Sometimes you're wrong even when you're right. In my case, I was right to buy shares of Akamai Technologies (Nasdaq: AKAM ) in 2004. I was right to recommend the stock to our Motley Fool Rule Breakers subscribers in 2005. But I was dead wrong to hang on when all signs pointed to an eroding competitive advantage.
From Breaker to Tweener
Akamai was never a cheap stock. I bought it and recommended it because I believed the Web would become a primary source for work, entertainment and commerce. Akamai, by acting as a traffic cop for directing and speeding traffic over the Internet, would add enormous value to the online experience -- value that vendors would pay a premium for, I reasoned.
And they did, for a while. Revenue had soared 45% annually through 2007. Normalized profits -- i.e., earnings adjusted for stock-compensation costs and other charges -- zoomed close to 60% annually over the same period. Competition wilted as Akamai became the go-to company for delivering files for the likes of Apple (Nasdaq: AAPL ) and Microsoft (Nasdaq: MSFT ) .
Yet there were warning signs, too. Gross margin fell from more than 80% in 2005 to less than 74% two years later. Early competitors clobbered by the dot-com bust had finally given way to a new breed, notably Limelight Networks (Nasdaq: LLNW ) . I should've spent more time analyzing the impact competitors were having. Instead, I took management's word that Akamai didn't typically face rivals in bidding for business.
Education was a bigger barrier than competition when it came to growth, executives told me at the time. CEO Paul Sagan still says there's a preponderance of do-it-yourselfers who simply won't outsource Web-content delivery, no matter which vendor is pitching.
From Disruptor to Disrupted
Despite the signs, in November 2007 I insisted that Akamai wasn't nearly as expensive as most analysts believed. The company's proprietary software for determining the best path to route traffic over the Web could be tuned to create new services, I argued. Also, when you considered the growth analysts were expecting, Akamai was cheaper than most of its peers and Google (Nasdaq: GOOG ) .
None of it mattered. The 2008 financial crisis took a heavy toll, forcing Akamai to cut staff as it faced off against new competition from Amazon.com (Nasdaq: AMZN ) . That should have been a warning sign. While no company is fully immune from looming economic catastrophe, true Rule Breakers manage hypergrowth in even in tough times. Akamai looked normal even as I argued it was exceptional.
Yet I wasn't done. As 2009 drew to a close -- a good year for Akamai investors -- I returned to my soapbox, this time arguing that price cuts were good, so long as they helped stave off competitors. Lower returns on deployed servers didn't matter because Limelight and Level 3 Communications (Nasdaq: LVLT ) lacked the balance-sheet strength for trench warfare. Akamai was a survivor, I argued, and would be 2010's best tech stock because of the rise of online video.
For a time it seemed I was right. Akamai more than doubled, starting the year above $48 a share. The 11 months since then have proved to be anything but kind. Disappointing first-quarter estimates and competitive losses in the streaming-media side of its business led investors to dump the stock.
Sagan and his team insisted that a combination of new deals, higher volume, and high-margin services would lead to a reacceleration in revenue and profit growth in the second half of the year, but they, too, were wrong. Seeing no other choice, I sold, and recommended Rule Breakers subscribers do the same.
3 things I learned
In hindsight -- always 20-20, I realize -- I still would have recommended Akamai but sold a lot sooner. Here are three specific ways my experience with researching and owning this stock have helped me learn as an investor:
- Margins matter. True Rule Breakers so disrupt markets that they possess pricing power in both good times and bad. Consider Apple. Did the iEmpire cut iPhone prices as the world struggled to recover from the Great Recession? Nope. Akamai wasn't so fortunate, and I should have more carefully considered that when deciding whether to hold.
- Competitive advantage isn't fleeting. Big Money venture capitalists never stopped pouring money into would-be Akamai killers. Some say they finally found one in Cotendo, which has teamed with Google on an open-source project for delivering content. Akamai has since sued and is reportedly working on a $300 million acquisition deal to retire the threat.
- Valuation is never a good reason to buy a Breaker. Price matters in investing. But in this case, I let a cheap price blind me to structural faults with Akamai's business. I had forgotten a key tenet in our process -- that we look for stocks others believe are expensive on an absolute basis. We do this because history tells us that true Breakers form sustainable advantages that deliver tremendous growth, and correspondingly massive share gains, over the very long term.
In the end, I consider Akamai a successful failure. The stock that helped me clarify a process for investing in high-flying tech stocks and would-be Breakers. Sound like an intriguing approach? The Motley Fool recently published a special report that identifies the top opportunities in a trillion-dollar market in the making. Get your copy now -- the report is 100% free.