Akamai (NASDAQ:AKAM) is expected to announce its Q3 2013 results on October 23. The company is seeing unexpectedly high growth in its traditional CDN business as consumers increasingly access the web to stream videos, access social media, shop and play online games. Last quarter, Akamai reported revenues and operating margins at the high-end of its guidance, mostly on strong traffic growth and faster than anticipated demand for its IP accelerator solutions. The strong performance came about despite one of Akamai’s large media customers transitioning away, as the impact was more than offset by a strong quarter for its performance and security value-added solutions (VAS). In addition to sustained strength in media delivery and VAS, software downloads are likely to bolster Akamai’s Q3 results given the highly enthusiastic response that followed Apple’s (NASDAQ:AAPL) iOS7 launch towards the end of the quarter.
We estimate that Akamai will generate revenues of about $10-11 million from the iOS7 upgrades – a substantial portion of which is likely to have been realized in Q3 itself. However, considering the overall size of Akamai’s business, the yearly iOS upgrade ritual doesn’t seem to add a lot of value when looked at from an annual context. Not only is the revenue contribution small for a company whose annual revenues are on course to exceeding $1.5 billion this year, but the margins associated with the delivery of 750MB-1GB iOS updates are likely to be low as well. Our price estimate of $45 for Akamai is about 10% lower than the current market price.
Volatile Online Traffic
Revenue-wise, almost all of Akamai’s verticals, Media & Entertainment, Commerce, High-Tech and Public sector, have performed strongly this year. Most of Akamai’s value (>70%), however, comes from the former two verticals, both of which are driven by web traffic growth and demand for online video. Internet traffic continues to surge, as social media, video streaming and online gaming grow at a frenetic pace. An increasing number of users are also accessing videos and other content from mobile devices such as smartphones and tablets. As a result, mobile data traffic is growing exponentially by almost 70% every year and is expected to grow 13-fold in the next five years, according to the most recent Cisco VNI report. Akamai, which delivers 15-30% of all web traffic, stands to benefit hugely from this surge in online traffic.
However, predicting traffic volume is an inexact science, and near-term growth could therefore be lumpy and volatile depending on the timing of software and online game releases as well as app downloads by consumers. The evidence of this near-term volatility was seen in Q4 2012 when the company disappointed the markets by posting weaker-than-expected growth in revenues in what was supposed to be a seasonally strong quarter. This was followed by two quarters of strong traffic growth despite the wind-down one of its media contracts.
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.  This makes it necessary for Akamai to sustain 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 rapidly every year, Akamai may find it tough to maintain the historically high growth rates with the base rapidly rising every year.
Given the increasing business coming from the traditional CDN side, we will be interested in seeing how the Q3 margins hold up in the face of a rising number of big-sized media and software downloads that is costlier to deliver than other content. Akamai has been investing in its network to drive efficiency in content delivery, which has helped its gross margins improve in recent quarters and could offset some of the impact from the higher mix of big-sized file delivery going forward.
What has also contributed to the gross margin improvement in recent times has been the increased adoption of value-added services. Value-added services (VAS) such as dynamic site acceleration (DSA), application acceleration, front-end optimization (FEO) and security solutions have higher margins than basic content delivery, which has been commoditized by the entry of many players in the industry. It is therefore a welcome sign that these services have grown in strength to account for almost 60% of total revenues. 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 somewhat and VAS supports margins.
The strong performance of Akamai’s VAS portfolio, which has been bolstered by the spate of recent acquisitions such as Cotendo and Blaze, is helping it not only augment its core CDN business but also grab more wallet share of customers. The performance of security this quarter points to a recently added value-added service that is adding to the company’s growth. Akamai launched its Kona Site Defender security solutions last year and has already seen as many as 650 customers sign up for the offering, as of Q2. This is a 30% increase over the previous quarter. As a result, the company is also seeing ARPU levels improve since Kona has a comparatively higher ARPU than some of the other security solutions.Notes:
- CDN Pricing Stable: Survey Data Shows Pricing Down 15% This year, Dan Rayburn, September 12th, 2012 [↩]