Akamai (NASDAQ:AKAM) is scheduled to release its Q4 2013 results on February 5. The dominant CDN provider has done well in recent quarters, growing its revenues at an average rate of 18% in the last three quarters. This came mostly on the back of unexpectedly high growth in its traditional CDN business, which continues to benefit from consumers increasingly accessing 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 guidance, mostly on stronger-than-expected growth in media traffic and the deployment of a significant IP accelerator contract. The strong performance came about despite one of Akamai’s large media customers transitioning away in the first half of the year, as the impact was more than offset by solid demand for its performance and security value-added solutions (VAS). We expect the trend to have continued in Q4, bolstered by a strong holiday season for online sales and software downloads.
However, there are concerns surrounding Akamai’s CDN pricing levels, which have been declining due to rising competition and could face further downside pressure in the coming months as it renegotiates a contract with its largest media customer, widely rumored to be Apple. Excluding the impact of the ADS divestment, Akamai’s guidance for the fourth quarter suggests revenue growth of 15.5% y-o-y at the mid-point, which is a step down from the 18% growth rate reported for 2013 so far. Although the large media customer accounts for less than 10% of Akamai’s revenues, we expect the impact to be notable considering that the current contract pricing was set a few years ago. Our $45 price estimate for Akamai is in line with the current market price.
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Pricing Pressure Could Offset Online Traffic Growth
Almost all of Akamai’s verticals – Media & Entertainment, Commerce, High-Tech and Public Sector – have shown strong revenue growth in recent quarters. We estimate that most of Akamai’s value (over 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. Additionally, user demand for high-quality content, driven by new formats such as 4K and ulta-HD which require higher bit rates than normal, means that bandwidth requirements are likely to increase significantly in the coming years. According to the most recent Cisco VNI report, mobile data traffic is growing exponentially by almost 70% annually and is expected to grow 13-fold in the next five years. Akamai, which delivers 15-30% of all web traffic, stands to benefit hugely from this surge in online traffic.
It is worth noting 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, but also the diversity of Akamai’s customer base.
However, due to 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 consistently. This makes it necessary for Akamai to sustain strong traffic growth in the coming quarters in order to offset the impact of falling prices. The contract renewal with its largest media customer is significant in this context, as it could set a 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. It will therefore be interesting to know the extent to which Akamai’s revenues took a hit in Q4, if the renewal happened last quarter. However, if the renewal has been deferred to Q1, management guidance for the current quarter will be a key takeaway this earnings call.
Sustainable Growth In Near-term Gross Margins
Since delivery of large video files and software is costlier than smaller-sized content, the recent growth in online media streaming could have pressured gross margins in 2013. However, Akamai’s recent investments in its network have led to lower bandwidth and co-location costs, which has increased efficiency in its content delivery. This helped Akamai’s Q3 gross margins improve by over 200 basis points over the same period last year. The company’s guidance suggests a similar year-over-year increase in gross margins in Q4 as well.
Another factor 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 have recovered well from the lows of 2011, and we expect the recovery to continue in the near-term as VAS help offset most of the impact of the CDN pricing declines.
The strong performance of Akamai’s VAS portfolio, which has been bolstered by a spate of recent acquisitions such as Cotendo, Blaze and Verivue, 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 180 customers sign up for the offering, almost a quarter of which came in the third quarter itself. 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.