Another Sigh for Akamai

Revenue rises 52%. Normalized net income rises 50%. And the stock sells off by more than 13% in early trading. Call it just another day in the crazy world of growth stocks.

That's how it was for Akamai (Nasdaq: AKAM  ) in reporting second-quarter earnings last night. Almost everything went right for the king of Web content delivery -- everything, that is, except for three things. First, bottom-line results didn't beat the Street's expectations. Second, Akamai didn't raise guidance. And third, free cash flow declined year-over-year. Let's examine, shall we?

Beat the Street ... with a wet noodle
Akamai booked $152.6 million in revenue for the quarter, up 52%. Net income according to GAAP was up 92% over the same period. On what Akamai calls a "normalized" basis (which, among other things, excludes non-cash charges for stock options, depreciation, and amortization), per-share earnings were up 50%.

Only the top-line number was good enough for analysts. They were expecting just $150.9 million in revenue. That's a 1% beat! Woo-hoo!

But that goodwill faded when management merely repeated its earlier guidance of $615 million to $625 million in full-year revenue. Who cares if that would make a 43% increase over 2006? It's not a beat. Release the hounds!

I've never understood this must-beat-the-Street, zombie-state behavior. Why sell into a panic? What's more, why sell a stock that's reporting excellent numbers? Surely Akamai isn't that overvalued? Tell you what -- let's get back to that.

Free-falling cash flow
If there's any real cause for concern in Akamai's numbers, it's with free cash flow (FCF), which declined 43.5% to $7.6 million during the quarter.

But even here, there's a reasonable explanation. Akamai is in the midst of a $60 million program to boost its network capacity. In Q2, that led to a 138% increase in spending on property and equipment, which, in turn, led to a 31% increase in its global server count (27,322 deployed as of June 30). No wonder FCF took a hit.

As a shareholder, I'm glad to see the spending. Competition looms in every corner. Limelight (Nasdaq: LLNW  ) is a well-funded up-and-comer. Internap (Nasdaq: INAP  ) has experience. Level 3 (Nasdaq: LVLT  ) has endless miles of dark fiber. And Google (Nasdaq: GOOG  ) threatens to co-opt the Web altogether. I want Akamai spending whatever it has to in order to make sure it can't be easily replaced.

Back to the big question
So, is Akamai overvalued? Yes ... and no.

Yes because, by my math, Akamai would have to grow its $75.1 million in trailing free cash flow by almost 50% annually for each of the next five years -- and then 20% more for each of the next five years after that -- in order to justify its current price.

But that's the wrong way to look at the business, because FCF will always look worse than it should during a company's high-growth phase, when excess cash is used to reinvest in the business.

Akamai has seen these days before. From 1999 to 2001, during the initial build-out of its network, capital expenditures averaged $74 million annually. Guess how much it was over the past 12 months? How about $89.6 million?

Interestingly, history also says that, once Akamai completes its network upgrades, the underlying business is capable of producing mountains of cash flow. That's what happened in 2004, when Akamai's initial investments finally paid off.

Let's account for these cycles by using the average capex from 2002 to now. Then we'll recalculate free cash flow for the purposes of valuation. Hang on one sec ... (key-punching sounds) ... OK, got it: $132.3 million.

Running a discounted cash flow analysis against that total suggests that, at today's low of $35.05 a share, Akamai is priced to grow FCF by 30% over the next five years and just 12% in the five subsequent years.

Strike up the broadband
I believe we'll see far greater growth than that. Here's why:

  • Out of 300 million people here in the U.S., 50 million have broadband access.
  • But there are only 128 million broadband subscribers in the remaining 29 most industrialized nations tracked by the Organisation for Economic Co-Operation and Development (OECD).
  • Meanwhile, the Chinese government says its country plays host to just 162 million Internet users, 122 million of whom have broadband. Not much for a land of 1 billion people. (And that's assuming these figures aren't pure hype, which they may be.)

See where I'm headed with this? If it's fair to assume that broadband Internet access is a global certainty, and that less than one-seventh of the world's population has broadband, then it's also fair to say that Akamai's long-term opportunity remains, at worst, vast.

So, Fool, take today's sell-off for what it is: a panic attack that bespeaks a deep misunderstanding of a fast-growing and well-positioned business that touches only a very small slice of the world's Web-wise population.

Or, in simpler terms: Go ask someone else to sell their shares, pal. I'm keeping mine.

Akamai is one of 11 stocks in the market-beating Motley Fool Rule Breakers portfolio to have more than doubled. Discover the identities of the rest with a 30-day free trial of the service. There's no obligation to subscribe.

Fool contributor Tim Beyers owned shares of Akamai at the time of publication. Tim's portfolio holdings can be found at his Fool profile. His thoughts on Foolishness and investing may be found in his blog. The Motley Fool's disclosure policy is feeling warm and fuzzy today. Need a hug?


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