. It's a more efficient use of our resources. We're seeing that across the board.
That's great. When I think about in terms of our framework, I'm thinking about some of the value drivers. And 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 checklist of items that customers expect from a provider like Fastly, where you are in terms of delivering those capabilities. And the second part of that question, Signal Sciences, I think it's been OK but potentially could be better. When do you think that becomes a bigger driver of expansion within the customer base going forward?
Yeah, it's a great question. Ron will tell you. We're very excited to start disclosing, instead of legacy Signal Sciences revenue, start disclosing security revenue holistically for Fastly so that people can start to see our revenue split by product lines. And I think that'll 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 2023. I think we can accelerate growth in 2024 there, which I'm excited about. There's two pieces to it. One is that 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 sale.
It's a very efficient way of increasing revenue and increasing stickiness for the customers. So we're super excited about that. And it comes from what you said, completeness of the platform and 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 gained scale. 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 Sciences intellectual property, 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.
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. We have been deficient in our bot mitigation offers until recently. We launched 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. 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. 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, a vision for so much more offering in this space and the opportunity for us to increase wallet share over the next 3-5 years. API security, and especially security in a performant API gateway, is going to be important. Anti-piracy 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.
Obviously, there's a big player in this space that's proven you can build a billion-dollar-plus business in this space. So you have a roadmap to follow. In security, it seems like 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?
We really took a swing at the beginning of 2023 to double down on the partner engagement, partner investment. We saw really remarkable results in that. I think we tripled the deal registration from partners bringing new logos to Fastly in 2023 over 2022. We have, I think, a little bit of a unique opportunity here. Our partner community before 2022 was 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've started 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 Presidios of the world, which is awesome.
That, I think, gives us an opportunity to reach just an enormous set of customers that we really haven't had access to in the past. So the partner motion's 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.
Just to 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 customers?
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 dimed. They get the no-overages value, et cetera. When it comes to revenue, there's always going to be large, sophisticated deals. At the last minute, they might decide to buy one way or the other. I'll take it any way they want. We try to be flexible, especially in large accounts.
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%.
Awesome. Let's talk a little bit about the delivery business and the dynamics that are going on in the delivery business. As you sort of mentioned, you're having players sort of drop out. So maybe a two-part question, is that helping on the pricing side as the market consolidates? Typically, that's been a more price-sensitive market. And then just more holistically, Todd, what do you see the role of the delivery business as part of the broader portfolio mid-term to longer term?
Yeah, I think pricing and pricing pressure, that pendulum swings. And you see the macro affects how tight budgets are and how many players are in the space also. And a couple of competitors leaving the space who, to be honest, who competed 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 profitable enterprise customer, low high six-figure, low seven-figure ARR customer, we're going to see them searching for strategic edge partners. 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. 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 had an enormous influx in intellectual property around edge security. 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. That feels like it's playing to our strengths.
Yeah, let's talk about the edge compute opportunity. You guys have been working on compute and edge for quite some time now. Cloudflare obviously has been talking to 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 and rolling out into production, customers are starting to pay for it? Is Gen AI the catalyst? Or is it more 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?
I think it's really focused on user experience is going to be the leap there. By moving workloads to the edge, you have the opportunity to deliver deep personalization with no compromise in performance. 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 product recommendation and shopping cart calculation, et cetera, being extremely, extremely performant 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. 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, that their app, their website is 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. Now, 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, I think, the catalyst right now.
When you think about the portfolio of opportunities that you have in front of you, a delivery business, a security business has a lot of potential. Then the edge compute piece, from our defocus, from a sales focus, 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?
That's interesting. We invest a ton into edge compute maybe for 2 reasons. The first is I believe the future lies there. We are going to see outsized growth in edge compute, not for the next 18 months, but for the next 6 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 mindshare 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.
I'm going to give Todd a break. Maybe we can talk to Ron a little bit. At the end of this day, you guys unveiled a three-year sort of target operating model, looking to hit $800-$900 million in revenue, gross margins to 65%, which will be very exciting, and operating margins of 7% in calendar year 2026. Given what you're seeing in the market today and heading into 2024, how achievable is that target operating model? What are sort of the levers to get there?
Yeah, I mean, I think we still see that as a very achievable goal over the next three years. I think some of the dynamics we saw fundamentally in 2023 give us some of that confidence, particularly around the margin increase 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 rate. So we're 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 2023 from those results that are important to achieve those.
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, and I think it was all the other talking about something that was missed, the margin expansion story continues to pace for Fastly. You're targeting 430 basis improvement in operating margins. Where do you expect to show the most leverage? And how are you going to give us those 400+ basis points?
Yeah, we embarked on kind of a strong effort around financial rigor. That was everything from establishing a purchasing function a year and a half ago to drive just better negotiation, 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 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 is 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 if we look at our outlook for 2024, we're going to bring down our operating losses by more than half again at the midpoint to 3% coming off of 8% in 2023.
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, both as partners and 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?
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. And they use Fastly to deliver that user experience. And it's that combination, that multi-cloud architecture that matters. We partner deeply with central 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 central cloud market went through a decade ago. We're seeing platform convergence. We're seeing the fact that point solutions can't compete, but a holistic platform can. We feel really well positioned for that. We're super excited about 2024.
Awesome. We'll leave it there. Thank you so much, Todd and Ron, for joining us at the conference again and updating us on the Fastly story. Thank you so much.
Thank you.
Thank you.