Netflix Story is No Reason to Sell Akamai

By David Gross

Akamai is down nearly 5% today after CDN expert Dan Rayburn published a story in Seeking Alpha saying that Netflix is leaving Akamai, and handing over its business to Level 3 and Limelight.   While he says he cannot precisely nail down how much revenue is associated with this, he estimates it's $10-$15 million.     So Wall Street is knocking the company down 5% for losing what amounts to 1% of annual revenue.   Yet another emotionally charged expectations multiple, although the 5 here (5%/1%) is lower than the double digits we've seen with Riverbed and Equinix.

The flip side is that not only is Limelight soaring, but Level 3 is out of the delisting zone, back over a dollar, which is an important development considering it got warning from NASDAQ last week due to its stock spending too much time trading under a buck, which means it would need to reverse split or hold above a dollar to avoid being booted down to the OTC market.

Level 3 is up 14% on this news, which like Akamai, would get about a 1% shift in revenue based on Rayburn's estimates, which means its getting an expectations multiple of 14, almost as high as Equinix's record 17 when it dropped 35% after guiding down 2%.  What makes this even sillier is that Akamai's cost structure hasn't changed a bit, and it still spends half as much per dollar of revenue on bandwidth as Limelight, and generates more revenue from CDNs than Level 3 does from managed hosting, colocation, Ethernet, wavelengths, IP/VPNs, wireless backhaul services, managed WAN Optimization, SIP Trunking, Wholesale VoIP, PRIs, and CDNs combined.

Part of the reason there is such an overreaction from the manic buyers and panic sellers on Wall Street is that the customer is Netflix, which is heavily followed, and whose executives can't go to the bathroom without some analyst pondering the greater meeting.   If a less exciting Akamai customer, like the Food and Drug Administration, or the National Center for Missing and Exploited Children, was going over to Level 3 or Limelight, I seriously doubt we'd see this response, even if the revenue opportunity was the same.

Limelight Earnings Disappoint

By David Gross

Limelight reported revenue of $49 million, an increase of over 50% y/y including revenue from its Delve Networks acquisition.   However, the company dropped the guidance midpoint for next quarter from $53.2 million to $52.5 million, or about 1.4%, and the stock fell nearly 7%, for an expectations multiple of 5.

While Wall Street overreacted to the news, this company is not that far from having some liquidity issues.   It has $71 million in the bank, with no l-t debt besides a small amount of capital leases.     However, it is burning about $10 million a quarter, and will need to break-even on an actual, not adjusted EBITDA, basis in order to keep funding its capital plan without borrowing.   Moreover, its bandwidth costs remain over 30% of revenue, while rival Akamai's are just 16%.    This is a serious cost disadvantage that the company has done little to address, and will be even more challenged to tackle if it has to cut capex to conserve cash.

While there has been some improvement in margins with growth, SG&As + R&D still add up to over 50% of revenue, compared to the low 40s for Akamai.   This is a big problem when Gross Margins are still in the 40s, while Akamai's in the high 60s.   While it's great to hear about all the exciting growth initiatives from mobile to enterprise storage, the company has a lot of boring expense reduction it still needs to complete in order to chip away at Akamai's cost advantage.

Akamai Beats Estimates by 2%, Stock Rises 4% After Hours

By David Gross

With Wall Street overreacting to every word that comes out of an Equinix executive's mouth, one of the metrics we've been watching very closely is the expectations multiple, or how much a stock rises or falls relative to the company's performance vs. expectations.

Yesterday, Akamai beat revenue estimates by 2%, with revenue coming at $254 million, and was trading up 4% after hours to over $52 a share, with its market cap now topping $9 billion.  This expectations multiple of 2, while not really justified, is still nothing like the 5x-20x we've seen recently with Equinix and PLX Technologies. 

Akamai is up nearly 40% of its early August low, when consensus thinking was that it had a light quarter because of growing competition from Limelight and Level 3.   I made the point after its last call that the selloff was not justified, especially when its competitors either have higher bandwidth costs, or are straining to bundle CDNs with bandwidth sales.  Additionally, Limelight and Level 3 are nothing compared to the Cisco/AOL and Inktomi coalitions that tried to take on the company ten years ago.  Moreover, insiders bought 88,000 shares in August, a fairly uncommon occurrence with tech stocks, where there are frequent sales due to stock option awards.

