Akamai Technologies Management Discusses Q4 2012 Results - Earnings Call Transcript

 |  About: Akamai Technologies, Inc. (AKAM)
by: SA Transcripts


Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Akamai Technologies Earnings Conference Call. My name is Darcel, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Ms. Natalie Temple. Please proceed.

Natalie Temple

Good afternoon, and thank you for joining Akamai's investor conference call to discuss our fourth quarter and full year 2012 financial results. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Jim Benson, Akamai's Chief Financial Officer.

Before we get started, please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements.

Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on February 6, 2013. Akamai disclaims any obligation to update these statements to reflect future events or circumstances.

As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the News & Events portion of the Investor Relations section of our website.

Now let me turn the call over to Tom.

F. Thomson Leighton

Thanks, Natalie, and thank you, all, for joining us today. I am delighted to be speaking to you as Akamai's new CEO, and I'd like to begin by thanking Paul Sagan for his leadership and many contributions to the success of Akamai during the past 14 years. The transition has been going well, and I look forward to continuing to work closely with Paul in his new role as Executive Vice Chair of the Board.

Now on to our results. Akamai posted record revenue and record earnings in Q4, and our strong results in the quarter capped off a full year of excellent performance in 2012.

Fourth quarter revenue was $378 million, a 17% year-over-year increase and a 9% increase over the third quarter of 2012. As you know, our fourth quarter revenue can vary depending on the strength of our e-commerce holiday traffic, which was strong this year but not as strong as the record levels we saw last year.

Normalized EPS for the fourth quarter was $0.54, of which $0.04 was from a favorable change in tax rates, which Jim will discuss further in a few minutes. Without the tax change, normalized EPS would have been $0.50, up 11% from Q4 of last year and up 16%, sequentially.

For the full year, we grew revenue to over $1.37 billion, up 19% over 2011. We generated normalized EPS of $1.81, also an increase of 19% over 2011. And we continue to generate strong cash flow, with full year cash from operations of $530 million.

Beyond the record revenue and earnings, 2012 was a strong year for Akamai in other respects. We introduced new products in each of our solution lines. We completed 4 acquisitions to accelerate the company's longer term growth. And after placing a major emphasis on driving efficiencies in our network operations, we improved margins in our core CDN business for the first time in several years.

These were clearly impressive results, but I'm even more excited about the opportunity that lies ahead. My excitement stems in part from our belief that the primary forces that are shaping the future of the Internet are very closely aligned with Akamai's core strengths. For example, the rapid growth of media over IP, the proliferation of new and more powerful mobile devices, the urgent need to defend against evermore powerful cyber attacks and the shift to business online as enterprises move to the cloud are all driving business to the Akamai platform.

Taken together, these mega trends have the potential to create significant growth opportunities for Akamai over the next 3 to 5 years.

So that you can better understand these opportunities, I would like to say a few words about how I view our business and the kinds of investments that we are making to drive the next phase of our growth. Of course, we'll say a lot more about these subjects at our Investor Summit on March 11 in Cambridge, where we'll have the time to provide a deeper view into the financial aspects of our various businesses.

In the past, we've talked about our business as having 2 broad product categories: content delivery and cloud infrastructure solutions. Roughly speaking, the content delivery category consisted of services for storing and delivering content, such as pictures or videos, and the cloud category comprised everything else.

For consistency, we will continue to report on the split of our revenue between these 2 categories. But going forward, we will also talk about the company in a more granular way. Specifically, we will talk about our 2 largest and most firmly established businesses, media delivery and web performance; as well as 3 smaller relatively new businesses, web security, network operator solutions and hybrid cloud optimization. I think of all of these businesses as being cloud businesses. And I want to say a few words about each of them today, starting with our media delivery business.

Our success in the media delivery business is determined by how fast the volume of traffic increases, our cost for delivering the traffic and the pricing that we can command in a highly competitive marketplace.

Our quarterly revenue and margins can also vary as we renew customers at lower price points or we refuse to pursue deals that we deem to be unprofitable or of little strategic value. Over the long term, I'm enthusiastic about the potential for profitable growth in the media delivery business. That's because of our proven ability to reduce our cost of serving video traffic and because of the potential for a large increase in the amount of video traffic that can move online.

If the industry were to reach a point where a significant portion of video is consumed over IP and if this video were to be delivered at true HD bit rates, then the volume of video traffic could increase by a factor of 100 or more from today's levels. To capitalize on this potential opportunity, Akamai will continue to invest in our Sola Media Solutions in 2013.

We will focus our efforts on growing network capacity, reducing network cost, improving quality and making the Akamai Intelligent Platform more user-friendly. By providing high-quality video at great scale and reduced cost, our goal is to continue to be the video distribution partner of choice for leading media brands, such as Apple, Sony BMG, News Corp., Nintendo and NBC.

In contrast with our media delivery business, Akamai's web performance business is less about traffic and more about enhancing the performance of mission-critical sites and applications. As many of you know, when it comes to Internet applications, performance matters, and Akamai has always been the leader in performance. That is why so many of the top brands on the Internet, retailers like eBay, Rakuten, Zappos and Ticketmaster, and enterprises like Morgan Stanley, FedEx, Boeing and Standard Chartered Bank, use our web performance services.

But we believe we can do even more in this area, going forward, particularly outside North America. We see 2 significant mechanisms are driving growth in our web performance business.

First, we are increasing our sales capacity and supporting go-to-market functions. In the short term, this sales investment shows up as OpEx, and it lowers EBITDA. But over the longer term, it will fuel further growth in this very profitable business.

