The first article I ever wrote for The Motley Fool, back in December 2003, covered one of my favorite companies, Akamai Technologies
Fast-forward 15 months. We now know that Akamai is likely to be around for a while, and I've also become an owner. But the euphoria has passed, and Akamai's resurgence may have crested. The stock has certainly crashed, having dropped by 29% over the past year. And short sellers are still expecting lower lows: Yahoo! Finance shows more than 11% of Akamai's shares sold short. Could the downer crowd be right? I had to ask. So I stopped by the firm's Cambridge, Mass., headquarters in February to do just that. What I found left me wanting to wax my board and hit the waves. That's right, dudes: The surf's still up. Here's why:
Catch a wave, hang 20
Like the rest of the analysts at the Fool, I'm a business-focused investor. I love businesses that show consistent fundamental improvement, especially when the gains come both sequentially and year-over-year.
When I invested, I figured this was exactly the kind of business Akamai could be. Its network of roughly 15,000 global servers was all but completed. That meant the company needed only to create and deploy new software to add services. Costs to gain more revenue would be incremental, leading to higher margins. More than a year later, that's pretty much what happened. Have a look:
Imagine the surfer who catches a wave and hangs 20, milking the curl for all it's worth. That, in a nutshell, is Akamai.
I've heard it said that Hawaii's "Banzai Pipeline" provides some of the most spectacular, and dangerous, surfing in the world. The same could be said for the surging content-delivery market. A recent report from AccuStream Research suggests that demand for streamed audio and video, led by the runaway success of Apple's
The good news is that Akamai remains the dominant player in the market with a 66% share. But as I said, this is also a market fraught with peril and driven mostly by rapidly falling prices. AccuStream says the cost to transfer 1 GB of bandwidth fell by 19% in 2004. That's bad news because networkers like Akamai typically charge by the gigabyte. Falling prices could lead to lower profits in the long term.
Keep the board waxed
So far, the falling prices haven't had an impact on Akamai. That's probably for two reasons. First, the company every quarter gets what it calls "bursting revenue." That's higher-priced network service provided in the event of a major Internet problem. For example, if a virus attack required Akamai customer Microsoft
Second, Akamai is successfully selling services beyond mere bandwidth. Consider a recent deal with Macromedia
This so-called "platform strategy" isn't unlike what Intel
Sharks in the water
Akamai isn't without risk, of course. For one, year-over-year growth in accounts receivable was 46%, vs. 27% growth in sales. This probably reflects the company's somewhat troubling practice of not collecting much upfront for its services. But the numbers appear to be improving. Accounts receivable grew only 6% from Q3 to Q4, while sales rose by 8%.
Customer churn hasn't abated, either. Roughly 5% of customers turned over in Q4. That's just about in line with its recent averages, but it hurt Akamai's ability to generate sustainable, predictable profit. Analysts estimate that reducing churn by even 1% could save the firm at least $0.02 in profit annually.
Yet shareholder dilution and debt still present the biggest threats. The latest balance sheet shows $108 million in cash and investments vs. $257 million in convertible debt. Whether Akamai can cover this obligation is no longer a question because the firm has been generating more than enough cash to do so. But $200 million of its notes offer a conversion price of $15.45, and all of them could be immediately redeemed for shares at any time after the stock's per-stub price reaches $18.54.
Unless the business goes really bad, this conversion seems inevitable, and it would introduce 12.9 million new shares into the market. Akamai's diluted share count now includes the convertible, which has led many on the Street to reduce their per-share targets for 2005 and beyond. No wonder the stock price has been in free fall since the beginning of the year.
Grab your board, dude
Still, taken as a whole, Akamai has every appearance of a strong business that's getting stronger. Look, for example, at how owner earnings have improved over the past year:
Akamai generated more than $41 million in cash in 2004 for retiring debt and improving operations. In terms of valuation, that means the stock trades for 38 times last year's owner earnings. That's important when we consider how that number could improve. Akamai management predicts at least 20% revenue growth for 2005. So, let's run two scenarios -- one showing growth in line with projections, or 20%, and the other with some upside, or 25%. I think we can safely estimate out to 2007:
|Fiscal Year||20% Growth
Pretty impressive, eh? Now what happens if we apply an owner-earnings margin against these totals? Let's find out. The table below shows Akamai's projected owner earnings if the company becomes inefficient (an 18% margin), stays the same (a 20% margin), or improves (a 22% margin). Have a look using 20% revenue growth:
Here's the outlook based on 25% revenue growth:
I know I've hit you with a ton of math, but it's really not all that difficult. Stay with me, OK?
Using the tables above, we ought to expect 2007 owner earnings to come in between $65 million, using the most pessimistic growth rate and margin, and $90 million, using the most optimistic figures. Investing demands a conservative eye, so let's err toward the pessimistic. Let's take 20%, the average margin, and stick with 20% growth to 2007, an approach that assumes none of the "at least" upside for 2005 that management alluded to. That brings us to $73 million in owner earnings in three years -- 78% growth in total and 21% annualized. As strong as that is, the numbers get better. Remember, Akamai today trades for 38 times owner earnings. Apply that same multiple to our 2007 projections, and we arrive at a total enterprise value of $2.8 billion. That's a 76% gain from today's stock price.
Am I estimating aggressively? I don't think so. Akamai is the dominant player in a market that's estimated to be growing by at least 40%. Our projected growth rate is half that. Naturally, we could be wrong: All investing requires some degree of arm-waving, especially Rule Breaker investing. I think Akamai's market position, well-known brand name, strong leadership, and demonstrated ability to transform its business over time is worth far more than the market today is willing to pay. And I find myself bolstered by the knowledge that these same characteristics are what drew Motley Fool Rule Breakers chief David Gardner to Marvel Entertainment
So, dude, what are you waiting for? Grab your board and get in. The waves look ripe.
Fool contributor Tim Beyers owns shares in Akamai. And, yep, more than a year later, he still TOTALLY digs Crush the sea turtle from Pixar's Finding Nemo. It may even be his favorite movie for kids. Unfortunately for Tim, his children are jonesing for DreamWorks' Shark Tales. Bummer, dude. What's your favorite flick? Share your picks with other Fools at theGreat Moviesdiscussion board. To see what other stocks are in Tim's portfolio, check out his Foolprofile. The Motley Fool isinvestors writing for investorsand has adisclosure policy.
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