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Akamai Technologies, Inc. (NASDAQ:AKAM)

Morgan Stanley Technology, Media & Telecom Conference

February 27, 2013 4:20 pm ET

Executives

F. Thomson Leighton - Co-Founder, Chief Executive Officer and Director

James Benson - Chief Financial Officer and Executive Vice President

Analysts

Jonathan Parker - Morgan Stanley, Research Division

Jonathan Parker - Morgan Stanley, Research Division

My name is Jon Parker. I'm with Morgan Stanley's U.S. equity research software team. We're very pleased today to have Akamai with us, and Dr. Tim Leighton, co-founder and CEO; and Jim Benson, CFO. Thank you very much, guys.

F. Thomson Leighton

Thank you.

James Benson

Thank you.

Question-and-Answer Session

Jonathan Parker - Morgan Stanley, Research Division

Maybe to jump right in, Tom, you've obviously been with the company for a long time, part of the cofounding team, chief scientist for a number of years. When presented with the opportunity to become CEO of Akamai a couple of months ago, what made you decide that the transition made sense and now was the right time for you to take on that role?

F. Thomson Leighton

I think we have an incredibly exciting future, a chance to make a real difference, a chance to grow the company to $5 billion by the end of the decade. And that's just too good an opportunity not to take. And as chief scientist, I was closely tied with Paul and with senior management, and so there's, obviously, been some difference in my day-to-day life, but I do a lot of the same things, seeing customers, meeting with investors, working with the engineering teams and with senior management. So it's not been a huge shift.

Jonathan Parker - Morgan Stanley, Research Division

And so I guess, the next sort of logical question it's only been, again, 2 maybe, 3 months, but has your perspective or view of the company changed at all now that you sort of have that formal CEO hat on? And do you expect that sort of stayed close to the course that Paul and you guys sort of set in place before any changes you guys are thinking about making in that strategy?

F. Thomson Leighton

Right, my perspective hasn't changed at all. We are on the same general course. We are making specific investments this year to grow sales capacity and to invest in the new product areas that we talked about on the call, security, carrier products and hybrid cloud optimization. And I'm very excited about the potential future of those product areas.

Jonathan Parker - Morgan Stanley, Research Division

Great. And next point I want to make was the one that you actually sort of reiterated earlier was that $5 billion, the aspirational goal that you guys set out a couple of years ago. And clearly, you're still feeling pretty strongly about that goal? What do you think -- what do you view as sort of the 2 or 3 key drivers in really enabling you to be able to hit that goal?

F. Thomson Leighton

Obviously, innovation, growing our existing twin major businesses of content delivery and web acceleration products is one category. And then new businesses. I think, as you think about towards the end of the decade, they'll be maybe the majority of our business by then. Security is a very large potential market for us, very rapidly growing the business. Still small. We exited the year at about $25 million of annual run rate, but growing very rapidly. You look at carrier products has the potential, not only in terms of the direct sales to the carriers, but having the carriers become a channel for us in various countries around the world to drive through additional Akamai products that they sell, the Akamai products. And then hybrid cloud optimization, which today is 0 revenue has the potential to be the largest of all as more business moves into the cloud, as enterprises need to find services to offload the traffic into their last mile into the branch offices into the retail stores, and as users of the enterprise need to get access to the Internet, to SaaS and to the corporate applications.

Jonathan Parker - Morgan Stanley, Research Division

Yes, that makes sense. And obviously, as you mentioned, you have a lot of new really innovative products right now that have a lot of interesting potential, and I definitely want to dig into a couple of them in a little bit. But as you look towards maybe this year in particular, it's hard to pick 1 or 2, but as you look at those, what do you think of those areas to be sort of the biggest upside surprise possibly to people here?

F. Thomson Leighton

Well, obviously, in terms of just dollar volume, our existing businesses, which is a vast majority of our revenue was where you'd look for the substantial growth, media CDN and web performance application acceleration. Security is getting to the point where you can start to make some of the difference, exiting a $25 million, and we have high hopes to substantially grow that this year. The other 2 businesses are way too small to make a difference in 2013.

Jonathan Parker - Morgan Stanley, Research Division

Okay. Maybe to dig into the enterprise business. Growth there has been very strong for the last couple of quarters, accelerated to close to 30% growth in the most recent quarter you reported. What do you think have been the real drivers in that growth over the last couple of quarters? And do you think that the level of growth we're seeing now is something that's sustainable over the next couple of quarters? Or as you start to anniversary some of the tougher comps, might we start to see a little bit of a deceleration there?

