Akamai (NASDAQ:AKAM) is expected to release its Q1 2013 earnings on April 24. While last quarter was a decent one for the company, it did raise a few questions about the sustainability of the huge revenue growth that Akamai had come to see in the previous quarters. Compared to upwards of 20% y-o-y growth in revenues that Akamai had shown in Q2 and Q3 of last year, Q4 came in a tad slow at 17% despite being a seasonally strong quarter historically. Moreover, the company’s guidance for Q1 2013 was lower than what the markets expected with revenues projected to grow at only about 12% y-o-y at the midpoint of the guidance. As a result, Akamai’s stock has dipped more than 15% since the start of the year. This earnings call will therefore be very important in setting revenue expectations for the coming quarters as well as giving us an idea of the margin trends given that Akamai has been taking initiatives to manage its network more efficiently in recent quarters.
The company has been generating strong cash flows over the past year. In 2012, it managed to covert almost 40% of its revenues to cash despite completing two big acquisitions of Cotendo and Blaze. Taking into account the long-term growth trends of cloud computing, mobility and online video as well as the possibility of a near-term slowdown in revenues, we maintain our $36 price estimate for Akamai’s stock, about in line with the market price.
Demand for online content on the rise
In terms of revenue, almost all of Akamai’s verticals like media & entertainment, commerce, high-tech and public sector are growing impressively. Most of Akamai’s value at almost 80%, however, comes from the first two verticals, both of which are driven by strong traffic growth and demand for online video. An increasing number of users are accessing videos and other content from mobile devices such as smartphones and tablets. It therefore bodes well that Akamai launched its own mobile site accelerator Aquaua last year and has partnered with dominant mobile chipset manufacturer Qualcomm to speed up delivery of mobile content to devices sporting its Snapdragon chipsets. The CDN provider has also strengthened its relationship with the carriers by launching its AURA Network Solutions, which will help internet service providers offer their own CDN services using Akamai’s technology. We believe this will ensure that Akamai keeps its place within the last mile of networks and mitigates the threat from carriers looking to develop their own CDN solutions.
The growth in streaming of online video could however have an impact on margins since the delivery of larger size files is costlier than other content. This is why Akamai has been investing in its network to increase efficiency as is reflected in its gross margin increase of over 120 basis points last year. We will be looking at the gross margins this quarter as well as future guidance to see whether the efficiency initiatives will help sustain margin expansion in the coming quarters or not.
Growing importance of value-added services
What has also contributed to the gross margin improvement in recent quarters has been the increased adoption of value-added services. Value-added services (VAS) such as dynamic site acceleration (DSA), application acceleration, and front-end optimization (FEO) have higher margins than basic content delivery, which has been commoditized by the entry of multiple players in the industry. It is therefore a welcome sign that these services have grown in strength to account for almost 60% of Akamai’s total revenues, as of Q4 2012. As can be seen below, Akamai’s margins recovered in 2012 from the lows of the previous year, and we expect the recovery to continue in the coming years as CDN prices stabilize and VAS supports margins.
In this regard, the acquisitions of Cotendo, Blaze and other VAS providers will serve to bolster gross margins going forward. These acquisitions will not only reduce CDN pricing pressures but also allow Akamai to strengthen its value added portfolio 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 grab more wallet share of its customers as it upsells some of its other products. This may boost its average revenue per customer (ARPU) over time. (see Akamai’s Cotendo Deal Would Add Margin Upside & Growth to Current $35 Value)