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Akamai Technologies (NASDAQ:AKAM) is a company that delivers video on demand better then any business on the internet. Their technology allows them to allocate their resources in such a way that they can send internet viewers to the servers located closest to them, which vastly speeds up the delivery of the rich media that we love and crave on the net. With 2006 having shaped up to be, the year of video on the net, Akamai has benefited not just from organic growth, but has consistently brought on new business partners as well.

After reporting their 3rd quarter earnings, it’s clear that Akamai continues to demonstrate their leadership in this industry. In looking at their numbers, they earned revenue of $111 million, up 11% over just three months ago and up 47% compared to the same period last year. Their profits for the quarter amounted to almost $42 million in normalized net income, up over 17% from last quarter and an astonishing 90% increase over their normalized net earnings from a year ago. The company also increased guidance for the upcoming year during their conference call.

Akamai logoBy all accounts, Akamai had yet another tremendous quarter and management should be congratulated for executing and extending their leadership in the VOD space.

Now normally, this type of wild growth would leave me frothing at the mouth with excitment. The VOD market is hot, young and Akamai is in an excellent position to lead the industry. Despite all of the possibilities however, these numbers aren’t the sweet spot that investors thought that they would be. Instead their most recent earnings report is likely to leave investors feeling very sour after many realize that much of Akamai’s potential growth has already been priced into the stock.

If you ask the average investor what Akamai’s stock is worth, they will tell you it’s around $50 as of today’s close. While theoretically this is true, in reality Akamai stock is really worth $7.6 Billion dollars. Over the last year, I’ve talked to many Akamai investors and have asked how they rationalize such an amazing valuation and they always point to the earnings as their justification for paying this much for a stock that makes less then a half a billion dollars in revenue.

Unfortunately for many investors though, they are in for a rude awakening tommorrow morning, when they realize for the first time that Akamai’s earnings, over the last year, have been artificially inflated by a special one time tax benefit from a year ago of $255 million.

If you take into consideration this one time tax benefit, Akamai’s real net income was actually down 95% from a year ago.

The reason why this is so important is because many companies trade based on a multiple of what their earnings are. More aggressive stocks deserve a higher multiple because theoretically, over time, the growth should cause earnings to catch up. More mature stocks will typically get a lower multiple because investors aren’t expecting the stock to maintain double digit growth rates.

Based on the last 12 months worth of data before earnings, Akamai was trading at a P/E ratio of around 25. With the S&P trading around a multiple of 15, this isn’t an entirely unreasonable valuation for a stock like Akamai. In fact this is probably a low multiple for a stock delivering Akamai’s type of earnings growth.

The problem is though, that with this latest earnings announcement, the one time tax benefit will now drop off and with the new earnings in place, investors who haven’t been doing their due diligence are about to learn that they really own a stock trading at a P/E multiple of 122.

While the analysts and professional investors are fully aware of this one time tax benefit, the average investor certainly is not and at a P/E of 122, this valuation is more reminiscent of the internet bubble then a reflection of Akamai’s true growth potential. With Akamai’s one time tax benefit now apparent to all investors, I believe that we are about to see a massive deflating of the video on demand bubble that’s been building over the past year.

akamai lemonTo help put these numbers into perspective, lets assume that your daughter wants to open up a lemonade stand. Because you’ve agreed to subsidize the business by supplying the lemons and sugar, any revenue she takes in will be pure profit. What better profit margins could one ask for? Lets also assume that she hires her older brother to beat up competitors and create a monopoly, so that she can charge $2.50 per glass of lemonade. If she is able to sell 10 glasses a day for a full year, she would bring in around $8,200 in profits for the year. At a P/E multiple of 122, this would value her lemonade stand at $1 million dollars.

Now I don’t know about you, but I’m not ready to pay a million dollars for a lemonade stand and investors shouldn’t be willing to pay that much for Akamai either.

Of course Akamai’s business is a little more complicated then a lemonade stand, but a business should only be worth what it’s eventual exit strategy will be worth. The way I see it, a company can be acquired, they can issue a dividend and reward shareholders or they can buy back their own stock to enhance their value.

While growth companies aren’t expected to do any of this, as the VOD industry eventually matures, Akamai will need to demonstrate shareholder value by utilizing one of these methods. In looking at their balance sheet, you can see that they have about $741 million in net assets. If you value the company on a book basis then, they closed today at about 10 times their book. Far too expensive for any business to seriously consider taking them over no matter how hot their technology is.

With earnings now showing a multiple of 122, it would take years for Akamai to raise the cash necessary to buy back their business from shareholders. Considering that they earned just $65 million in profits over the last year, even at an aggressive growth rate, I don’t see this as a reality at these prices.

Assuming that they eventually paid out $770 million a year as a dividend (this would be twice their revenue from the last 12 months) it would still only amount to a little over a 1% percent dividend based upon their current stock price.

Growth investors will tell you that my numbers are too low and that I’m not taking into account their years of 50% + future growth, but the reality is that there is very little upside from $7.6 billion unless you are prepared to wait at least 5 - 10 years for what could still end up being a minimal return. I believe this to be far too much risk to assume for too little potential return. If Akamai was a small cap stock, today’s earnings would have been very exciting indeed, but with the stock flirting with a large cap valuation, I see little for investors to be cheering about.

While I believe strongly that Akamai’s greatest growth years are ahead of them, I’ve yet to see a valuation model that supports a market cap of $7.63 billion dollars. With only $385 million in revenue and $63 million in earnings over the past year, Akamai’s market cap trades at a valuation that many companies who are already earning billions in revenue, still don’t even have. Saavy investors may have been aware of this tax issue for the last year, but many investors who have piled on over the last year will find this news very sour indeed. While I believe that when life gives you lemons, you should make lemonade, I believe even more in never paying $1 million dollars for the neighborhood lemonade stand.

In looking at the role that Akamai plays in a portfolio, I think that investors would be wise to consider the risk that they may be over paying for unrealized potential.

Disclosure: Author has no position in AKAM

Source: Akamai: Lots of Froth on This Lemonade