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.
Showing posts with label LVLT. Show all posts
Showing posts with label LVLT. Show all posts
Monday, August 9, 2010
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.
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.
Tuesday, July 6, 2010
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.
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.
Subscribe to:
Posts (Atom)