Akamai Spending a Concern While Competition Mounts

In Akamai’s (NASDAQ:AKAM) latest earnings report, we observed a pickup in capital expenditures related to the company building out its servers in anticipation of more business activity.  However, as new competitors such as AT&T (NYSE:T), Level 3 Communications (NASDAQ:LVLT) and Limelight (NASDAQ:LLNW) enter the fray, we worry Akamai will have some competitive margin compression and, at the same time, continue with significant capital outlays to stay ahead of competition, resulting in a double-hit to Akamai cash flows and the $31 Trefis price estimate for Akamai’s stock.

If investment stays at current levels rather than decline as we estimate, this would take 10% off of our current estimates.  Additionally, lower gross margins on its Online Shopping and Media Delivery from competition could subtract another 7-10%.

Potential Lower Pricing, Higher Spending Combo

We recently wrote that AT&T’s Cotendo deal signaled its intentions to offer services like dynamic site acceleration (DSA) and application acceleration that Akamai has long dominated.  These services consists of servers and software that help deliver content like videos and online transaction information faster to clients like ESPN, Hulu or Amazon.com (NASDAQ:AMZN).

Given AT&T’s scale in the enterprise market, it possesses the size to challenge Akamai on a larger scale, as this business grows and has existing relationships with many of Akamai’s customers. Newer entrants such as Limelight Networks and Level 3 Communications are targeting the booming area of online video.

For Akamai, we expect 2010 capital expenditures to be around 23% of gross profits, compared to only 15% for 2009 ^[1]. These current investment levels (as % of gross profits) are notably higher then historical average witnessed in past five years as evidenced in the chart below.

Recent quarters have confirmed a broad based acceleration across its two main business, Media Content Delivery and Online Shopping Content Delivery, which combined make up about 45% of the company’s overall value.  These two businesses carry high gross margins — 90% for Online Shopping Content Delivery and 75% for Media Content Delivery — which will inevitably fall in a more price competitive environment.

While we currently forecast these gross margins to remain largely stable, a 10 percentage point drop in margin for Shopping and 5 percentage point drop in Media equate to a 7% lower Trefis price estimate for Akamai’s stock.

While we have not factored this in to our price estimate yet, we recognize the combined higher spend, lower margin threat a large competitor like AT&T presents, which could spell problems for Akamai in the longer term.

You can see the complete $31.11 Trefis price estimate for Akamai’s stock here.

1. Calculated based on information available in Akamai’s SEC filings [↩]