Akamai (NASDAQ:AKAM) plans to announce its Q2 2012 earnings on July 25. Last quarter was good for Akamai in terms of top-line growth as the company blew away its own revenue guidance. However, the earnings didn’t match revenue growth, falling 15% over Q1 2011 on higher taxes and other one-time costs related to the acquisitions of Cotendo and Blaze completed during the quarter. While we expect the acquisition-related costs to continue to impact the earnings in the near term, offsetting any revenue gains from the acquisitions, we expect the acquisitions to bolster the company’s higher margin value-added offerings and have a positive impact on its gross margins in the long run.
Importance of value-added services
Growing competition from rivals such as Limelight Networks (NASDAQ:LLNW), Edgecast, Level 3 (NASDAQ:LVLT), Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG) has had an adverse impact on the company’s core CDN margins. As shown below, Akamai’s margins have trended down over the past couple of years under the weight of pricing pressures as CDN offerings were commoditized.
However, the decline could have been more pronounced if Akamai hadn’t started offering value-added services (VAS) to counter the growing competition. While competition continued to eat away at its core business margins, it was able to offset those losses with higher margins on value-added offerings. These services also served to bolster its product portfolio and have over the years grown in importance, not just as a pricing hedge, but also as a growing source of revenue. Value-added services accounted for about 57% of total revenues in Q1 2012.
Acquisitions to bolster margins
A sustained growth in value-added offerings has helped Akamai stem a sequential decline in gross margins for two quarters in a row now. Akamai’s gross margins last quarter and the quarter before improved sequentially by 300 and 200 basis points, respectively, mainly due to strong top-line growth and strength in its value-added portfolio. It will be interesting to see whether the company manages to sustain that increase this quarter or not.
In either case, the two acquisitions of Cotendo and Blaze completed during the March quarter should bolster the company’s margins in coming years. Both these acquisitions will not only reduce CDN pricing pressures, but also allow Akamai to strengthen its value added portfolio with their respective DSA and FEO offerings and help it gain share within the broader CDN market. Having a strong value-added service portfolio to augment its core CDN business will enable it to price its combined services at a higher price point, which will boost its average revenue per customer (ARPU) over time. (See Akamai’s Cotendo Deal Would Add Margin Upside & Growth to Current $33 Value)
However, in the near term, Akamai’s operating expenses associated with the twin acquisitions will continue to mount, taking a toll on its net income. Akamai has even guided for a higher tax impact for the full year compared to its earlier guidance as a result of the acquisitions. Our DCF model for Akamai takes into account the near-term negative impact on operating income and the long-term positive impact on gross margins to arrive at a price estimate of $35 for the stock, which is about 17% ahead of the market price.