Content distribution specialist Akamai Technologies (NASDAQ:AKAM) has seen its shares surge 52% in 2018, powered by a string of solid earnings surprises. Does this bottle rocket have any fuel left to burn, or should Akamai investors brace themselves for an upcoming correction?
Let's have a look.
Why Akamai is soaring this year
This spring, Akamai shook up its business model a little bit. The company added two new members to its board of directors, backed by activist investor firm Elliott Management, and drew up a plan to double its operating margins in three years. There's no magical hand-waving involved here -- Akamai is actively reducing its operating costs by tightening up its processes and applying automation where that makes sense. Furthermore, a newfound focus on security-related products and services should help in the long run.
The company also increased its share-buyback program from $417 million to $750 million, with an eye toward exhausting this larger authorization by the end of this year. Akamai had retired 2.2 million shares or 1.3% of its share count by the end of July, consuming 22% of the beefed-up buyback policy.
Direct cash returns to shareholders should continue in the coming years, most likely by means of additional buyback boosts. Akamai has never paid a dividend, so it would be somewhat out of character to allocate funds for that purpose. At the latest quarterly reckoning, Akamai balanced $1.9 billion in cash equivalents against $1.5 billion of total debts, with $418 million of free cash flow rolling in over the last four quarters.
Investors love these shareholder-friendly initiatives, especially the long-term ambition to boost the company's operating margins. This stock has some good reasons to rise.
So Akamai is pulling some serious levers in order to improve its business, which should unlock plenty of shareholder value in the coming years. However, a lot of that upside might already have been priced into the stock.
Massive price jumps come with the downside of giving new investors a loftier and less profitable starting point. Today, Akamai shares trade at 48 times trailing earnings and nearly 5 times trailing sales. These are lofty valuation ratios for nearly any stock, and it's been five years since Akamai last enjoyed similar P/E ratios.
The attempt to widen Akamai's operating margins is admirable, but cost-cutting programs can run into unexpected problems. Worst of all, I'm worried that Elliott might want Akamai's management to cut operating costs a little too close to the bone, leaving crucial departments underfunded and unable to respond to an ever-changing business environment.
The final verdict
In short, I don't think Akamai has earned these sky-high valuation ratios quite yet. Ask again in a couple of quarters, giving the company and its activist backers a chance to walk the talk, and I might reconsider. But I would not recommend buying Akamai shares today.