Will Post-Earnings Gains at Level 3 and Akamai Be Short-Lived?

Level 3 and Akamai are soaring after earnings, but will fears of an Apple CDN make these gains short-lived?

Feb 6, 2014 at 4:00PM

Level 3 (NYSE:LVLT) reported strong earnings on Wednesday, showing that the communications services company is thriving and quieting the naysayers who questioned the Global Crossing acquisition. But with news that Apple (NASDAQ:AAPL) plans to build its own content delivery network, might Level 3 and peer Akamai's (NASDAQ:AKAM) strong session be short-lived?

A presumed risk finally pays off
Back in 2011, when Level 3 was prepping its acquisition of peer Global Crossing, the company convinced shareholders that the synergies would create a company with more miles of fiber than any other communications services company in the world. Subsequently, Level 3 would have a competitive edge on its peers, would attract more business, and despite the companies sharing a massive debt load, the synergies would create profits.

As a result, shares soared from $14 to nearly $40 in anticipation of the acquisition, before falling and hovering around $20 for the last couple years. With that in the past, Level 3 has seen a boost in positive trading activity over the last three months, and on Wednesday reported earnings that finally showed the improvements that investors sought.

Rvenue was slightly lower more than the prior year at $1.6 billion, but its EPS was positive $0.06. This means that Level 3 generated net income of $14 million, compared to a loss of $56 million in the year prior.

This move to profits is a huge win for the company, representing a 490-basis-point rise in Level 3's earnings before interest, taxes, depreciation, and amortization, or EBITDA, to 29.1%. Gross profit margin rose 200 basis points, while general and administrative spending fell 6% -- all very positive for Level 3.

A lingering concern
With Level 3's earnings in mind, it's no surprise that the stock soared 10% following the report. However, those gains could be short-lived, as many are concerned about the impact of Apple building its own CDN, which is something we've seen other tech companies do as of late.

Apple uses Level 3 and Akamai for its CDN to deliver apps, services, and iTunes content to Apple's large network of users. However, columnist Dan Rayburn of StreamingMediaBlog.com reported that Apple has hired networking veterans with a lot of experience in building large-scale networks. Further reports have confirmed that Apple is in fact developing a home-grown CDN.

This makes sense for Apple, because with the quantity of apps being created and downloaded, along with the music and videos being streamed via iTunes, the expenses that Apple pays to utilize Akamai and Level 3 services could be higher than what creating its own CDN would cost

Essentially, it's just another way for Apple to protect margins at a time when its profitability is under heavy scrutiny.

With that said, Apple is not the only big content syndicator to build its own CDN. Microsoft, Google, Yahoo!, and most recently Netflix have begun using their own networks.

Where does this leave Level 3 & Akamai?
Neither Apple, Level 3, nor Akamai speak of specific clients, but it has been widely reported that Apple paid Akamai $100 million last year, making Akamai its largest CDN client.

With that said, we already know the fundamental performance of Level 3, and at this point in time, profitability seems to be the main focus. Also, if less than $100 million was spent on such services, it would account for less than 1.6% of Level 3's total business.

Level 3 gave guidance on its conference call, saying that its core network services operations -- which account for 90% of total revenue -- are growing at a faster rate than last year's 2.9%, which implies that Level 3 will be fine regardless of what Apple builds.

Conveniently, Akamai also reported earnings on Wednesday after the market closed, and it's currently trading higher by 15% after beating expectations. With $1.6 billion in revenue over the last 12 months and expected growth of 14% this year, roughly 5% of Akamai's revenue is at risk. And while this may seem minimal, an Apple loss could spell trouble for shares of Akamai.

Final thoughts
When we look at the three noted companies, Akamai looks to have the most to lose. Level 3 still looks like a company that's moving in the right direction, and Apple might have many more moves like this up its sleeve.

Apple has set a capital-expenditure budget of $11 billion for 2014, which is nearly a 60% increase over last year. With such a boost, it stands to reason that Apple will release new products, but also make additional moves to lessen its dependence on suppliers to increase margins long-term.

Over a period of years, this will likely work well in the favor of Apple, but it puts the long list of suppliers and Apple providers at risk of similar decisions by the tech giant.

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Brian Nichols owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of 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.

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