With Akamai, Wall Street didn't just overreact, it failed to size up the competitive environment accurately.     While I'm sure there will be another drop next time revenue misses by a fraction of a percent, or some analyst downgrades the stock based on inaccurate assumptions, I'm sure those who held on throughout the summer are glad they did now.

Akamai: A Logical Takeover Target?

By David Gross

It's always interesting to see what Jim Cramer has to say about this industry.  Last year, he had his infamous rant about "Equinox", and he still seems to think this month's 2% guidance drop from Equinix means the whole industry is done.  Now, his latest idea is that Akamai is a logical takeover target.

In an article on TheStreet.com, Cramer claims that:

-Akamai Might be a Fit for HP Via 3Com.    Really?   3Com struggled to gain market share in Ethernet, which was a technology invented by its founder.   How well it could run a business where it presently has very little knowledge?

-Akamai Could Also Be a Fit for Cisco.  Cisco actually invested in Akamai in 1999, before developing an alliance to fight the company in 2000.  Moreover, it has been rumored to be building its own CDN service.  Nonetheless, Cisco does have an unmatched record in the networking business turning proprietary technologies into dominant products.   But that has never extended to services, and Cisco's track record in layer 4-7 technologies is mixed.   But the biggest problem with offering services like this is that it would put Cisco in competition with its customers, especially AT&T.   Additionally, it would create an awkward situation with Verizon, which currently resells Akamai.    Would make very little sense for Cisco to do this, although I'm sure it would make Juniper very happy.

-Limelight Does Not Have the "Scale" that Akamai Does.   More importantly, Limelight is spending twice as much per dollar of revenue than Akamai is on bandwidth.   While Akamai has withstood many attempts by carriers to bundle bandwidth services with CDNs, Limelight would benefit far more from a partner that could knock down its bandwidth costs than Akamai would.

Cramer knows this kind of speculation will get Wall Street pondering the possibilities, but if any of these deals with Akamai actually ever happened, there would be an overdiversified company that would make him want to throw another chair across his studio.

Rackspace, Equinix, Akamai, Savvis, Limelight All Near 52-Week Highs

Data center stocks have had a very strong quarter, with Rackspace (RAX), Equinix (EQIX), Akamai (AKAM), Limelight (LLNW), and Savvis (SVVS) all near 52-week highs. The REITs, however, have not shared in many of the recent gains, in spite of CoreSite's IPO last week. Digital Realty (DLR) is up just 1.4% over the last three months, while DuPont Fabros (DFT) has been essentially flat since the third quarter began.

Is this all justified? Rackspace is now trading at roughly 45x annualized earnings, on a top line growth rate in the low 20s, and a bottom line growth rate of 60% over the last 12 months. Equinix is just under 4x revenue on a 21% top line growth rate (excluding Switch & Data), and the company is barely breaking even. Savvis is up 37% over the last three months and hasn't had any top line growth over the last 12 months. While the industry's fundamentals remain very strong, there's not enough growth to support a 5x multiple on revenue.

Akamai Insiders Have Bought Nearly 88,000 Shares This Month

I've made the point in a few recent articles that Wall Street and many industry observers are overestimating the threat that Level 3 and Limelight pose to Akamai (AKAM), just as they overestimated Cisco, AOL, and Inktomi's threats to the company then years ago.

CDNs require large support organizations dedicated to the service, which makes it challenging to simply bundle them with bandwidth. This is why after all these years, Verizon is still reselling Akamai, not competing against it, and why the top two providers of this now decade+ old service are not telcos. Moreover, in Akamai's case, its bandwidth costs are just 16% of revenue, compared to 33% for Limelight (LLNW), a figure that is not declining significantly.

Insiders at Akamai have endorsed this view, and bought over 87,950 shares since the post-earnings call sell-off. The biggest purchase came last Wednesday from Director Peter Kight, who bought 47,950 shares at $41.70, CEO Paul Sagan bought 15,000 shares a week ago Wednesday, and Director David Kenny bought 25,000 shares at $38.78 on August 4th.

