Akamai Trades At A Lofty Valuation As Market Drools Over CDN Growth

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Akamai

As consumers increasingly access the web for streaming videos, shopping and playing online games, Akamai (NASDAQ:AKAM) is seeing an unexpectedly high growth in its traditional CDN business. Last quarter, the company beat its own guidance on both the revenues and margins front, mostly on the back of strong traffic growth in the media division. Akamai’s revenues for Q1 2013 were $368 million, a 18% jump over the prior-year quarter when adjusted for the recently completed divestment of ADS (Advertising Decision Solutions). The out-performance was driven by the media delivery business, which grew 4% sequentially despite the company winding down some of its less profitable media contracts during the quarter. On the other hand, the company’s higher-margin value-added services declined 3% sequentially over the seasonally strong holiday quarter.

See our complete analysis for Akamai stock here

The surprisingly high growth in the commoditized CDN business caused Akamai’s stock to jump almost 20% in trading on the day the earnings were released last month. Since then the stock is up another 10%, supported by the rally in the broader markets. While it is true that the company has guided for traffic growth, which had accelerated towards the end of last quarter, to continue into Q2 as well, it is tough to see if the company will be able to sustain it beyond that. The volatility in predicting traffic growth remains an issue with Akamai’s CDN business – something the company’s CEO highlighted at a JPMorgan conference earlier this month:

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Traffic prediction is an inexact science. Traffic levels can change based on the dates of software releases, how many apps you download into your cellular devices, how many games get distributed. I think we do a pretty good job of predicting the traffic, but it’s not perfect.

Unusually high traffic growth may just have been a one-time spike

The evidence of this near-term volatility could be seen in the Q4 2012 report as well when the company had disappointed the market by posting weaker-than-expected growth in revenues in what was supposed to be a seasonally strong quarter. The issue here is that due to high competition in the commoditized CDN business from the likes of Level 3 Communications, Limelight Networks, Edgecast and, more recently, Amazon, pricing levels in pure content delivery have been declining by 15-20% every year. [1] This makes it necessary for Akamai to sustain the high traffic growth in the coming quarters in order to offset the impact of falling prices. While the fundamentals of the industry that Akamai operates in remain solid, with mobile data traffic growing exponentially every year, Akamai may find it tough to maintain the historically high growth rates with the base rapidly increasing every year.

The recently released Cisco VNI report paints a very rosy picture of mobile data traffic in the coming years, predicting 66% CAGR over the next five years. However, the 2012 mobile data traffic figure of 0.9 exabytes per month (EBM) is about 30% lower than the previously estimated figure of 1.3 EBM for the year. [2] Where the report had previously estimated the mobile data traffic to reach about 11 EBM by 2016, it now expects the same to happen by 2017. The tempering of expectations may not be a sign of bearishness considering that Cisco still expects a growth rate of over 65% in the next few years, but it does show the risks attached to expecting very high data traffic growth rates in the coming years.

Aside from the data traffic volatility, another concern with Akamai is that demand for its newer value-added services (VAS) seem to be slowing down a bit. While Akamai started offering these cloud infrastructure solutions as a means to diversify its revenue streams toward higher margin products, they have grown in importance to account for more than half the company’s current revenues. It is therefore disappointing that the company had a weaker-than-expected holiday season last year in terms of online e-commerce traffic, and then followed it up with a 4% sequential decline in performance and security solutions last quarter.

While the near-term outperformance in the traditional CDN business has more than offset the weakness in VAS, it is concerning that the higher-margin business that has helped create a moat around the otherwise commoditized CDN business is facing headwinds.

Keeping these risks in mind, we have a $41.50 price estimate for Akamai’s stock, about 10% below the current market price.

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Notes:
  1. CDN Pricing Stable: Survey Data Shows Pricing Down 15% This year, Dan Rayburn, September 12th, 2012 []
  2. Cisco Mobile Data Traffic Report 2011, Cisco Mobile Data Traffic Report 2012 []