Second, we are allocating resources to improve the performance of our services. Our ultimate goal is to provide nearly instant response times for applications and web pages, even for mobile devices, which today often suffer from painfully slow performance.

As I mentioned earlier, Akamai has 3 emerging businesses: web security, network operator solutions and hybrid cloud optimization. Among these newer focus areas, you've heard the most about security. Last February, we introduced Kona Site Defender. This web security solution is designed to leverage our global distributor platform to defend a website or application against a large-scale DoS attack without sacrificing performance, something that we believe solutions offered by other companies can't do.

Kona Site Defender was critical to the defense of some leading U.S. financial institutions as they battled the operation [indiscernible] attacks over the last several months. Despite the large volumes of these attacks, upwards of 65 gigabits per second in some cases, Kona Site Defender kept our customer sites accessible and performing well.

To best defend against such large-scale attacks, we believe that you need the capacity and distributed architecture that is unique to the Akamai platform. In 2013, Akamai will continue to increase investment in our security solutions, with a focus on extending our protective capabilities and in making our product easier to deploy and more channel-friendly for key partners.

Our second emerging business is focused on solutions that we sell to major carriers, such as our AURA Network Solutions. These solutions are designed to help operators reduce cost, improved performance and create new revenue streams by offering their own CDN services based on Akamai technology.

In addition to generating revenue, we believe that having a deeper relationship with carriers can benefit Akamai over the longer term by reducing our CapEx, co-location and bandwidth cost as we leverage the carriers' infrastructure, by improving performance for our customers as we deploy our software even deeper into the last mile networks and by improving sales capacity and efficiency by extending our channel relationships.

We have already made positive inroads with major networks as witnessed by the recent announcements with AT&T and Orange. And we believe that our acquisition of Veraview in December will accelerate our time-to-market with a license component of our operator CDN solution.

Third, I'd like to talk about a new opportunity that we see in helping enterprises take advantage of hybrid cloud computing strategies. For nearly 15 years, Akamai has excelled at improving performance for websites and applications delivered over the public Internet, outside the corporate firewall.

Our goal going forward is to extend our services to reach behind the enterprise firewall, applying our acceleration security and offload capabilities to applications wherever they reside and however they are accessed. Such a capability is rapidly increasing -- becoming increasingly important to enterprises as their applications move into the cloud and as their employees need to access those applications from mobile devices and locations outside the corporate headquarters.

Capitalizing on the opportunities that I have described today will require investment. In this context, it is -- I think it is important to understand 3 things: First, our 3 emerging businesses are highly synergistic with each other and with our core media delivery and web performance businesses. And so they all benefit from the common technology base in an economy of scale associated with the Akamai Intelligent Platform.

Second, we believe that the proven capabilities of our platform, combined with our ability to innovate, puts Akamai in an excellent position to be able to offer unique, compelling and highly profitable services in important adjacent markets.

Third, we will continue to keep a close eye on overall expense and to carefully track performance. If an initiative is not proving to have a desired synergy or potential for future profit, then we will have the discipline to terminate that initiative. As an example, we've recently announced the sale of our Advertising Decision Solutions business to MediaMath. As our ADS business grew and as the online advertising industry evolved, it became clear that the potential for our ADS business could best be realized outside of Akamai and through a partnership with MediaMath. And so we divested that business, thereby freeing up operating expenses for more promising areas that we believe will be more synergistic and profitable for Akamai in the future.

In summary, 2012 was an excellent year for Akamai, and I am very excited by the opportunities that lie ahead. In 2013, we plan to continue to innovate and to make the disciplined investments needed to fuel our long-term growth.

Jim will now review our 2012 results in detail and look ahead to the start of 2013. Jim?

James Benson

Thank you, Tom. As Tom mentioned earlier, our business performed well in the fourth quarter, capping off a very strong 2012.

We grew revenue $33 million sequentially and 17% year-over-year to $378 million in the fourth quarter, coming in just shy of the midpoint of our guidance range. I mentioned on our last call that the online holiday shopping season will play a large role on where we would land relative to our fourth quarter guidance. And while we had a solid e-commerce season, it was not as strong as the record growth we saw last year.

During the quarter, we grew our content delivery solutions revenue 11% year-over-year and 5% sequentially, solid growth when you consider the timing impact of the significant Q3 software releases we discussed in our last call, releases that historically took place and benefited Q4 growth.

Our cloud infrastructure solutions grew 20% year-over-year and 12% sequentially in the fourth quarter. We are particularly pleased with the great traction and demand for our security solutions, with more than 5x year-over-year revenue growth in the fourth quarter, and we had more than 400 customers leveraging at least one of our security offerings at year end. For the quarter, total cloud infrastructure solutions comprised 60% of our total revenue.

Turning to our key industry verticals. Enterprise was our fastest-growing vertical, with revenue up 28% year-over-year and 11% sequentially, as our customers shifted more applications to the cloud and we saw increased demand for our optimization performance in security solutions.

Our commerce vertical increased 17% over Q4 of last year and 21%, sequentially. We continue to see strong growth in our flagship website acceleration solutions, as well as continued traction with our security solutions.

Revenue from our Media & Entertainment vertical grew 15% year-over-year and 6% sequentially. This is particularly strong growth when you consider the timing of the significant Q3 software releases I just mentioned.

High tech revenue grew 13% compared to Q4 of last year and 6% sequentially. Growth in the quarter was driven by solid software download volumes and Software-as-a-Service customers adopting more of our cloud infrastructure solutions.

And finally, Public Sector revenue grew 14% year-over-year but was down 6% from a very strong Q3, due to the timing of several large custom government projects that were completed in the third quarter.