F. Thomson Leighton

Well, in the enterprise, they're buying typically the performance products, so application acceleration, Terra Alta, they're increasingly interested in mobile. And we have the new offerings there that we launched in Q4, specifically around mobile performance, which is a really big pain point today. Enterprises are very concerned about security. And last year, around this time, we launched Kona Site Defender, and that's getting a very rapid adoption. I think those are the main product areas that you will see the enterprise buy there on a rapid growth rate. And they have good margins for us.

Jonathan Parker - Morgan Stanley, Research Division

And do you have any sort of sense following up on -- I mean, do you think that sort of growth that we've seen recently could be sustainable going forward? Or is it too early to tell?

F. Thomson Leighton

Well, we're not giving specific guidance as to what the growth rate will be in a vertical, but that's a very good vertical for us. It's in a good position with adoption of mobile, the need for security and SaaS and moving into the cloud. All are excellent drivers for our products.

James Benson

And I think it's fair to say that we're not nearly fully penetrated for that customer set. So while we're not going to provide guidance specifically for that vertical, I think that there is still significant opportunity to extend kind of our footprint of our products into those customers.

Jonathan Parker - Morgan Stanley, Research Division

Okay. And then following up on, I guess, the Kona Site Defender you mentioned. This week, you -- in the last couple of days at RS day, you announced a new release of the Kona Site Defender security. As you've mentioned before, it's obviously a big growth potential area for the company going forward. How do you think about the potential size of that market? And how that might shape over the next couple of years? And also who do you consider the main competitors in that space today? And sort of what are you sort of doing and seeing in that sort of area?

F. Thomson Leighton

I think roughly speaking, the security business can become much like our web performance business, the application acceleration. The sales motion is comparable. The margins aren't all that different. The ARPUs are roughly comparable. It's a transaction-based business, the rep needs to go in and sell it. It's not a traffic-based business per se like media would be. So I think -- and the size of the markets are comparable. And today, we have an offer, we go out, we say, protect and perform. We actually lead with Kona, and it drags through the application performance products. So I'd say, they're comparable. One, is many years behind in terms of the growth, but I think they're comparable businesses in the long run. The competitive landscape is very different for security than it would be for our existing other businesses today. There's a variety of modes of competition. Nobody really does what we do. You can buy boxes and put them in your data center. IPS/IDS systems, firewalls, application firewalls. When you go in your data center, you can buy Clean Pipe Services from the big carriers where if you're getting hit, you can call them up and they'll try to filter the traffic. A challenge there is that they don't do the deep packet inspection. It's a reactive process, and it doesn't work especially well. You can get cloud washing services, again, reactive. You're getting bombed. You can press the big red button, and they'll try to redirect the traffic into a washing facility. Again, it's IP-based, which is it can be spoofed. So it's not really a foolproof solution. The boxes themselves that you put in your data center can be very good at low volumes of traffic. But if you get swamped in the traffic, there's nothing the box can do because the pipe gets filled. And you can see the impact of this with the banking attacks that started again yesterday, you probably saw some of the headlines if you were looking there, where the Ababil attacks are taking down major North American banks for lengthy periods of time. And those banks for sure have bought all those services, but there's nothing they can do against the volume. And that's where really we're unique because we intercept the traffic out at the edge of the Internet, where all the bandwidth is. It's the same principle that we had for delivery and acceleration now used for security. Our servers are not necessarily in the data centers, they're out in thousands of locations near where the capacity is, near where that bombs are, and so we stopped the traffic there. And there were banks on the hit list that you did not see in the headlines yesterday for going down because they're using our services. So Kona Site Defender really today is in a unique position to stop the big attacks from the major name brands out there like Anonymous and so forth that are running these attacks.

Jonathan Parker - Morgan Stanley, Research Division

And what's the go-to-market looks like for -- from the sales after the security offering? Is it -- do you have separate team just going out with that offering you, just an overlay team. How are you approaching that today?

F. Thomson Leighton

Yes, so we trained the regular force to be able to sell. The enterprise force is trained to sell the security products. The SEs that go with them are trained there. We made a big effort on that. We also have the overlay and Tiger teams. So when you need the security guy to go in and talk to the CSO there is help, specialization there that can help out the rep and the SE and the account.

