Thursday, July 29, 2010

Akamai Selloff is Completely Unjustified

Akamai (AKAM) reported quarterly revenue yesterday of $245 million, up from $240 million last quarter, and $205 million for the last year.

The stock is getting hit hard, however, as some traders seem concerned about a slight EPS hit, some of which is from currency conversions, as well as rumors of heavy price competition against Level 3 (LVLT) and Limelight (LLNW).

I think this beating is completely unjustified. The stock has a P/E of 30 overall, which drops to around 25 when you factor out its $1.1 billion cash balance. Moreover, the analysts on the call yesterday were fretting about one or two points of gross margin. I've been doing financial plans for telecom service providers for over a decade, and not one has come close to a 70% gross margin on a GAAP basis, or the low 80s on a cash basis. Moreover, the difference in cash and GAAP gross margins shows what a poor job financial accounting does of revealing cost structure with depreciation and stock-based compensation thrown into the Cost of Goods Sold line. This is why I recommend modeling businesses like this using managerial accounting techniques. Contribution margin provides a lot more insight into future profitability than GAAP gross margin for a company like this.

In addition to Wall Street's sudden concern about valuation, the strangest reaction I've seen to the earnings call is Citi's comment about competitors and pricing. CDNs are like semiconductors, the prices are almost always declining, but the margins remain high throughout because the underlying costs are declining at the same rate. This is Microeconomics 101, prices for CDN services will keep dropping because the marginal costs of delivering them keep dropping. The servers and network connections in Akamai's network aren't getting more expensive. Moreover, Akamai's got the lowest cost per bit because its got the largest CDN network. Its operating margins have been holding around 25%, while competitor Limelight has been holding around minus 15%. Competitors therefore have to go Akamai's cost per bit, so guess who gets hurt more in a price war. Moreover, it takes a lot of specialized, expensive knowledge to sell CDN services, which is one reason why telcos have struggled with it, because they could easily handle the capital requirements. At the end of last year, Akamai had 820 people in sales and support. Even large telcos don't have this level of CDN expertise, which is why Verizon and Telefonica resell Akamai's service rather than trying to compete against it.

There might be temporary spikes up and down, but this company has accumulated over $1 billion in cash while prices for its service have kept dropping. If Intel (INTC) can hold a $120 billion market cap for a business with no pricing power but the lowest marginal cost per unit of production, Akamai's $1.1 billion of cash and quarter billion of operating income are certainly enough to justify a $7.5 billion market cap.

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