Turning to our geographies. Sales from outside North America represented 29% of total revenue in Q4, consistent with the prior quarter and up 1 point from the prior year. International revenue grew 22% year-over-year and 10% sequentially in Q4.

Foreign exchange provided roughly a $1 million benefit on a sequential basis in the quarter. This benefit was lower than our guidance expectations by about $1 million. On a year-over-year basis, foreign exchange had a negative impact of about $1 million.

Excluding the impact of currency, revenue growth outside North America grew 23% year-over-year and 9% sequentially. Revenue from North America grew 15% year-over-year in the quarter and was up 9% sequentially. Resellers represented 23% of total revenue in the quarter, up 1 point from last quarter as we expanded our partner ecosystem in new markets.

Turning to costs. We were extremely pleased with our continued execution on managing cost of goods sold and gross margins in the quarter. Our cash gross margin for the quarter was 82%, up 1 point from the last quarter and up 3 points from the same period last year and at the high end of our guidance range. GAAP gross margin, which includes both depreciation and stock-based compensation, was 70% for the quarter, up 2 points sequentially and from the same period last year. We've continued to find ways to make our network even more efficient while taking advantage of our scale. These are critical factors in our ability to deliver gross margins at these levels.

GAAP operating expenses were $170 million in the fourth quarter. These GAAP numbers include depreciation, amortization of intangible assets and stock-based compensation. Excluding noncash charges, our operating expenses for the quarter were $137 million, up $15 million from Q3, up 26% on a year-over-year basis and in line with our expectations for the quarter.

Adjusted EBITDA for the fourth quarter was $173 million. That's up 17% from the same period last year and up 11% from Q3 levels. Our adjusted EBITDA margin came in at 46%, better than our guidance due to our higher gross margins in the quarter. This level was consistent with the same period last year and up 1 point from the prior quarter.

For the fourth quarter, total depreciation and amortization was $55 million. These charges include $44 million of network-related depreciation, $6 million of G&A depreciation and $5 million of amortization of intangible assets.

Net interest income for the fourth quarter was $1.6 million, roughly flat with Q3 levels.

Moving on to earnings. GAAP net income for the quarter was $68 million or $0.38 of earnings per diluted share. As a reminder, our GAAP net income includes $23 million of stock-based compensation, including amortization of capitalized equity-based compensation and $5 million from amortization of acquired intangible assets.

Taxes included in our GAAP and normalized earnings were $29 million, based on a full year GAAP tax rate of 36.6%, but driving a 30% tax rate for the fourth quarter. As Tom mentioned earlier, this tax rate is more favorable than our 39% full year guidance range, due primarily to higher foreign earnings as a result of a full year tax adjustment to our global cost-sharing model.

Specifically, we adjusted the way we share our R&D costs across our subsidiaries. Including these tax charges, our normalized net income for the fourth quarter was $98 million. That translates to $0.54 per diluted share on a normalized basis, up $0.09 from Q4 of last year, up $0.11 from Q3 levels and coming in $0.04 above the high end of our guidance range.

The favorable tax rate contributed to $0.04 of this overachievement.

Our weighted average diluted share count for the fourth quarter was 182 million shares.

With our solid fourth quarter results, we finished the year with $1.37 billion in revenue, an increase of 19% over 2011. Full year GAAP gross margin came in at 69%, up 1 point from 2011. Cash gross margin was 81%, up 2 points from the prior year.

We are extremely pleased with our margin expansion this past year. Our improvements in this area are a direct result of the work by our engineering and network teams to implement a number of hardware and software initiatives to manage our global network more efficiently, and we believe we can maintain our momentum in scaling the network going forward.

Full year GAAP operating expenses were $628 million. These GAAP numbers include depreciation, amortization of intangible assets and stock-based compensation. Excluding these noncash charges, operating expenses for the full year were $493 million, up 25% on a year-over-year basis.

As we discussed throughout 2012, we are committed to pursuing the exciting opportunities in front of us. Last year, we invested both organically and through M&A, taking steps to increase the pace of innovation and accelerate growth. We hired over 700 employees across the company, focused primarily in additional engineering resources, service and customer support staffing and network efficiency scaling. We also began to ramp sales and supporting go-to-market capacity and expect to further ramp hiring in this area in 2013.

Full year adjusted EBITDA was $615 million, up 17% from 2011. And full year adjusted EBITDA margin was 45%, consistent with the prior year.

GAAP net income was $204 million or $1.12 of earnings per diluted share for 2012. This GAAP net income included $98 million of stock-based compensation expense, including amortization of capitalized equity-based compensation and $21 million of amortization of intangible assets. Excluding these items, our normalized net income for the year was $329 million or $1.81 of earnings per diluted share. That's up 16% from 2011. This number includes a full year GAAP tax charge of $118 million based on a full year GAAP tax rate of 36.6%.

Now let me review some balance sheet items. Cash generation was very strong. Cash from operations for the fourth quarter was $147 million. And for the full year, we generated $530 million of cash from operations or 39% of revenue. At the end of Q4, we had over $1 billion in cash, cash equivalents and marketable securities on the balance sheet.

Capital expenditures in Q4, excluding equity compensation, were $61 million. For the full year, capital expenditures were $220 million or 16% of revenues, in line with our expectations heading into the year. This number includes both investments in the network, as well as capitalized software development, facilities and IT.

During the quarter, we spent $30 million on share repurchases, buying back about 800,000 shares at an average price of $37.50. For the full year, we spent $141 million, buying back over 4 million shares at an average price of $32.50. We are also pleased to announce that our board has authorized an extension of our share repurchase program, authorizing an additional $150 million over the next 12 months, effective February 1. As with our existing program, we intend to fund it out of our cash generation, with a primary goal to offset dilution from ongoing equity grants.