While AKAM is not cheap, the market continues to overestimate its competitors' strength, and the insiders are buying on the dips.

Cisco and AOL vs. Akamai

by David Gross

Exactly ten years ago in August 2000, industry leaders were concerned about Akamai's (AKAM) domination of the CDN business, and formed two separate coalitions to do something about it. Cisco (CSCO) created the "Content Alliance", which included most of the major business ISPs of the time, such as Cable & Wireless, Genuity and PSINet. AOL and Inktomi created the "Content Bridge". Akamai's chief competitor at the time, Digital Island, joined both groups.

The conventional wisdom among analysts and Wall Streeters was that Akamai wouldn't be able to stand the competitive threats, and with the world turning against the company, it would struggle to hold its market share, let alone survive. Moreover, Cisco wanted to take matters to the IETF, to neutralize the market value of Akamai's patents.

Akamai's biggest problem back then wasn't these content groups trying to destroy its business, but its own over-expansion. It didn't need any help from AOL or Cisco when it came to wrecking its balance sheet and income statement. And successive generations of competitors haven't stopped it from improving its financials. In 2000, the company spent 47% of its revenue on bandwidth and colo fees, in 2010, it spends 16%. In 2000, it produced 62 cents of revenue for every dollar of property, plant, and equipment on its books. In 2010, it produces five dollars of revenue for every dollar of PP&E.

The conventional wisdom chorus that fretted about Cisco and AOL ten years ago, is now worrying about Limelight (LLNW) and Level 3 (LVLT). Level 3's CDN business is the old Digital Island service, three owners later. While Akamai was in the process of growing fourfold between 2003 and 2009, the Digital Island CDN was being passed through the hands of Cable & Wireless, Savvis, and Level 3, which cut the growth of what would otherwise have been a much stronger competitor. Limelight did grow faster than Akamai last quarter, and is now 1/6th the size of its larger competitor. However, Limelight's network is far more centralized with 76 POPs compared to 1,200 for Akamai. While there are operational benefits to both approaches, Akamai's is far more cost effective, with its bandwidth and colo fees amounting to just 16% of revenue, compared to 33% for Limelight.

After ten years of worrying about Akamai's competition, investors would be better off finding the next company that will grow on the back of a major cost advantage, because no one who's competed directly against Akamai the last decade has developed one.

Internap Needs to Figure Out What Business It's In

Internap (INAP) reported yesterday that quarterly revenues had declined 6% year-over-year to $61 million. The drop was expected as the company is trying to transform itself from a reseller of other provider's assets to a facilities-based data center provider. As part of that initiative, it has committed to a $50 million capital program.

Financially, Internap looks like the anti-Level 3 (LVLT). It shares Level 3's broad product line, but historically it has taken a hit on its income statement for reselling services at low margins, while Level 3 has taken a hit on its balance sheet by building large networks. Internap has much lower debt/revenue and much higher revenue/PP&E than Level 3 as a result. But now Level 3 is cutting capex to shore up its balance sheet, while Internap is increasing capex to improve its income statement.

Internap has never been a typical reseller. It developed a proprietary algorithm for routing traffic across multiple networks, but then extended the marketing concept behind this strategy to become a reseller of a broad range of IP and hosting services. Not unlike most resellers, it has a fairly broad product catalog. But transforming itself to more of a facilities-based provider means more than building up the capital budget, because it will not get a reasonable return on assets as without growing market share substantially.

Offering IP services, colocation, managed hosting, and CDNs. Internap is like Level 3, Equinix (EQIX), Rackspace (RAX), and Akamai (AKAM) rolled into one company, but without the market leadership in any of these services. To date, this has made it a balance sheet strong, but income statement weak distributor of other company's assets. But as it now builds on its own, it has to do more than commit capital to data centers, it has to look at where it can develop some kind of cost advantage over its competitors, and that won't happen in all four services.

Unlike its larger competitors, Internap owns proprietary routing software - MIRO (Managed Internet Route Optimizer) - that tackles many of the latency problems associated with BGP. But there is no reason to limit this technology to just its own service. If makes more sense economically to spread MIRO's development costs to other companies by selling it to them directly, not as part of a monthly IP service where the market has demonstrated it will not pay much premium for a proprietary technology.

