Akamai Price Estimate Revised To $54 On Strong Quarter And Near-Term Outlook

Akamai (NASDAQ:AKAM) released an extremely strong set of Q4 2013 figures, beating the high end of its guidance on both revenues and earnings. The company generated revenues of $436 million in the fourth quarter, about 20% higher than the prior-year quarter when adjusted for the ADS divestment. Net income of $0.55 came in at about 2 cents higher than the top-end of guidance. The outperformance was driven by a stronger-than-expected holiday season, as people increasingly took to the web for shopping, streaming videos, accessing social media, playing games and downloading software on newly purchased as well as existing mobile devices. As a result, the company saw increased media traffic growth and strong demand for its value-added services (VAS) such as security solutions and app accelerators. The strong revenue growth, as well as efforts to drive network efficiency, helped Akamai post gross margins of 78%, up almost 300 basis points over the same period the previous year. However, continued investments in sales and marketing saw EBITDA margins decline year-over-year by 2 percentage points to 44%, as Akamai explored opportunities to grow its business in value-added services and in international markets.

More than the guidance beat, what stood out for the company was its revenue guidance for Q1, given the backdrop of pricing concerns surrounding the renegotiation of a contract with its largest media customer. Akamai said that it expects revenues for the current quarter to be in the range of $426-442 million, which translates to flat sequential growth at the mid-point, despite headwinds from the contract renewal and weak seasonality. Given that the earlier contract pricing was set a few years ago, the revenue impact from the renegotiation is likely to be significant, but the company expects growth from other media contracts and performance and security solutions to more than offset any near-term impact. While the company declined to reveal any contract-related specifics, the Q1 guidance and management comments alleviate our concerns about the precedent that this sets for the future. Moreover, Akamai’s network scale and the fact that no customer accounts for more than 10% of its revenues mitigates the leverage that clients have in negotiating large-scale future deals.

We have increased our revenue estimates for 2014 as well as the coming years to incorporate the impact of the rising traffic volume and growing traction for Akamai’s value-added services, offset to a smaller extent by pricing declines in the near term. Our new $54 price estimate for Akamai is about 20% ahead of our previous estimate and in line with the current market price.

See our complete analysis for Akamai here

Strong Holiday Demand Across The Board

Akamai’s holiday quarter saw strong revenue growth across business verticals as well as geographies, despite some macroeconomic concerns in Southern Europe and emerging markets. While online sales saw the usual surge in traffic during the holiday season, even media and software traffic benefited from the launch of new mobile devices and games. We estimate that almost 75% of the company’s value is driven by e-commerce and media traffic, which continues to surge as mobile devices proliferate and demand for social media, video streaming and online gaming grows at a frenetic pace. Akamai’s media delivery business saw its revenues grow by 19% y-o-y and 10% sequentially.

In the coming years, we see an increasing proportion of online traffic being driven by international markets, which account for less than 30% of Akamai’s revenues currently. It is therefore a welcome sign that Akamai is making a majority of its investments in markets outside North America in a bid to capture this future growth in traffic. Akamai’s SG&A costs last year increased by 42% over the previous year, as it hired sales reps in new geographies and to up-sell its value-added solutions to the existing customer base.

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. With adoption of 4G LTE rising in developed markets and carriers in emerging markets such as China looking to transition to the new standard for wireless communication, mobile data usage is also set to surge. According to the 2013 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 huge surge in online traffic.

However, pure-play CDN is rapidly becoming commoditized, with increasing competition from rivals such as Level 3 Communications, Limelight Networks, Edgecast, and more recently, Amazon. This has heightened CDN pricing pressure in recent years. Akamai’s renegotiation with its largest media customer is important in this context for it could set a tough precedent for future deals. However, the company’s strong guidance for Q1, which accounts for the renewal impact, shows that the pricing concerns were somewhat overblown. Given that there are few players with the scale and reach of Akamai’s CDN, the company faces somewhat limited pricing pressure when it comes to large-scale content delivery. While we continue to expect Akamai to face increased pricing pressure due to rising competition in the long term, especially in smaller accounts, the scale of the estimated declines are lower than we previously forecast. While our long-term revenue estimate for Akamai is about 25% higher than our previous forecast, we expect the company’s revenue CAGR over the remaining part of the decade to slip to about 11% – down from the 18.5% annual growth posted in 2013.

VAS Mix To Support Gross Margins

Moreover, the fact that Akamai has been bolstering its performance and security value-added solutions through new service launches and acquisitions will help it grab a bigger wallet share of customers as well as mitigate the impact of CDN commoditization. These services, which have higher margins than content delivery, have grown to account for almost 60% of Akamai’s revenues in recent quarters. Akamai’s margins have also benefited from recent network investments, which have lowered bandwidth and co-location costs as well as increased efficiency in content delivery. As a result, Akamai’s gross 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.

However, the company has been splurging on hiring sales representatives, particularly in performance and security, to bolster its VAS revenues. This caused Akamai’s EBITDA margins in Q4 to decline by 2 percentage points over the same period the previous year to 44%. The company saw its sales team increase by about 40% over the past year. Over time, the company expects its margins to decline to the low-40s. However, we expect the impact of the margin decline to be more than offset by the bigger market that Akamai will be able to address in the coming years due to the sales ramp-up, not just in emerging markets but also in performance and security solutions.

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