Akamai Posts Strong Quarter But Pricing Concerns Remain, Maintaining $45 Price Estimate

Akamai (NASDAQ:AKAM) delivered strong Q3 results on October 23, beating the high-end of its revenue guidance on sustained growth in its media delivery business, which benefited from the big iOS7 launch towards the end of the quarter. Revenues for the quarter came in at $396 million, about 19% ahead of the same period last year when adjusted for the ADS divestment and foreign exchange headwinds. The outperformance was also driven by a strong 19% y-o-y growth in its value-added services business, which was helped by the recurring revenues from a new IP accelerator contract won last quarter as well as one-time gains from a managed CDN contract and the completion of a custom federal project. The strong top-line growth as well as the continuing efforts at driving network efficiency helped Akamai post stable EBITDA margins of 44%, which was at the top-end of its guidance.

Despite the strong Q3, Akamai’s shares fell more than 11% in trading Thursday on concerns that increasing competition could push down pricing levels as its largest media contract comes up for renewal in the coming months. Akamai’s guidance for Q4 suggests a 11% y-o-y growth in revenues at the mid-point, which is a step down from the mid-teens growth rate reported so far this year. Although the large media customer accounts for less than 10% of Akamai’s revenues currently, the company expects the impact to be notable considering that the current contract pricing was set a few years ago. We maintain our $45 price estimate for Akamai, about in line with the market price.

See our complete analysis for Akamai here

Pricing Pressure To Offset Online Traffic Surge

Almost all of Akamai’s verticals – Media & Entertainment, Commerce, High-Tech and Public sector – continued to show strong revenue growth. Most of Akamai’s value (>70%) 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. Increasing penetration of mobile devices such as smartphones and tablets has made shopping and accessing online content a lot easier. 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.

It is worth noting here that halfway through Q1, Akamai indicated that it would be winding down some media contracts which were not adding much value. The wind-downs continued in Q2 as well, with one large media customer fully transitioning its traffic away from Akamai. The fact that this has had little impact on results shows not only the fundamentals of the industry that Akamai operates in, but also the diversity of its customer base.

However, 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 high traffic growth in the coming quarters in order to offset the impact of falling prices. The upcoming contract renewal with its largest media customer is significant in this context, as it could set a tough precedent for the future. While mobile data traffic should continue to surge, pricing pressure from rivals means that Akamai could find it tough to maintain its historically high growth rates with the base rapidly rising every year.

Sustainable Growth In Near-Term Gross Margins

Since delivery of large video files and software is costlier than smaller-sized content, the growth in online media streaming could have pressured gross margins this year, However, Akamai’s recent investments in its network have led to lower bandwidth and co-location costs, which has increased the efficiency in its content delivery. This helped gross margins improve by over 200 basis points over the same period last year. The company has guided for a continued expansion of gross margins in Q4 as well.

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, 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 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 augment its core CDN business. The company is seeing success with its Aqua Ion app accelerator, which it launched last year. The performance of security, in particular, 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 700 customers sign up for the offering as of Q3, a 75% increase since the start of the year. Since both Kona and Ion are priced at a premium over the earlier flagship products, Akamai should see its ARPU levels rise as customers transition to the new products.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. CDN Pricing Stable: Survey Data Shows Pricing Down 15% This year, Dan Rayburn, September 12th, 2012 [↩]