Finally, days sales outstanding for the quarter was 55 days.

With a solid Q4 and a very strong 2012, we are optimistic about our long-term growth potential. We continue to see strong demand for both our content delivery and our cloud infrastructure solutions. We believe that we are executing well in our management of cost of goods sold and expect that to continue. We are also committed to making the investments to deliver near-term performance for the business and to drive Akamai's growth beyond 2013.

Before I get into guidance for the first quarter, I wanted to address 3 items that will be factored into our future results: First, and as Tom alluded to earlier, we announced on January 24 that MediaMath acquired our Advertising Decision Solutions business, which we call ADS. Given the timing of the divestiture, our Q1 guidance will include roughly 1 month of the ADS business. To help you understand the impact of the ADS divestiture to our previously reported 2012 results, a detailed breakout of the ADS business can be found on the Investor Relations section of our website.

Second, our Q1 guidance will include a full quarter of the Veraview business. This business will have virtually no impact to the top line but will add roughly $3 million of operating expense in the quarter.

And third, it has become clear that the expected average useful life of our network servers is actually closer to 4 years rather than the current 3-year depreciation convention, due to the software and hardware initiatives we have undertaken to manage our global network more efficiently. Effective Q1, we plan to extend the useful life depreciation methodology of our network assets by approximately 1 year. This will result in less network depreciation recorded in Q1 2013 as we distribute the depreciation expense over a longer period of time.

This change in methodology will impact both existing network equipment on our books as of December end and future network purchases. A supplemental table highlighting the impact of this change on our existing assets can also be found on the Investor Relations section of our website.

Now on to guidance. We are expecting Q1 revenues of $352 million to $362 million. This range represents 13% to 16% year-over-year growth adjusted for the ADS divestiture. The expected deceleration versus Q4 growth of 17% is due to the following: First, as Tom mentioned, we are continuing our selective approach to the management of our media delivery business, and we will be winding down some contracts with a few media accounts in the first quarter that are not of long-term economic value.

Second, we anticipate more difficult comparisons in our cloud solution growth rates, partially due to the wraparound effect of the Cotendo acquisition, which we closed in March -- last March.

And third, we expect that foreign exchange will be a headwind in Q1, with expected negative sequential impact of about $1 million based on current spot rates.

We expect first quarter cash gross margins of roughly 82%, up 3 points year-over-year and consistent with the Q4 levels. We expect GAAP gross margins of roughly 73%. Included in our GAAP gross margin guidance is a roughly 4-point favorable impact to depreciation as a result of the change in our estimated useful lives of existing assets as of December 31 and new assets acquired during Q1.

Q1 operating expenses are projected to be up about $4 million from Q4 levels. This increase is driven primarily by a full quarter of Veraview and continued headcount investments focused in sales capacity, building out some of our new partnerships and in some of the R&D areas outlined by Tom. As a result, we expect adjusted EBITDA margins to be in the range of 42% to 43% for Q1. And we expect to continue to accelerate investment, likely yielding an EBITDA margin in the low 40s for the next several quarters.

At this level of revenue, we expect to see normalized EPS in the range of $0.50 to $0.52 for the quarter. This EPS guidance includes taxes of $26 million to $29 million based on an estimated full year GAAP tax rate of 34% to 35% and a quarterly tax rate of approximately 31%. The driver of the lower Q1 tax rate is the full impact of the reinstated 2012 federal R&D tax credit in Q1.

This guidance also reflects a fully diluted share count of roughly 181 million shares.

On CapEx, we expect to spend about $65 million to $70 million in the quarter, excluding equity compensation. This reflects our desire to stay ahead of the growth we expect on the network and, more specifically, the impact of increased capitalized software and facility build-out investments to support the headcount growth in the business.

Overall, we are pleased with the performance of the business, and we remain optimistic about our growth potential. We look forward to having an opportunity to go into more details with you about the business and the future trends in the industry at our upcoming Investor Summit in Cambridge on March 11.

Now Tom and I will take your questions. Operator, the first question, please?

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Mark Kelleher with Dougherty & Company.

Mark Kelleher - Dougherty & Company LLC, Research Division

I was just wondering if you could go into some more detail on the accounting change. Did you say -- first, just a clarification, did you say 4 points of gross margin effect to that? And if that's right, can you kind of give us an apples-to-apples on the -- what the EPS guidance would be without that change of accounting?

James Benson

Sure. Let me clarify again kind of what we're doing here. So as we talked about over the last year, we've made tremendous progress on improving the hardware and software initiatives and implementing a bunch of hardware and software initiatives to actually manage our network more efficiently. We're actually getting more utility out of our servers. We've been watching that over a period of time. And actually, the useful life of our servers on the network is actually more in the range of 4 years than the current 3-year depreciation convention. That's why we're making the change because we believe we're going to be able to have these assets on the network for a longer period of time. And to your point or question around the impact, yes, it has about a 4-point impact on GAAP gross margins. So think of that as, if you look at the Investor Relations section of our website, that's about $14 million for the quarter. We actually provided what the impact is for the year as well. And if you look at that impact on an EPS basis, because you have to tax effect that, and so when you tax effect that, the EPS impact or benefit in the first quarter is about $0.05.


And your next question comes from the line of Bob (sic) [Scott] Kessler with SP Capital IQ.

