Why Everyone Is Wrong About Akamai

Akamai Technologies (Nasdaq: AKAM  ) was down as much as 4% in early trading today because, once again, the chinwags have it wrong.

Akamai no more missed estimates in reporting first-quarter revenue than I won the $162 million Powerball lottery here in Colorado. (If only.)

Let's review what Chief Financial Officer J.D. Sherman actually said in giving guidance during February's call to announce Q4 results:

Looking more near-term, for the first quarter this year, we're expecting revenue in the range of $186 million to $190 million. That translates into 34% to 37% growth over Q1 of last year and represents 2% to 4% sequential growth off of our seasonally strongest fourth quarter, where we grew 14% sequentially ... we expect normalized EPS in the range of $0.38 to $0.39 per share, up by 36% to 39% from Q1 of last year but down slightly from Q4. [Emphasis added.]

Akamai earned $0.41 in normalized per-share earnings on $187 million in revenue in its 2008 first quarter.

Investing in an ATM
Analysts, of course, were expecting more than a 34% gain on the top line. One million more, to be precise. Me? I couldn't care less. These numbers matter most to me:

Metrics

Trailing 12 Months

2007

2006

2005

2004

Revenue

$684.2

$636.4

$428.7

$283.1

$210.0

Free cash flow*

$173.4

$134.9

$62.6

$46.7

$31.1

FCF margin

25.3%

21.2%

14.6%

16.5%

14.8%

Source: Akamai earnings reports and Capital IQ, a division of Standard & Poor's.
*Free cash flow also accounts for capitalization of internal-use software.
Numbers in millions.

Notice how the free cash flow margin continues to blossom. In essence, tax-efficient Akamai is cashing more from its sales than generally shows up on the net income line.

There's a good reason for that. In its early days, Akamai racked up huge losses to build out its network. Those losses are now being used to offset corporate taxes. The difference shows up on the cash flow statement as a credit. (A $23.2 million credit in Q1, specifically.)

These credits won't last forever, of course. By my math, Akamai will be paying its tax burden in cash by sometime in 2011. But even then, cash should continue to flow. Why? Growth. Akamai is already on track to reach at least $800 million in 2008 revenue and, if CEO Paul Sagan has his way, $1 billion by the dawn of 2010.

Assuming top-line growth slows to just 15% over the ensuing two years, Akamai would be on track for $1.32 billion in 2011 revenue. Applying its worst FCF margin since reaching profitability -- 14.6% -- to that total still yields $193 million in free cash flow that year. At a much more likely 20%, Akamai would be pumping out $264 million in FCF.

My point? FCF growth will slow at some point. But even then, Akamai is likely to be a tech ATM -- a junior member of the cash club that Oracle (Nasdaq: ORCL  ) , Apple (Nasdaq: AAPL  ) , and their peers have built.

My, what a big wallet you have
And its corporate wallet should continue to fatten as a result. Through Q1, Akamai had $321 million in cash and short-term investments. Longer-term securities held were valued at $361 million.

Impressive, yes? Absolutely. Especially when you consider that Akamai's cash and investments account for roughly 12% of its market value as of this writing. There's only one minor problem: $280 million of that is in auction-rate student loan securities of the sort that torpedoed First Marblehead (NYSE: FMD  ) .

I say "minor" because Akamai doesn't resemble First Marblehead; student loans aren't core to its business. What's more, Sherman said in an interview earlier today that Akamai has marked-to-market these securities and taken a $16 million unrealized loss to account for the current market malaise. His estimates also call for trouble to persist for five years, which seems unlikely in my opinion.

When competitors lose, Akamai wins ...
Thus, the thesis for investing in Akamai remains as strong as ever. Revenue, profits, and cash flow are all soaring.

My guess is that all of this will continue though 2011 and beyond. Why? Competition is getting weaker, not stronger. Look at gross margin. Though down from 75.2% to 72.4% year over year, that's still at least 15 percentage points better than what peers Limelight Networks (Nasdaq: LLNW  ) and Level 3 (Nasdaq: LVLT  ) earn. Internap (Nasdaq: INAP  ) , meanwhile, collects about 42% from the top line.

It's unreasonable to claim, as some do, that Akamai is in a commodity business, and that low-cost competitors will destroy it. They've already had the opportunity and failed.

And if margins are holding up now -- during a period of heavy competition and even heavier capital spending -- isn't it likely that free cash flow margins are just as likely to expand as they are to contract? With or without the tax penalty?

You know the answer. And you know, too, that the best time to buy is when everyone else is running in the other direction. ... Days like, you know, today.


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