Jonathan Parker - Morgan Stanley, Research Division

Okay. Let me turn over to the Media & Entertainment volume business. At a high level, you talked about the huge potential, magnitude of traffic increases if we were to see video consumed at sort of HD bit rates over IP, sort of hundred x magnitude increases. At this point, what do you view as the key barriers to sort of seeing that sort of transition happen? Do you see sort of an inflection point? Or do you think it's going to result in sort of consistent growth over a number of years? How do you see that sort of evolving?

F. Thomson Leighton

Yes, there's a couple of components that go into the possibility for the hundred x growth. The first is the amount or the percentage of video watching that's done over IP. Today, it's a tiny fraction. There's easily a factor of 10, but that could increase. The second is the quality level. Today, most video over IP is watched at under a megabit a second. Standard-def TV for the purpose of comparison is 1 to 2 megs. So most Internet watching is still substandard SDTV. If you go to a DVD, that's 4 to 5 megabits a second. Blu-ray or HD is way beyond that. So there's the potential to go from under a meg to over 10 megs. In fact, if you look at the new 4k offering from Sony, and that's at 40 megs or something in that ballpark. So there's -- you get the double effect of 10x of percent of time watching, 10x of the actual bits per second. Now what needs to happen to allow that, there's a couple of things. First, the cost has to come way down. There's no way the ecosystem can handle 100x increase in price because today pricing is linear in the number of bits per second that are being transmitted. And so we're putting a lot of effort, both into the regular blocking and tackling to reduce the cost of delivering every bit, and that's why we were able, for the first time, in many years to increase gross margins last year in the media business. But we're also working on the development of a next-generation platform that will be a quantum leap or a discontinuity in terms cost reduction. And the goal, the long-term goal there is to try to find a couple orders of magnitude in cost reduction, and that can enable the couple orders of magnitude increase in performance and increase our margins at the same time. Now it won't be just that. There's going to need to be some trigger that causes people to want to have the high-quality video over IP as their -- as a more substantial fraction of their video watching. And I don't know exactly what that trigger will be. If it will be the right device that hits the marketplace that everybody has and all of a sudden there's the demand for it, that might be the possibility, but you need those 2 things. And in our case, we're working with the device manufacturers and we're working with the networks and the media companies the design of a platform that can allow it, at least, economically and allow the scale to happen to get the 2 orders of magnitude.

Jonathan Parker - Morgan Stanley, Research Division

And trying to predict the growth of that business, I think, has been -- it's been a little bit challenging for both investors and probably yourselves over the last couple of years. We've seen that business peak, I think, as high as maybe 20% or so year-over-year growth at some point; at some point, it's been more flat. But if I look over a longer period of time, 4 or 5 years, it's sort of been in that sort of low-teens growth on an annual basis. Is that the right type of rate that you think investors should think about that business being able to grow in the long term? Or do you think you can sustain higher levels of growth without, obviously, talking about guidance? How do you think about that business longer term in the growth potential?

F. Thomson Leighton

It's a variable business. It's highly competitive. Every year you see dramatic increases in traffic. It could be 50%, 70% or more. And you see substantial price reductions. 20%, more or less, it depends. And the revenue is the product of the 2. And then margins are even more complicated because you got to figure out our costs. And we're working very hard to make our costs go down at a substantial rate each year, more than the price reductions are going down. And so you do see the variability. Whenever you have 2 highly variable measures themselves, you're taking product, you get a double whammy. And so that makes it -- it's hard to predict exactly what the revenue growth is going to be, and it varies. And I would expect that to continue. Our goal, as I said, is to actually change the whole mechanism for the delivery, which will have a discontinuity in terms of the technology. Now the technology may be implemented over a period of time, so it might be a gradual adjustment to the discontinuity, but a substantial reduction in our cost, allowing a substantial reduction in price but a huge increase in traffic. And our goal is to have substantial growth in revenue over the long term and growth in margins due to the new technology.

Jonathan Parker - Morgan Stanley, Research Division

Okay. Now on your most recent call, you spoke about handful of customers that didn't necessarily meet your strategic or sort of profitability objectives and that you'd be looking to ultimately churn off your platform in Q1 and maybe into Q2 as their contracts came up for renewal. Tom, can you help us maybe think a little bit about this process and sort of why now is the right time for this sort of transition with them? And then maybe, Jim, help us think a little bit about what the financial impact is going to be on the model in the first half of the year?

