No stock on our Motley Fool Rule Breakers scorecard makes investors more nervous than Akamai Technologies (Nasdaq: AKAM ) . Here's a sampling of the questions we received during a recent live chat with the team (subscription required):
"Has [Akamai] lost its lead and [is] doomed to compete strictly on price?"
"Do you still like Akamai??"
"Why is Akamai's stock price under attack these days?"
No investor likes a downtrend, and Akamai is in one -- down 15% over the past 12 months. Chief competitors Limelight Networks (Nasdaq: LLNW ) and Level 3 Communications (Nasdaq: LVLT ) have rallied substantially over the same period, soundly beating the S&P 500 in the process. Why am I staying faithful to a stock that hasn't delivered?
Traders won't like my answer, but in truth, that business performance matters more to me than short-term stock performance. Why? Because business gains lead to the largest stock gains, as Apple has proved time and again.
The cloud, distributed data, and the need for a distributed network
Skeptics will tell you that Akamai isn't Apple. You know what? They're right. Returns on capital have barely budged since 2008. Gross margin has declined over the same period. And while revenue grew 19% last year, normalized net profit has improved by less than 10% in each of the past two years. Growth isn't what it once was.
Competitive pressure is partly to blame. Upstarts EdgeCast and Cotendo both do business with AT&T (NYSE: T ) , and Cotendo is working with Google (Nasdaq: GOOG ) on an open-source form of application acceleration. It's a collaboration that strikes at the very heart of Akamai's suite of value-added content delivery services. The company has filed a patent infringement claim in response.
And yet Akamai is positioning itself for better days. Over the past year, the company has:
- Renegotiated and reupped long-term contracts with some of its largest clients.
- Bulked up its global server count by 36%, to more than 89,000 worldwide.
- Upped its global workforce by 21%, to 2,225 employees.
- Transitioned its business so that 58% of revenue now comes from delivering a value-added service, such as an e-commerce transaction.
Continuing this trend, cost of revenue grew more than twice as fast as revenue last quarter. CEO Paul Sagan explained during a call with analysts that he and his team would continue to make investments to capture the largest share of the market for accelerating everything that flows from the cloud to a device.
"We believe all of these trends -- cloud, mobile, commerce security and online video -- create growth opportunities for Akamai," Sagan said during last month's first quarter earnings call. The message? Get used to high capex and lower gross margins for a while.
Two metrics to watch in the second half of the year
Yet investors needn't sit idle. During the Q4 call, Chief Financial Officer J.D. Sherman predicted renewed growth in the second half of the year, as late-2010 contract renewals with Netflix (Nasdaq: NFLX ) and others take full effect. If he's right -- and I have no reason to believe he isn't -- Akamai's financials should begin to show improvement in two areas:
- Margin declines should stop. Even if we have to accept lower margins for a while, investors rightly expect margin declines to stop at some point. High-volume deals such as the one with Netflix should carry efficiency benefits. Meanwhile, value-added services should continue to produce premium margins as they have.
- Revenue growth should reaccelerate. Akamai grew revenue by 22.8% and 19.5%, respectively, in last year's third and fourth quarters. I'd like to see these growth rates go higher now that its toughest contract renewals have been inked.
Fair warning: This won't be an easy stock to hold
You might say that Akamai is starting over. When the company was born, it was built to capture the dominant share of the market for delivering static Web content, by caching that data and placing it geographically close to consumers. Today, Sagan and his team are upgrading and expanding that network to deliver dynamic content such as targeted advertisements and e-commerce transactions securely in real time.
That has several implications. Over the short term, Akamai will cut prices to win long-term contracts, spend to expand its server footprint, hire to go after big deals, and fund lawsuits to protect its intellectual property. In each case, the spending is aimed at tapping Akamai's biggest opportunity to date: the fundamental shift to delivering everything -- from video to business software to phone calls -- over the Web.
Akamai isn't the only one positioned to profit from this shift, of course. Take a minute to watch this free video right now, and you'll walk away with a richer understanding of the cloud model.
Want to read more about Akamai? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.