Surf's Up for Akamai

Named for the Hawaiian word for clever or intelligent, Akamai Technologies (Nasdaq: AKAM  ) is riding a righteous wave of investor enthusiasm. The stock, having traded below $2 per share at the beginning of 2003, closed yesterday above $10. That's more than a 400% gain. Righteous, indeed!

But investors have fallen for Akamai before only to be crushed. What's different this time? To answer that, we'll have to brave the breakers of Akamai's rise and fall. So, hold on. You're in for a ride.

The Big Kahuna
Akamai owns 80% of the content delivery network (CDN) market. The firm operates more than 14,000 servers, all bringing Web content geographically closer to customers, bypassing Internet bottlenecks along the way.

Akamai was born when Web creator Tim Berners-Lee challenged MIT colleague Tom Leighton to find a way to alleviate Net traffic congestion. Student Daniel Lewin pitched in and Leighton's group was a finalist in the 1998 MIT Entrepreneur's Competition. That finish attracted enough venture capital to launch Akamai.

Along with similar work by Digital Island, now a part of Cable & Wireless (NYSE: CWP  ) , the algorithms identified by the Akamai team helped pioneer the CDN and what's since become known as utility computing -- a means of allowing customers to buy processing power on a usage basis. CDNs, in a sense, deliver processing power like an old-economy utility.

An attractive solution
Back in 1999 and 2000, this CDN pitch was appealing. Without Akamai, for example, e-tailers preparing for holiday shoppers would have needed to build out their infrastructures to handle the worst-case traffic scenario -- akin to a Wal-Mart (NYSE: WMT  ) keeping every checkout counter open all hours of the day.

In fact, Akamai provided an economical alternative to building a data center. As a result, a great many dot-coms subscribed to Akamai's services, including Yahoo! (Nasdaq: YHOO  ) . Even The Motley Fool got into the act and has been serving its content through Akamai since June 1999.

Investors bought, too. Akamai shares rocketed 400% their first day of trading and then crested at $344.88 on December 31, 1999. That party spilled over into 2000 before things got ugly. Akamai closed the year at $21.06 a share.


Living with loss
Not long afterwards, Akamai's customers were hit by the recession. Between the first and second quarters 2001, the company lost more than 12% of its recurring contracts, the lifeblood of its business. Then came September 11 and Akamai lost something even more precious. Co-founder Danny Lewin was a passenger on the American Airlines jet that struck the World Trade Center.

Yet, in a strange twist of fate, the tragedy helped confirm the power of Akamai's business, even as it took one of its visionary leaders. News sites like MSNBC.com, powered by Akamai, kept the public informed despite heavy Web traffic volumes, providing a lifeline to those left without phone service.

Still, by November of 2001, Akamai would be forced to lay off 25% of its staff. Two months later, the firm reported full-year losses of $2.4 billion, more than triple the year before.

Faced with irrelevance, Akamai sought in 2002 to shed its dot-com-era image and sell to the Fortune 500 and other large firms looking to build a Web presence. The linchpin was EdgeSuite, a new technology which improved on the original FreeFlow service by adding the ability to deliver streaming media, accelerate downloads of digital files, and provide secure Web content.

Results came quickly. According to the company's 2002 annual report, Akamai added as customers The Bombay Company (NYSE: BBA  ) , FedEx Corporation (NYSE: FDX  ) , catalog retailer L.L. Bean, Staples (Nasdaq: SPLS  ) , and Viacom's (NYSE: VIA  ) MTV Networks. Akamai also struck a major partnership with IBM (NYSE: IBM  ) that it expanded this week.

Wade in deep and wait
So we've determined Akamai has recovered and is getting stronger. Now back to the original question: Is the current appetite for the firm's shares merited?

In a word, yes. Akamai is resilient. CEO George Conrades explained why in a June 2002 interview with The San Jose Mercury News: "We miss him (Lewin) and many of us work hard in his memory. We would be embarrassed if we let him down."

Looking at recent events and the numbers, there's reason to think Lewin would be proud:

  • Akamai has won and settled important lawsuits. Akamai has settled disputes with Cable & Wireless while retaining the right to seek damages won against C&W in a 2000 patent infringement claim. Less litigation means fewer dollars spent in fees, which means more moolah.

  • Akamai is closing in on positive operating margins and free cash flow. Operating losses have narrowed by $46 million since Q4 last year. Operating cash expenditures are down 50% from last year. Restructuring has reduced lease obligations and produced lower fees from service providers. A new round of convertible notes introduced this week should help lower interest payments.

  • New services could boost margins. Revenue per customer rose to $13,300 per month in Q3, a 21% year-over-year improvement. Logitech International (Nasdaq: LOGI  ) , Sony (NYSE: SNE  ) , Ericsson (Nasdaq: ERICY  ) , and Royal Caribbean Cruises (NYSE: RCL  ) have successfully deployed new Akamai products that deliver Web-enabled business applications on demand.

  • Akamai is (mostly) still under the radar. Institutions own only 33% of the stock vs. management's 20% stake.

There's really just one problem, but it's a biggie: Akamai's accounts receivable has been rising roughly 9.5% per quarter, more than double the 4.2% quarterly gains in revenue. There may be a good explaination. Akamai has been moving customers on to the higher-margin EdgeSuite platform. Of Akamai's 1,056 customers in Q3, 560 were using EdgeSuite, up from 269 in Q4 last year. The firm may be extending favorable terms now to encourage the transition and collect big later.

Where to from here?
Akamai can hang ten with the best.

On Monday, management bumped its fourth-quarter revenue guidance to $43 million to $45 million, up from $42 million to $44 million. That means total 2003 revenue should reach $160 million. If sales were to grow by 20% annually, Akamai would bring in $275 million, or $2.17 per share, by the end of 2006.

Valuing the company on a price/sales basis (PSR) is probably best since the firm isn't yet profitable. The industry average PSR for Internet Software and Services is 4.72. True, Akamai's current multiple is roughly twice that, but a PSR of, say, six times might appropriately reflect a firm that controls 80% of its market. (Industry giants Cisco (Nasdaq: CSCO  ) and Microsoft (Nasdaq: MSFT  ) both trade at more than eight times sales.)

Factoring in share dilution related to option grants at roughly 2% annually and assuming $2.17 in per-share revenues, a fully valued Akamai at a PSR of six times trades at $11 to $13 per share in three years, making $5 to $7 per share a nice entry point unless fundamentals fail to improve.

Now, if you'll excuse me, I've a board to wax. Later, dudes!

Tim Beyers doesn't own shares of Akamai or any of the other companies mentioned. He isn't a surfer dude and doesn't live anywhere near an ocean. But he TOTALLY digs Crush the sea turtle from Pixar's Finding Nemo. The Motley Fool has a disclosure policy. You can find Tim surfing the Fool.com discussion boards as tbeyers or reach him at tbeyers@earthlink.net.


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