Scott H. Kessler - S&P Equity Research

It's Scott Kessler. So I guess, a couple of questions. Tom, you highlighted some of the strength that you've seen in the businesses. And Jim, I think you touched upon the particular strength in enterprise, being up 28%. I'm wondering if you could go into some specifics as to maybe some noteworthy wins as to how people are kind of thinking about purchasing and deploying your product. And I'm also wondering if you think you might have benefited from the equivalent of a budget flush. And I have a follow-up as well.

James Benson

I can start, Tom, and you can kind of comment on it. So enterprise in particular, we talked about getting good traction with our security solutions. We've gotten really good traction with our security solutions with our enterprise customers. So I'd say, one notable area that's fueling kind of an acceleration in our enterprise growth actually is the adoption rate of our security solutions. We also continue to get good penetration in the enterprise market with our web performance solutions as well. So we just had -- I think the focus there, I think the focus of the sales force and the investments that we've made there is starting to prove a return in the enterprise space. Tom, I don't know if you want to comment more on the solutions?

F. Thomson Leighton

Yes, I think the message of protect and perform is unique in the marketplace, and it's being very well received. And we're seeing many accounts now where an enterprise will buy the solution driven by our ability to defend them against the cyber attacks and then also buy the web performance solution, the acceleration for their website. And it's a shift in our business that, traditionally, it's always been about performance for enterprises. Now the security aspect is often in the driver's seat and very important.

Scott H. Kessler - S&P Equity Research

My second question involves the balance sheet. So obviously, you talked about, I guess, the new $150 million authorization, given that the other authorizations had expired. I'm wondering if you could talk a little bit about how you think about capital and, more specifically, what percentage of the indicated cash and investments resides overseas at this point?

James Benson

Sure, that's a good question. So of our roughly $1.1 billion of cash, about $100 million is overseas. So actually, we have most of our cash is not overseas, which actually we're in an enviable position in that regard. But as far as the way we're looking at our capital and our capital structure, for sure, there are significant market opportunities in front of Akamai. And one of the things that we're looking at our balance sheet for and our cash position is to, first and foremost, see if we could put that cash to use in the form of M&A. And what you see us do in 2012 is we actually acquired 4 companies and spent over $300 million on acquisitions. So we will continue to be very active shoppers in the market across our various portfolios, we're going to be very disciplined buyers. And we're pretty much be looking not in any one particular area, but across where it makes sense to have a logical adjacency. So that's probably the first area to be put to use as far as the cash. The second area is we will continue -- as we've done before, continue with the buyback of stock to basically offset dilution from new equity. So that's really the approach that we're taking to the management of the balance sheet.


And your next question comes from the line of Gray Powell with Wells Fargo.

Gray Powell - Wells Fargo Securities, LLC, Research Division

Just had a couple. Can you help us just think about customer demand for Aqua Ion versus your legacy DSA product? And has the addition of front-end optimization technology to the offering created any incremental demand?

F. Thomson Leighton

Yes. Ion was launched in Q4, as you may know. And the initial results are positive, both in terms of offering greater performance, particularly in the mobile environment. As you know, mobile is really critical in the web going forward as the world moves to mobile. And also, in the uplift, we're seeing customers upgrade from DSA to Ion, in some cases, also with Kona for the security offering. And so we're seeing a very nice uplift in the revenues as we convert those deals. Now a key component of the new Ion solution, the first version, is front-end optimization. And that has a variety of capabilities to make the experience be really tailored to the device into the environment where it's operating. So for example, if you're in a congested network and you've got a small form factor device, we'll automatically adapt the images to compress them. So you still get a good picture, but a lot fewer bits are passing through the congested environment. So the front-end optimization has been very favorably received, especially in the mobile environment.

Gray Powell - Wells Fargo Securities, LLC, Research Division

Got it, got it. And I guess, just -- since you touched on it, can you just give us some insights on how customer demand is changing for mobile beside acceleration-type services? And then I don't know if it's possible or not, but like can you help us just think about the additional ARPU lift on a DSA contract if a customer signs up for Aqua Mobile as well?

F. Thomson Leighton

Yes. I think you go couple of years ago and mobile was barely an afterthought among folks with websites and applications. And today, it's mission-critical. As more commerce moves online and moves on to mobile devices, more business is done on mobile devices, performance now really matters. So you see the folks of websites are actually making special applications or sites for the mobile devices and now they worry especially about the performance there. And that's particularly important because mobile performance is often very bad. Some of studies say that if you look at the mobile Internet today, it performs sort of like the landline Internet performed 9 years ago. And we remember how bad that seems in comparison to today. So mobile acceleration is important. We have a special offering there of Aqua Ion for mobile, and it's doing very well.


And your next question comes from the line of Michael Turits with Raymond James.

Michael Turits - Raymond James & Associates, Inc., Research Division

Some expense questions for Jim, and then a bigger picture question for Tom. So on the expense side first, so it sounds like a couple -- you said several quarters, I think, of EBITDA margin is in the low 40s, so I assume that's about where we end up kind of at the year. And what is the OpEx growth really going to be like? It was in the upward to 25% last year. What is it this year? And also, I guess, back to the EBITDA question, you're cutting out ADS because it looks like ADS had a $5 million EBITDA loss. And that's why I particularly want to get a sense of the OpEx because even with getting rid of that $5 million of loss here, you're down a couple of points in margins.

