Previewing 2007: Akamai

If you're looking for clues as to how Motley Fool Rule Breakers pick Akamai Technologies (Nasdaq: AKAM  ) will perform during 2007, look no further than CEO Paul Sagan's comments to analysts in October. Allow me to quote:

"There are thousands of software companies in the world. I think the number is 15 today that have $1 billion in revenue. That's the club we're going for."

And quite a club it is. Many of them are either Akamai partners or potential competitors, including Google (Nasdaq: GOOG  ) , Microsoft (Nasdaq: MSFT  ) , and Yahoo! (Nasdaq: YHOO  ) . Mentioning Akamai in the same breath is enough to make many wonder if Sagan is just plain loony.

That's doubtful. More likely he's optimistic because the company is well positioned and the team is motivated. And with good reason. Danny Lewin, an Akamai co-founder, was a victim of the September 11, 2001 attacks. When the five-year anniversary arrived a few months ago, Akamai posted a tribute: "Danny's spirit and energy remain strong in all of us at Akamai."

How appropriate. It's also comforting for this investor. The remarks mirror those made by former CEO George Conrades in 2003. "We miss him [Lewin] and many of us work hard in his memory. We would be embarrassed if we let him down," Conrades said at the time.

When you have an advantage, exploit it
They haven't. Since the beginning of 2004, Akamai has been a five-bagger. Sales and profits have ballooned. And free cash flow (FCF) -- which was nonexistent in 2003 -- has come within spitting distance of $100 million over the trailing 12 months.

Meanwhile, Akamai's competitive advantages remain intact. At the same conference where Sagan made his Kennedy-esque prediction, executive vice president of technology Chris Schoettle said that the firm's network of 20,000-plus global servers was outperforming rivals by a factor of 2.5.

But Sagan and his team aren't satisfied. In November, Akamai issued 3.1 million shares of new stock and spent $7 million in cash to acquire Nine Systems, whose "Stream OS" helps clients distribute and track the effectiveness of content.

That's smart. Speculation abounds that network owners who are in the content hosting business may want to also get into the delivery business. Consider Google. Or Yahoo! Or Microsoft. Or Apple (Nasadq: AAPL), whose iTunes store has been a boon for Akamai. Doing more for these and other, smaller clients can only help the firm to preserve its greater than 50% market share in content delivery.

Not buying what management is selling
Still, skeptics remain. Those who see a fall for the stock in 2007 blame competition. Consider this thesis from Motley Fool CAPS all-star astrodogind:

"Based on the trades made by insiders, the fact that they're in a painfully commoditized market at this point, the 7.7 [billion] market cap, and the lack of growth to their bottom line, I think this one is headed down.... In the end, this is a web hosting company, with some interesting, but not particularly revolutionary products, that exists entirely without a moat because of the relatively low capital cost associated with leased datacenter space and bandwidth."

Factual problems aside -- Akamai's secret sauce is a patent-protected algorithm, for example -- my fellow Fool makes an interesting bear case. Data center space is becoming easier to obtain. And there's almost zero pricing power in bandwidth.

Fuel still in the rocket
That would be a major concern if Akamai's margins were closely tied to bandwidth prices, which have been dropping faster than the temperature in the Arctic at sunset. But that's not the case; gross margin was 77% as of the latest quarter and is expected to remain between 75% and 80% long-term.

Still, the stock trades for 47 times next year's earnings, which analysts believe will grow by 38%. I'd prefer to see that reversed, but there can be little doubt that Akamai's market position and extraordinary ability to generate cash deserves a premium.

Then there are the trends working in Akamai's favor. For example, online shopping still accounts for a just a fraction of all retail spending. Fitch Ratings says digital ad spending as a percentage of all advertising is set to move from 4%-6% today to 20% within a few years. And less than 10% of the 1 billion people on the Internet today have a broadband connection. That's important because broadband feeds tend to create demand for streaming media, downloads, etc.

My math says that Akamai's shares are fairly valued at today's prices if you assume FCF will grow 31% annually for the next 10 years and 3% thereafter, and then discount that growth by 11%. Frankly, that may or not be fair.

But Akamai's top brass still owns 7% of the company, are positioning for more massive growth in Web-connected industries, and have amassed a $400 million war chest, which will probably be used to add water to an already wide moat.

Foolish final thoughts
2006 was a great year for Akamai investors. 2007 probably won't be as great. But this is a stock that's only worth viewing through the lens of decades. 10 years from now, will Akamai be as important as it is today? You know the answer. You're on the Internet right now, reading this, because of Akamai. Don't expect that to change soon. Cowabunga, baby.

Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.

How great is growth? Three of the dozens of stocks in the market-beating Motley Fool Rule Breakers portfolio have quadrupled in two years, including Akamai. Care to find out the names of the other two?Click hereto get 30 days of free access to the service.

Fool contributorTim Beyers, ranked 1,013 out of 17,523 inMotley Fool CAPS, is a regular contributor to Rule Breakers and a very happy owner of Akamai shares. Get the skinny on all of Tim's stock holdings by checking his Foolprofile. Microsoft is an Inside Value selection. Yahoo! is a Stock Advisor recommendation. The Motley Fool'sdisclosure policygrows in influence daily.


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