F. Thomson Leighton

Yes, I think that process is always taking place. It's a highly competitive marketplace. Large volume customers sometimes decide to try to do it themselves. Sometimes they want to have price points that don't make sense for us, and so we choose not to pursue the business or at renewal time, decide that it doesn't make sense to keep going forward. This has always been the case in the media business, and I expect it probably always will be. We've talked about it on Q1 because -- at the call, because it's had an impact, not dramatic, but there were some impact on the business, and I expect that to continue.

James Benson

Yes, I think what I'd offer with that, I think, to Tom's point, this isn't like any substantive change because Tom became CEO in December and all of a sudden there's a change in direction with the accounts that we choose to keep on the platform or actually come on the platform in the first place. But I think what you found is that this happened to be a quarter where maybe it's a little bit more noticeable on the company's growth rate as far as Q4 to Q1. We thought it was appropriate to share in our guidance that there was a kind of a modest impact for this beyond what we usually see seasonally Q4 to Q1. Q4 to Q1, we seasonally decline. We're declining a little bit more when you adjust out to the ADS side estimate, and this is one area for that. And the color I provided for folks is this wind down of a handful of contracts have about a $3 million sequential impact from Q4 to Q1. And so you can imagine these are customers that are on your platform throughout Q1, but they wind down from January to March. And so you'll have revenue for them in Q1, but you will actually not have revenue for those customers in Q2. So to your point about near-term impact, you'll have a little bit of an impact, again, in Q2 because you'll have some revenue for those customers. And the way I've tried to characterize it to folks is that assume you had $5 million for these customers in Q4 and if you're going to have a $3 million sequential impact from Q4 to Q1, it means you have $2 million for them in Q1, which means you have nothing for them in Q2. So that's the way to generally think about the impact of that kind of as you think about modeling. As far as what happens in our CDN business beyond that, I think as Tom alluded to, that there are a lot of factors that drive that. So there's some near-term headwinds relative for these wind downs, but certainly, an opportunity to see traffic acceleration for other reasons. So I don't want to necessarily call beyond the quarter that you'll see a deceleration for the business throughout the year because you just don't know, that you might see an uptick in traffic. One of the things we saw last year was an uptick in traffic as a result of people concurrently consuming social media, while they were consuming traditional media. And so we might see that again.

Jonathan Parker - Morgan Stanley, Research Division

Okay. And they're asking a concern that, that some investors might have is as we think about some of these changes, this is obviously -- some of these customers that were coming up for renewal in Q1. How do you sort of look ahead at the cadence of customers, larger customers might be coming up for renewal in quarters ahead as we've thought about that as well? And whether there might be any larger group of customers where this type of strategic change could happen throughout the year?

F. Thomson Leighton

We certainly, internally have a forward look of all of our contracts. We have a forward look around when they are scheduled to renew. Sometimes they are scheduled to renew from a calendar perspective and sometimes they're scheduled to renew because of the contract structure that we have they might burn through their commitments earlier. So we certainly look at them. It happened 2 years ago, where we happened to have 8 of our top 10 media customers renew in the same quarter. That has never happened before. You don't want to say never say never, but I think it's unlikely that, that will happen again. But you're always going to have a handful of large customers renew every a quarter, and there will be a pricing reset for those customers. That's always been the case. I think what you saw this quarter was maybe a couple of larger customers that we consciously made a decision to wind down off the platform. I would say that doesn't happen every quarter. And so that's probably more of an extraordinary case. I wouldn't expect to see that in any substantive rate going forward.

Jonathan Parker - Morgan Stanley, Research Division

Okay, great. I want to make sure I get time to the audience's questions if there are any out there? We see one up here.

Unknown Analyst

Can you talk about the winding down of some of those customers that you talked in the call and just now about sort of a joint decision? What drives that? And why would you want to take somebody off of the platform?