James Benson

Well, we didn't lose -- they were -- the ADS business was EBITDA positive. But let me just kind hit [ph] your question more directly, which we have been making investments in 2012 and we specifically made those investments very targeted at accelerating the pace of R&D innovation. And you've seen us introduce products in every single one of the company's product categories. And we're going to continue to make investments in R&D innovation going forward, they're going to be very focused on the areas that Tom had outlined, specifically, building out a security product more fully, expanding our carrier product solutions or our network operator solutions and actually going into an area of hybrid cloud optimization. So from an R&D perspective, we're going to continue to make investments in those areas. I'd say an area that we made some investments in 2012 but probably more in the back half of the year was around incremental sales capacity. There is significant demand and market opportunity for our offerings. And one of the things that I think we talked to you guys about before is that 40% of our business that is CDN-driven, that is more traffic-related, is not a sales resource intensive business. The 60% of our business that is cloud solutions is a transaction monthly recurring revenue business that does require sales capacity to grow. And so we are going to continue to make investments in sales capacity because we believe the market opportunity today are to reaccelerate our growth in our cloud solutions areas. So those are 2 very specific targeted areas. And the reason we're guiding kind of to be low 40s EBITDA is because we believe these are the right investments to make for the company for the, one, to deliver near-term potential for the company, and also to deliver what we believe is future growth potential in kind of some new adjacent markets.


And your next question comes from the line of David Hilal with FBR.

David M. Hilal - FBR Capital Markets & Co., Research Division

A couple ones. First, I believe you're having the sales kickoff this week in -- with the calendar year starting, I'm wondering, are there any interesting changes in the sale structure or quotas, alignment, anything that could help or disrupt the pipeline for the most immediate 1Q?

James Benson

I think the main emphasis and change is around our security offerings and getting the reps in the field up to speed on selling that. We're very excited about the potential for security this year and going forward in the future. Otherwise, I would say, it's a pretty typical sales kickoff, and things are going well.

David M. Hilal - FBR Capital Markets & Co., Research Division

Okay. Let me shift to your comments about not doing uneconomical deals in the media sector. When you say uneconomical, should we interpret that as breakeven or deals that lose money? Or actually, is there a threshold? In other words, are there -- is there profitable business that you would turn away because it doesn't meet the profit requirements that you guys have set?

F. Thomson Leighton

Yes, I'll take that. So I mean, we've always taken a disciplined approach to the management and pricing of our media business. So it really isn't a change necessarily. However, we don't view all customers the same. Some customers are of more long-term economic and strategic value to Akamai that we believe you can make an investment in. And then there are other customers that we don't believe are worth making that investment in. And I think what you're seeing us do is in a handful of cases where we're choosing to wind down a relationship and a contract with a customer because it doesn't have the economics that we're looking for and it isn't of strategic value long term for Akamai.


And our next question comes from the line of Ben Rose with Battle Road Research.

Ben Z. Rose - Battle Road Research Ltd.

With regard to the recent AT&T partnership that you announced, I was hoping, Tom, you could give a little strategic context to that? And then if Jim could provide any kind of financial color on how the partnership might unfold during the course of 2013?

F. Thomson Leighton

Sure. I think that's a very exciting development for the company. As you probably know, AT&T has, for years, invested significant money and resources into building their own CDN, specifically to compete with Akamai. And so it's really great. That's a great validation of our platform, that they have decided to discontinue that. And they're standardizing their offerings today on the Akamai technology. They'll be a very valuable channel for us going forward, and we're very much looking forward to going forward to the market with them in 2013.

James Benson

Yes, I can comment a little bit about the kind of the rate and pace. So obviously, beginning in Q1, I would say the first half of the year is going to be more of an investment phase where both companies are going to be making an investment in the partnership. We're going to be investing in kind of channel resources to support them. They're going to be investing in sales resources to basically sell the kind of the Akamai product set. There's also some work that we're doing with them from an engineering perspective around building out some particular portal features that they're looking for. So the way to think about it is, it's an investment probably in the first half of the year. We'll begin to get some revenue streams probably for the latter half of the year. And our expectation is going into 2014, that they're actually going to go to be a very significant channel partner for us in the U.S., in particular.


And your next question comes from the line of Colby Synesael with Cowen.

Colby Synesael - Cowen and Company, LLC, Research Division

I have 2 questions. They're follow ups to questions already asked. But the first one, just going back to AT&T for a moment, can you just talk about -- is that really going to be focused on what we think of as traditional CDN services and more of a focus towards the Media & Entertainment and the e-commerce verticals? Or is there going to be more of a broad focus to sell some of the new services that you're introducing, particularly in 2012, to call up that enterprise base? And then the second question, just goes back to the guidance you mentioned, the low 40s for EBITDA margin. I assume that's -- when you say low 40s, that's pretty much the same guidance you gave for the first quarter. What I wanted to just make sure I understand is that, you're expecting your gross margins to remain at the levels that we've seen really in the last quarter or 2 in that, call it, low 80s. And it's really the increase in the sales and marketing that's going to go up, that's going to drive those margins down relative to what we saw probably in 2012.

F. Thomson Leighton

I'll take the first question. The AT&T partnership is broad-based and, in fact, that's one of the advantages that AT&T saw in working with Akamai. Just having a CDN really doesn't cut it anymore. You need the advanced solutions and the road map for those solutions that really Akamai uniquely has. And I think that was the key factor why AT&T chose to abandon the internal efforts and to decide to standardize their offerings with Akamai.

