2 Challenges Akamai Must Address

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.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Akamai, Apple, and Google at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services have recommended buying shares of Google, Akamai Technologies, Netflix, Apple, and AT&T. Motley Fool newsletter services have recommended buying puts in Netflix and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 25, 2011, at 3:51 PM, Canephan69 wrote:

    I couldn't agree with you more, Tim. As a fairly large Akamai customer, I have watched upstarts come and go, but Akamai always seems to stay the course. The recent decline bothered me more than some of the others, mostly because there was no good fundamental reason for it. So I am taking your advice and ignoring the short-term swings. This is a long-term retirement investment for me, and they still have my confidence.

  • Report this Comment On May 25, 2011, at 5:29 PM, bottomfisherman wrote:

    Hmmm Akamai losing market share now where have I heard someone saying that on this site I wonder?

  • Report this Comment On May 25, 2011, at 5:37 PM, TMFMileHigh wrote:

    @bottomfisherman,

    Hmmmm. Not sure. Must be someone who isn't obsessed with the short-term stock drop? (Do correct me if you've cited numbers that show declining market share -- I've only seen you talking up the YTD price drop.)

    Foolish best,

    Tim (TMFMileHigh)

  • Report this Comment On May 25, 2011, at 5:39 PM, carlkiefer wrote:

    Tom, it is true that Level 3 Communications has rallied significantly vs. Akamai during the past year with Limelight Networks currently in decline mode as well, following Akamai's earlier trend which began after the Netflix news whereby Level (3) became a primary carrier for their bits.

    http://finance.yahoo.com/q/bc?t=1y&s=LVLT&l=on&z...

    This issue has been being debated for five years minimally, ever since (3) made its transition by looking due north on the horizon making certain it would not be considered "dumb pipes" by its customers, and moved up the stack to the higher margin CDN services. Yes, they're looking to the CLOUD as well. As a matter of fact, after digesting Global Crossing later this year, they maintain $37.5B in PP&E internet footprint "conservatively" across the globe.

    The days of free loading their backbone are behind us, as "The Network Partner You Can Rely On," continues connecting all of the eyeballs around this planet seamlessly and "end to end."

    In the final analysis, the true value of any "network" are its "END TO END" connections.

    I would suggest you find some new religion and abandon your old in order to CAPITALIZE on this SHIFT! Good skill in finding the conviction to do so.

    It's never easy for men to admit being wrong.

  • Report this Comment On May 27, 2011, at 6:09 PM, jlnowling wrote:

    Think about this, NFLX stores all the movies at LVLT. Canada and South America on LVLT Pipes. I would hate to be short LVLT.

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