Akamai Technologies (AKAM) has many secular winds at its back for growth, which include the migration to mobile devices and cloud computing. Yet, there are risks to the AKAM story. These risks along with a limit to catalysts for positive change in share price make the company's valuation seem lofty. The stock trades at approximately 22x forward earnings, well above the threshold of 15 we use to judge value and overvaluation. According to proprietary research done by The Oxen Group, AKAM is a HOLD with an implied value of roughly $34.00.
This target is below current prices and given some of the outlined risks AKAM could fall; however AKAM is not a short. The fundamental drivers and secular trends that make AKAM a strong company should keep stocks fairly strong. The company is simply a more prudent investment at lower prices - a HOLD
A portion of AKAM's business involves online shopping. AKAM provides a network (or a platform) that allows for timely transactions and quick fulfillment. This real-time data expedites the shopping process given its efficient network. AKAM sells the online Internet retailing space for nearly all the top e-commerce websites. While on the topic of website data, AKAM also helps businesses track content and data real time for web users. AKAM is a stealth way to play the online shopping revolution…a massive secular trend. Another secular trend that AKAM directly benefits from is the mobile device wave.
Work and play is exponentially gravitating more and more to mobile devices. This includes smart phones and tablets among others. AKAM helps enterprises reach their customers, partners, and employees on these devices in addition to regular personal computers. The need to properly manage this massive embracement from the public is playing into the hands of AKAM seamlessly. Streaming data and content is normally very cumbersome for networks and stressful for mobile devices, but AKAM is looking to relieve that problem with its superior technology.
Cloud companies tend to trade at a higher multiple than traditional tech. The recently released SKYY ETF (SKYY), which tracks the cloud computing industry, holds companies with on average a PE ratio at 33. AKAM trades at a discount to this average, but it lags some of the leaders in other important areas. Further, the entire sector as a whole has priced in significant future growth in a crowded space.
Outside the SKYY ETF, AKAM's peer group makes the company look just about average, adding to the hold thesis. The median forward PE of SKYY holdings is 20.1x. AKAM is about 22x making it a tad rich. Under the net margins category, AKAM is just between the average and the median (16.9% and 12.4% respectively) at 14%. It is also interesting that AKAM's return on equity (ROE) is below the average range of the S&P 500 (10%-15%) at 9.3%. In the category of bottom line EPS performance, AKAM has had the tendency to beat Wall Street expectations. Over the last six observations (quarters), AKAM has posted positive EPS results over the street's expectations. The average beat is 6.6% over the same sample. Overall, valuation for the company does seem quite rich. Yet, with all growth stocks, we ask the question of whether this future growth can be sustained or does it come into question.
What will keep AKAM moving forward? Thomson Leighton is a potential catalyst in either direction. He started 2013 as the new CEO and President of AKAM. Dr. Leighton is extremely qualified. Dr. Leighton was a co-founder of AKAM and has served as Akamai's Chief Scientist director since August 1998. Dr. Leighton has also been a professor of Mathematics at the Massachusetts Institute of Technology since 1982. New management always poses a threat to an established norm, good or bad. Shares are not a buy or sell off this news, but longs should keep an eye on their shares because a CEO change can create new opportunities as well as hurt future customers.
Additionally, what we look at for AKAM is will the company continue to grow at strong rates or will it be limited. We worry it will be limited. The problem for AKAM is that while the pie is very big in the cloud area it is getting cut by too many. The company appears better than most in that it has found stability in the growth of mobile and online shopping, but at the same time, the technology creates no economic moat.
Large companies often acquire tomorrow's growth stories and value opportunities. These small firms that are purchased are intended to preserve and grow the core business. FastSoft, Blaze, and Cotendo were recently purchased by AKAM and looking into what these firms do can give investors a clue into what AKAM plans to do in the future. How does the company stack up against its competition though?
