Content distribution specialist Akamai Technologies (AKAM 0.97%) 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.
The view up here is great, but it's a long way down! Image source: Getty Images.
Worth it?
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.
