Akamai Technologies: An Integral Part of the Digital Revolution

Despite dropping off a cliff after its most recent earnings report, Akamai Technologies (AKAM) remains my favorite tech stock. On April 25, Akamai reported first quarter earnings of $19.2 million, or 11 cents per diluted share, versus $11.5 million, or 7 cents a share, year-over-year. Revenue came in at $139.3 million, compared to $90.8 million in the first quarter last year. Excluding special items, net income was $50.7 million or 28 cents a diluted share. Analysts surveyed by Thomson Financial/First Call had forecast earnings of 28 cents on revenue of $138.82 million.

Shares of Akamai have climbed more than 300% since the beginning of 2005, and more than 5000% since its lows back in 2002. Having gotten used to Akamai beating earnings expectations quarter after quarter, investors rushed for the exits this time around when earnings were simply “in line.” Valuations were indeed stretched when momentum investors bid the forward P/E up to 34 as Akamai hit its high of $59.69. However, after pulling back about 30% since the earnings report, Akamai is too cheap with a PEG of just 1. If Akamai’s PEG falls much below 1, it will not only be a growth play but also a value play. As one of the few internet companies with a future of growth, including Google (GOOG), Akamai should not be trading at such low valuations. Even if investors’ fears of slowing growth does occur and Akamai cannot grow revenues over 30% a year, Akamai should still be able to do so in the high 20%’s. Meanwhile, older internet companies such as Amazon, with growth in the low 20%’s, have ridiculous valuations, with forward P/E of 54 and PEG of 2.86.

When Akamai raised full-year guidance at the first telecon of the year, shares surged to its 52-week high. I believe if Akamai continues on that path by meeting or beating expectations in upcoming quarters, investors will regain confidence in this internet-backbone once again, with a target price of $68-$74.

Background: FedEX of the Internet

Akamai’s primary business is operating a CDN, or a Content Delivery Network. By giving their customers the scalability and reliability they need to deliver content over the web, Akamai is an integral part of the digital revolution occurring on the web. Countless corporations large and small use Akamai’s network to deliver various types of content ranging from video to advertisements or software downloads. For instance, Apple (AAPL) put Akamai on the map when Apple chose Akamai’s services as the backbone for downloading songs and movies from iTunes possible. In fact, Apple generates virtually nothing from sales on iTunes. Rather, the $0.99 per song goes to credit card transactions, music labels, and Akamai. Other notable customers who depend greatly on Akamai are Yahoo (YHOO), Adobe Systems (ADBE), Charles Schwab’s (SCHW) and E*Trade’s (ETFC) online trading, and FedEX’s (FDX) package tracking.

Akamai’s recent surge in business isn’t by accident but as part of the digital revolution. Just about everything nowadays, especially media, can be seen on the web, but corporations providing the content do not have the technical expertise nor the infrastructure to move entertainment and other things online. By outsourcing this task to Akamai, corporations have access to Akamai’s global network of more than 20,000 servers to store and distribute the content without having to actually build out a 20,000 server network in every major network around the globe. This is significant because often there are surges of web traffic such as the NCAA March Madness or 2006 winter Olympics which many people watched online. Such surge of web traffic requires massive web infrastructure of servers and routers to handle the traffic, but no company would want to build out such a network for just one event. It’s like building a 10 story department store just for the after thanksgiving sale- it is just not economically feasible. With Akamai, and especially with virtual machines on each server, Akamai allows all of its customers to store content on most or all of its 20,000 servers.

Akamai’s advantage since the day the company began is its dynamic traffic management system, which monitors all traffic such that data travels along the shortest path to reach the web user in the shortest time. Moreover, Akamai’s monitoring system pools together as many servers as needed to handle surges of traffic such as March Madness so that such events can be experienced online without a glitch. Finally, Akamai stores a lot of content “on the edge,” or at servers closest to the web user. This way, the song, for instance, would reach a user in Singapore much faster than if the user had to get the song from Apple’s iTunes server in Cupertino, California. Although edge servers have already played a great part in speeding up the internet experience, edge servers should play a huge role in the sea change to put smart ads online. As more and more people spend more of their time online, advertisers have shifted much of their focus from traditional media such as newspapers and radio to the internet. Edge server technology allows for the targeting of specific ads to the right web users since ads targeted for a specific type of person must show up instantly within the webpage, requiring the ad to be pulled quickly from an edge server rather than from miles away.

Acquisitions

While Akamai has made a couple of interesting acquisitions recently, it does not worry me that Akamai’s internal growth is slowing and must grow by acquisitions. Technology is constantly in rapid change and tech companies must change accordingly or risk being outdated, like the NASDAQ highfliers in 2000 who aren’t around today. The Netli and NineSystems, and most recently RedSwoosh, are all accretive to earnings, but also allows Akamai to maintain its dominance in content delivery while removing possible competitors from the market. The Netli acquisition seems like a similar move to Google’s launch of Google Documents, allowing people to use programs such as Word or Excel online rather than on their PC. This may be the next shift in the internet revolution as applications are moved online so people can do their tasks regardless of which computer they use as long as they are connected to the internet.

The RedSwoosh acquisition is just as exciting, paving the way for Akamai to take advantage of high definition video online for everything from TV shows to movie downloads. With consumers citing the lengthy download time as the biggest drawback for streaming movies from iTunes to watch instantly on TV, Akamai’s RedSwoosh would significantly increase the download time. RedSwoosh uses the same P2P technology that bitTorrent uses to take apart content such as movies, forward them in bits and pieces along the fastest route, and reassemble them for the end user. Thus, RedSwoosh would make Akamai’s services much more attractive to corporations, as larger files would be subject to longer download times.

Crosswinds

With less than 50% of U.S. households having broadband internet, and the unstoppable trend of moving everything online, Akamai’s services should remain a crucial part of most corporations’ IT backbone. Although there are concern that broadband providers such as Level 3 Communications (LVLT) are competitors to Akamai, Level 3 providing more broadband in the U.S. should only boost the internet’s usage and the demand for the high speed media distributed through Akamai’s network. Moreover, Akamai itself uses the internet to move content between servers; therefore, more broadband availability should lower the cost for Akamai to distribute content.

Disclosure: Author has a long position in AKAM

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