F. Thomson Leighton

Well, I think what drives that is that, first of all, you have -- we're always looking at customers whether they'd be new customers or customers that are coming up for renewals. So in this case, these might be customers that are coming up for renewal. When you made the decision to bring them on the platform, you look at them around their strategic values and economic value to Akamai over the long term. And so there might be a reason why you are willing to take a very, very aggressive price point. There may be cases where the profile of that customer and your relationship with that customer changes sometimes driven by their own desires to potentially serve traffic themselves. That could be an example. Where they've made a decision that they would desire to serve traffic themselves, and that becomes the case where Akamai then, in the course of a renewal, has to evaluate whether or not a customer that has chosen to want to move a direction of serving traffic themselves, whether they actually strategically warrant us having a very aggressive price point for them because Akamai doesn't necessarily want to be an insurance policy if, in fact, they have struggles and being able to deliver the traffic themselves. So sometimes you make decisions like that based on the dynamics of the relationship with the customer, and I think that that's the way we evaluate things. We evaluate whether they have good, long-term economic value. And then during the renewal cycle, we evaluate kind of the relationship with them and the price point, whether the price point that they're looking for is warranted.

Jonathan Parker - Morgan Stanley, Research Division

Up here.

Unknown Analyst

Can you talk about the carrier business products indiscernible] what kind of -- explain more about that? And how that is going to generate revenue going forward, and to what magnitude? And then, what you hope to achieve in that business over the next 12 months or 24 months, if you want to go longer?

F. Thomson Leighton

Right. The question is about our carrier products business related to Veraview in Q4 to help accelerate that business. The business has sort of 2 components. The first is that we're now selling an Akamai capability for CDN, 2 carriers, so that they can offer for sale and operate their own CDN service based on Akamai technologies. It will federate in with the existing Akamai platform. This gives us a new source of revenue and for example, that's the relationship that we have with Orange. Now in addition, with, for example, with Orange and with other entities, for example, AT&T, there's a deeper relationship wherein they will not only base their offerings on the Akamai capabilities and the Akamai technology, but they'll also resell effectively Akamai's advanced services. And this gives us a chance to leverage their sales forces to -- we have a broader -- we have a broader reach at lower OpEx cost to us. As part of these relationships, we will much more deeply embed our technology into their networks. In many cases, it will be their CapEx and co-lo cost, not ours. And so we look at this as an opportunity to grow revenue and also grow margins at the same time because we're reducing our costs. And we hope to take this model and do it in many countries around the world. As we look forward to the Orange relationship in France, they will be the direct go-to-market, and our existing direct field force there will evolve into a support model for Orange, and we get a much larger sales force at a more higher-margin business.

Jonathan Parker - Morgan Stanley, Research Division

I think we have time for one more.

Unknown Analyst

[indiscernible] before they sell to their customers, in other words, do they give you revenue before they -- just for that capability, will they pay you for that? Or is it only once they sell to their customers?

F. Thomson Leighton

Yes, with the carrier products, we get revenue both ways. We're selling a platform, and we get revenue for that. And then as they use the existing Akamai platform in terms of federation, we'll get revenue. Or as they resell our advanced services that aren't yet in the product from, we'll get revenue that way as well. So both ways.

Unknown Analyst

[indiscernible].

F. Thomson Leighton

Well, I will hope long term that's a substantial business for us. In many parts of the world, there's a dominant carrier in the country. They are heavily engaged with all the enterprises in that country, and it's the best way to go to market. So I think, this year, you're not going to see a lot of revenue there. We're just getting that business started, but over the longer term, could be a substantial portion of revenue for Akamai.

Jonathan Parker - Morgan Stanley, Research Division

I think time for one really quick question right here.

Unknown Analyst

Just you talked about how the content delivery is always price competitive. Amazon recently cut price on their CloudFront CDN. They also introduced some dynamic site acceleration capabilities. Are they making life incrementally tougher for you, or they're just kind of more of the same?

F. Thomson Leighton

We have a lot of competitors in the CDN space. And there's not any particular change in that recently. In the site acceleration business, nobody really does what we do there. And as a result, nobody is really in a position to offer the performance gains that we do, and that's a business that really is all about performance. You make the site faster like a commerce site, and they'll have higher conversion rates. Every study proves that. And we're in a position today where we can offer unique performance gains against anybody else who's out there touting to have services there.

Jonathan Parker - Morgan Stanley, Research Division

Great. And with that, I think we're out of time. Thank you, gentlemen, very much for that.

F. Thomson Leighton

Thank you.

James Benson

Thank you.

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