James Benson

Yes, and I'll take your -- you're thinking about it the right way, Colby, that we made great progress last year on improving gross margins in our CDN business. And we're actually very confident that we can maintain the momentum that we've had in 2012 into 2013. So the way you're thinking about it is the right way that what's going to drive EBITDA margins to probably be in the low 40s is we're going to make very targeted investments in operating expenses. It's not -- I mean, I would say, it's going to be very heavily focused on sales and marketing and building out sales capacity and supporting go-to-market resources, but it's not going to be just in those areas. We're also going to continue to invest in R&D innovation in the areas that Tom had outlined. Certainly, the Veraview acquisition is but one example where you're going to see that we basically acquired 70-plus employees that you're going to see for -- and we will continue to add on top of that, one, to build out and accelerate our time-to-market for our network operators solutions. Two, Tom talked about security, we're going to continue to make investments in security R&D. We're going to make investments in hybrid cloud optimization. And we think that there's an opportunity for us to continue to innovate in the web performance area as well. So the area -- I would say the investments are going to be targeted towards incremental sales capacity and go-to-market investments. And because our solution sets also are very high performing and very complex, you also need a level of service infrastructure to support them, but we're also going to be investing in the R&D area as well.


And your next question comes from the line of Sterling Auty with JPMorgan.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

Tom, I'm wondering with all the different announcements today in terms of the investment, the focus, et cetera, how much of this is you putting your stamp on the strategic vision now that you're in the CEO role versus how much of this was already kind of set into motion prior to that decision being made?

F. Thomson Leighton

Well, Paul's job, which he did extremely well, was to lead us past the $1 billion. My job is to lead us past $5 billion. And my strategy is going to be to use our very strong cash flow and market position, the unique capabilities of our platform and our ability to innovate to develop new businesses in security, in carrier products and in hybrid cloud optimization, all of which are adjacent markets, new markets for us with very large potential. We're also going to work to improve the growth of our web performance business, as we talked about, in part, by improving performance with a special focus on mobile. Of course, a lot of business is moving to mobile, as you know. And also, by growing our sales capacity, as Jim talked about, that's really vital for that business. We're also making a special effort going forward on making our services easier to integrate and easier for our partners to sell and deploy, with the goal of growing the share from our channel partners. And of course, in media, as we talked about, there's always been a large potential for growth. The traffic always grows at rapid rates, and the key there is to have quality at scale at very low cost. And so we're continuing to work on reducing the cost of our media business. I might add that Paul and I worked together for many years. We share the same vision, and I look forward to working with him in his new role as Executive Vice Chair of the board.

Sterling P. Auty - JP Morgan Chase & Co, Research Division

On the AT&T partnership, you mentioned they're standardizing. But can you review for us, is AT&T putting all of their CDN, both business and content delivery, through Akamai? Or is there a portion, like in the volume content delivery, that they'll continue to be a participant and be a competitor to Akamai?

F. Thomson Leighton

No, they are standardizing their CDN offerings on the Akamai platform.


And your next question comes from the line of Jennifer Lowe with Morgan Stanley.

Jonathan Parker - Morgan Stanley, Research Division

This is actually Jon Parker calling in for Jennifer Lowe. I was hoping that we can actually dig in a little bit more to the volume businesses. The deceleration was a little bit more than, I think, we were looking for. Two years, around the time we saw a little bit of an issue with a large number of significant renewals coming up at the same time. And I'm wondering how much of the deceleration might be a function of some dynamic around those just coming up for renewal again versus the uneconomical type business, media business, you assessed earlier, versus any other changes in pricing or anything else that we should be aware of? And so I would appreciate any additional color you guys might have on that.

James Benson

No, I'll take that. That's a good question. I mean, I think that it's coincidental. You're right that 2 years ago, we had a phenomenon in Q1 of 2011, where 8 of our top 10 media customers renewed. And it's now 2 years later, and the question is, is that because those customers are now up for renewal, and the answer is no. So we've not having that same effect. I think what you're seeing is just a consistent approach that Akamai is taking. It just happens to be there's a couple of maybe larger ones this quarter where we've looked at the relationship, we've looked at the economics of the business, we've looked at the strategic value of the customer and we've just decided that it's in the best interest of both parties for -- to wind down the relationship. So that's really the driver of kind of what's happening in the near term. I would kind of bring you back maybe to Tom's point earlier, which is there is huge opportunity for traffic growth with media customers. And so what you're seeing here is kind of a slight dip or wind down in these customers throughout Q1. Obviously, they'll be on the platform in Q1. They'll be off the platform in Q2. So you can kind of have an expectation of what's going to happen in Q2 as well. But we also have significant opportunity to continue to grow and penetrate and grow with customers that are of strategic value for Akamai and new customer acquisitions that meet the financial profile for the business.


And our next question comes from the line of Phil Winslow with Crédit Suisse.

Sitikantha Panigrahi - Crédit Suisse AG, Research Division

This is Siti Panigrahi for Phil Winslow. Could you talk about your competitive landscape? And also, if you could comment on any pricing trends that you're seeing in M&E versus commerce business and anything that you expect to see going forward?

F. Thomson Leighton

Sure. Our competitive landscape varies depending on the business you're talking about. In media, as we talked about, of course, it's a highly competitive landscape, lots of competitors, and there's always pricing pressure there. And it's all about growing the traffic and providing a lower cost of service that we can grow that business profitably. In the web performance business, it's a different situation. The primary competition is do-it-yourself. Our customers see tremendous value in our service because as we make their applications and sites be faster, they get a higher ROI, higher conversion rate, more use of their site. And so we are the fastest out there. We're the most reliable and the most secure, and that has real value to our customers. Now that said going forward, we're making our services even better, to set even a bigger gap between us and the competition to grow that business going forward. If you look at the security space, you have a different set of competitors. You have carriers can offer solutions. You have the cloud washing companies, and you have companies that will sell a device you stick in your data center. Now this is an exciting area for us because none of those solutions can protect the major enterprises against the big attacks. Akamai is unique in its capacity and its ability to do the packet inspection and filtering out of the edge. And really, that's the only way to defend yourself against the large attacks. That's why you see [indiscernible], for example major banks, don't have Kona Site Defender made headlines because you have a large-scale attack and all those cloud washing solutions, boxes and carrier solutions simply can't work once the attack gets to the data center. You go into the carrier operator solutions, different set of competitors, again. And hybrid cloud is sort of a new space moving forward, where, again, I think we're in a unique position because we can leverage the Akamai platform and connect it to software we're placing in the branch offices and in the retail stores to accelerate the performance they see for all of their applications, be it in the private network and the public network or in SaaS, and to offload the connection into that branch office, which is often very expensive. So the competitive landscape is variable, but I think Akamai is very well positioned going forward.