AKAM's main competition is Rackspace (RAX), IBM (IBM), and Digital River (DRIV). All three companies work in the cloud services area with DRIV perhaps being one of the closest competitors with its online store application software. RAX and IBM provide significant cloud services, but in the end, what creates a moat for any of these companies. IBM has some moat due to its scale, long-standing business relationships, and solid hardware infrastructure. At the same time, in cloud technology, its all about execution. Looking at the four, one of the best ways to see moat is Return on Assets and margins. Let's compare the four. AKAM's operating margin is 22%, ROA is 8%, and ROE is 9%. IBM has an operating margin at 19%, ROA at 15%, and ROE at over 70%. Right away, we can see the moat that IBM has from its great execution. RAX has 13% OM, 9% ROA, and 15% ROE. Finally, DRIV has an OM at 4%, ROA at 1%, and ROE at 1%. AKAM is one of the market leaders in its space, but with such strong competition and the company showing no strength in key ROE/ROA metrics, we see little moat.
FastSoft was purchased with a goal of complementing Akamai's cloud infrastructure solutions with technology for optimizing the throughput of video and other digital content across IP networks. AKAM's buy-out of Blaze achieved the goal of complementing Akamai's site acceleration solutions with technology designed to optimize the speed at which a web pages are rendered. Akamai acquired Cotendo to push the pace of innovation in the areas of cloud and mobile optimization. These are all clues into what AKAM wants to preserve in the technology sector from competition. One could argue that AKAM is now growing inorganically, or by acquisition, but as long as AKAM puts up impressive returns on assets (in the neighborhood of 60%) AKAM will be in great shape. The M&A team has historically done a good job performance wise, this increases AKAM's barriers to entry and protects its precious gross margins.
While these acquisitions do give the company some economic moat, they do not create any type of technology or long-standing relationship that gives the company enough competitive advantage. The one moat the company does have is high switching costs for any company that has developed a mobile system with AKAM. Acquisitions create better scale in many cases, but if ROA suffers as a result, we will know that they did not create a moat. Rather, they were acquisitions to keep pace. That is similar to what Google (GOOG) did over the past ten years.
Revenue and EPS Outlook
AKAM specifically outlines in its SEC documents that it relies on the rate of traffic growth in its video and software download solutions for revenue growth. Additionally, AKAM has historically experienced seasonal variations of higher revenues in the fourth quarter of the year and lower revenues during the summer months. This is mainly a function of e-commerce services by retail customers…revenue trends are also important to identify.
In our scenario, a conservative look implies slowing operating income growth going out to 2015; 14% average growth with 2015 slowing to just under 9%. Growth naturally slows in the product cycle…especially in the technology sector. Should AKAM expand out to other more attractive areas of business, estimates would have to be adjusted. The $7B company says even in its SEC documents that it only operates in one segment…away from the sector's norm.
Price Target Analysis
The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices
Here is how to calculate price targets using discounted cash flow analysis:
(all figures in millions)
Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).
WACC for AKAM: 8.08%
PV Factor of WACC
PV of Available Cash Flow
* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.
For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.
Cap Rate for AKAM: 3.58%
Available Cash Flow
Divided by Cap Rate
Multiply by 2016 PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.
Divide equity value by shares outstanding:
In the end, we have found that AKAM is worth around $34, which we believe accurately reflects the company's five-year projections.
AKAM stated in its latest annual report that it believes the cost of revenues will continue to increase. It also expects to deploy more servers and to deliver more traffic on its networks, which could result in higher expenses associated with the increased traffic and co-location fees. Such costs are likely to be partially offset by lower bandwidth costs per unit and recent reports indicate that AKAM has cut costs in other places. Continued efforts like this could increase net income and EPS, leading to the stock moving upward without a pullback. The flip-side to this is a prolonged sell-off. AKAM recently made a low of $20.00 in late 2011; such a decline would scare most away.
AKAM has many things going for it, but without very strong continued growth and an increased moat, the stock is not exciting at these multiples. Major items of interest include gross margins and secular trends. Cloud and tech stocks are very risky and given the historic volatility of shares, accumulating AKAM on a pullback is a better idea than buying near highs given the fundamental picture.