In the collocation market, Internap has long relied on locating at existing facilities built by companies like Equinix and Switch and Data (which is now part of Equinix). But as long as its selling IP services, it will never truly be carrier neutral, which has been a key selling point for Equinix's service. Moreover, a $50 million boost in capital investment is not going to be enough to match the billions Equinix and Telx have already invested. It will likely have to compete on price, which is unpleasant if you are reselling, but deadly if you're selling access to your own assets.

Instead of competing against Akamai, Equinix, and Rackspace, Internap really should be competing against someone like privately-held Packet Design, which is selling its proprietary routing software to large carriers and enterprises alike. Routing is still an expensive, high latency, but necessary long distance network function, and Packet Design has had success solving corporate customers pain points with Cisco's proprietary EIGRP, and carriers' challenges with BGP. I know Internap is not about to shut down its network and just start selling its software, but there is a unique technology sitting within the company that is being stifled by the requirement that no one else can have access to it.

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.

Equinix, F5, and Akamai - Growing More by Doing Less

by David Gross

I wrote last week that data center revenue continues to grow in spite of the economy. In particular, three companies from different segments of the data center market, Equinix (EQIX), F5 (FFIV), and Akamai (AKAM), have increased their top line over the last 12 months. However, in years past, I remember hearing how they were going to go away.

Equinix has grown 24% year-over-year as its data centers continue to fill up, and its lease rates continue to rise. But I remember in 2000 hearing how Equinix was not going to stick around a long time, because hosting leaders like Exodus, in addition to the telcos, would put it out of business, and that its service line was too thin. Ten years later, Exodus and many of the ISPs who were supposed to put Equinix out of business are now out of business themselves.

The benefits of a tight product focus have extended to the network equipment market, where Cisco (CSCO) did not have a strong presence in layer 4-7 switching market until it bought Arrowpoint at the top of the market in 2000. And I remember in 2000, the load balancer everyone raved about was not Arrowpoint's, or even F5's BIG-IP , but Foundry's ServerIron. The challenge for the ServerIron was not performance, customer acceptance, or market share, but its parent company's focus on the much larger Ethernet switch market. Today, F5 has twice the market cap of the merged Brocade (BRCD) and Foundry company.

As with F5, economic conditions did not prevent Akamai from reporting year-over-year growth of 12% last quarter. But the last recession did not go too well for the content distribution network provider. It lost its founder in the 9/11 attacks. In 2002, its revenue declined, and it posted an operating margin of minus 141%, which led Wall Street to classify it as another low margin telecom transport provider. The consensus thinking was the CDN market was too small to be important, and if it ever got big, a large carrier would come in and take it over. Yet as it recovered in the mid-2000s, Akamai wisely avoided any temptation to over-diversify. Eight years since bottoming out, the company has grown its top line sixfold, and is on the verge of crossing $1 billion in sales. However, much of its financial strength is not reflected in its income statement, but its balance sheet, where unlike virtually every telco, it has very little long-term debt.

Akamai's primary telco competitor is Level 3 (LVLT), which got into the CDN market by buying Savvis' (SVVS) old business, which got into the CDN market itself by acquiring the American assets of my former employer, Cable & Wireless, which got into CDNs by acquiring Digital Island. Level 3 has had some big wins recently, including mlb.com, but in addition to having to support a wide range of telecom services, it is weighed down by a significant debt load.

It is very easy to cave in to Wall Street pressure to boost top line numbers by making questionable R&D choices, or by entering a market where there is little chance of ever being the number one or two supplier. This pressure is often greatest when multiples are high, and executives start scrambling to justify a growing market cap. But by refusing to go on wild revenue chases when times were good, these three companies have increased sales when times have been bad.

Data Center Providers Hit Particularly Hard in Selloff

NASDAQ was down 3.85% today, but data center providers did even worse.   Some of the big decliners today included:

• Equinix (EQIX) down 4.66%
• Savvis (SVVS) down 5.33%
• Rackspace (RAX) down 5.33%
• Internap (INAP) down 8.97%
• Akamai (AKAM) down 8.59%
• Terramark (TRMK) down 5.99%

One company bucking today's trend was CDN provider Limelight Networks (LLNW), which finished up 3 cents.