And your next question comes from the line of Chad Bartley with Pacific Crest.

Chad Bartley - Pacific Crest Securities, Inc., Research Division

A lot of moving parts with the acquisitions and divestitures. But it seems like the cloud business grew maybe in the mid-teens in Q4 on an organic basis, and then you talked about CDN at 11%. So can you talk at all about growth rates for those 2 segments that's sustainable going forward? I mean, what are the growth ranges we should be thinking about? Or do you guys expect any sort of pickup or slowdown anywhere?

James Benson

I'll take that. That's a very good question. So you're right, our cloud solutions growth kind of for 2012 organically. If you kind of separate out the benefit that the company received from the Cotendo acquisition, it was about 18% growth year-on-year, so very good growth rates. But as I mentioned earlier, what really fuels the growth of the cloud solutions business is sales capacity. It is highly attractive financial model because it has very, very high gross margins but -- and it has very, very low capital expenditures, but it does require operating expenses to grow. In particular, it requires sales capacity and it also requires service capacity, as well as some R&D innovation. So it's been a very healthy financial model. It's actually a more attractive EBITDA and then the company's kind of average EBITDA. But the way this -- the way the business works is you have to make an investment in the sales capacity, and it takes a while for the sales resources to become productive. And the way this business works, because it's a monthly recurring revenue business, once they ramp and become productive, you get them on -- you basically book a piece of business, we integrate them on to the Akamai platform and then they grow. So you have this lag period of time where you have investment in advance of accelerating revenue growth. So I think what you're going to see is that we think we can get the growth rates back in that business, back to the levels that they were, maybe in the 20-plus percent growth range but it's going to take some time for the sales capacity to become productive and then to turn them on to the Akamai platform and turn that into revenue. So it's not -- we're not gated at all by market opportunity. The market opportunity is huge, a significant demand for our solutions. What we need to do is we need to increase sales capacity to accelerate that growth, and it's going to take a little bit of time. So I think what we're signaling a little bit is, one, we're going to see the wraparound effect of the Cotendo acquisition, which will come up in March. And therefore, the comps become more difficult for the company, but we're making the right investments. We began making these investments in 2012 in sales capacity, and we're going to do more in 2013. And our expectation is that you should be able to see accelerating growth in that business going into 2014.


And your last question comes from the line of Heather Bellini with Goldman Sachs.

Sonya Banerjee - Goldman Sachs Group Inc., Research Division

This is Sonya on for Heather. I guess just as it relates to the core content delivery business, what are you guys anticipating in terms of pricing erosion and traffic volume growth relative to 2012 just for this year? And then are there any dynamics that would drive a more steep price decline this year than what was seen last year?

James Benson

I'll take that so -- because I don't think we really commented on the pricing, that's a good question. A couple of people have asked that. So the pricing environment in the CDN space, as Tom mentioned, has always been highly competitive. But we track it. And I've been with the company now for about 3 years, we've tracked it for the last several years around the pricing. It's been pretty consistent, the rate and pace of pricing. And pricing is declining, but kind of the bands of pricing erosion have really not changed materially. And actually, we don't expect that going forward, they will. We don't expect that they're going to worsen, and we don't expect they're going to get better. We expect them to continue at the rates they've been at. And so really growing the content delivery solutions business has really been about traffic. Right? If you can -- if you believe that the price component of it is going to be relatively stable, meaning that the pricing declines are going to be consistent with what they've been, it's a matter of traffic growth. And admittedly, that is a harder area for Akamai to call. We can call it pretty well in a 3-month period. But beyond the 3-month period, it's really a function of how successful our customers are with basically their products in getting traffic to their websites that we are serving. So certainly, in the near term, we're quite confident in the range that we've provided. I think there's huge opportunity, as more and more content moves online, as Tom outlined, that I would say, that the rate and pace of when that happens quarter-to-quarter is hard to see. I think we know over time, there's going to be an explosion of traffic. And as long as we can make sure that we're the platform of choice for the various companies that we're serving their traffic for, there's a significant opportunity for long-term growth for Akamai.

Sonya Banerjee - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. And then just really quickly on Veraview. You said no impact to the top line, but a $3 million impact to cost. Do see this business progressing toward breakeven or profitability later in the year?

James Benson

Yes, what we had talked about when we made the Veraview acquisition in December was we actually said they would probably be about a $0.01 dilutive to our 2013 earnings. And the way to think about that is, that $0.01 dilutive to probably in the first half of 2013. What we're going to be able to do is get and accelerate our time-to-market with products in that space, get customers on basically a licensed CDN product. So that towards the back half of the year, what you're going to see is revenue that offsets that expense. But for the first half, it's probably slightly dilutive. But in the second half, you'll see it be breakeven.

F. Thomson Leighton

Thank you very much. We look forward to seeing you all at our Investor Day on March 11 in Cambridge.


Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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