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Akamai Technologies, Inc. (NASDAQ:AKAM)

Q1 2010 Earnings Call Transcript

April 28, 2010 4:30 pm ET

Executives

Noelle Faris – IR

Paul Sagan – President and CEO

J.D. Sherman – CFO

Analysts

Lauren Ye – JPMorgan

Mark Mahaney – Citigroup

Tim Klasell – Thomas Weisel

Michael Turits – Raymond James

Mark Kelleher – Brigantine Advisors

Brian Thackray – Deutsche Bank

Kerry Rice – Wedbush Morgan Securities

Katherine Egbert – Jefferies & Co.

Sri Anantha – Oppenheimer & Co.

Sameet Sinha – JMP Securities

Mike Olson – Piper Jaffray

Donna Jaegers – D.A. Davidson & Co.

Derek Bingham – Goldman Sachs

Jeff Van Rhee – Craig-Hallum

Mark Clark [ph] – FBR

Operator

Good day, ladies and gentlemen and welcome to first quarter 2010 Akamai Technologies Inc. earnings conference call. My name is Alisha, and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder this conference is being recorded for replay purposes.

I would now like to turn the call over to Noelle Faris, Director of Investor Relations.

Noelle Faris

Good afternoon and thank you for joining Akamai's investor conference call to discuss our first quarter 2010 financial results. Speaking today will be Paul Sagan, Akamai's President and Chief Executive Officer; and J.D. Sherman, 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 April 28, 2010. 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 and events portion of the Investor Relations section of our website. Now, let me turn the call over to Paul.

Paul Sagan

Thanks, Noelle. And thank you all for joining us today. Akamai performed extremely well in Q1. Top line growth accelerated year-over-year as we posted record revenue of $240 million, up 14% from the same period last year. Gross margins improved year-over-year and we achieved our highest adjusted EBITDA margins ever. While generating fully taxed normalized net income of $66 million, or $0.35 per diluted share, up 14% from Q1 of last year. These results came from strong demand for our services in all verticals.

Our cash flow generation was also strong with $88 million of cash from operations in the quarter. And so we are pleased to announce that our board has authorized a $150 million extension of the share buyback program we started a year ago.

I'll be back in a few minutes to talk about some of the key trends we are seeing in the market, but first let me turn the call over to J.D. for details on Q1. J.D?

J.D. Sherman

Thanks, Paul. As Paul just highlighted, our business performed extremely well in the first quarter. We grew revenue $2 million sequentially and 14% year-over-year to $240, coming in above the upper end of our expected range for the quarter. During the quarter we saw an acceleration in traffic growth, particularly in media and entertainment, as well as continued solid growth in our value-added solutions. We are particularly pleased with the sequential growth of our business coming off of very strong fourth quarter.

E-commerce continued to be our fastest growing vertical, increasing 19% over Q1 of last year, but declining 5% compared to Q4 due to normal seasonality, primarily in our advertising decision solutions. Excluding advertising decision solutions, E-commerce actually grew modestly from Q4, with growth coming from both dynamic side and application performance solutions. These cloud based solutions continued to gain traction in the marketplace.

Signings in the quarter, both from new customers and from existing customers, who are upgrading and adding additional applications were very strong. In fact the dollar value of new customers’ signings for our value-added solutions was up nearly 40% from Q1 of last year. And overall, 54% of our revenue in the quarter came from value-added solutions, up from 41% in Q1 of 2009 with 77% of our total customer base using at least one value-added solution.

Our media and entertainment vertical grew revenue 5% sequentially and 10% year-over-year in the first quarter, driven by accelerating volume growth and exceeding our expectations. We are beginning to see media companies offering higher quality video online, and as a result performance, reliability and scale are becoming increasingly important for them leading to key wins for Akamai.

The high tech vertical was up 15% year-over-year and flat on the sequential basis, driven by increased software download volumes in Q1. We also saw increased traction among Software as a Service or SaaS providers with our APS solutions. We now have over 100 SaaS providers leveraging Akamai’s platform to drive their businesses.

Public sector revenue was up 21% from Q1 of last year and 11% from last quarter continuing the solid performance we have seen for the past several quarters from government contracts. During the first quarter, sales outside North America represented 28% of total revenue consistent with the prior quarter. International revenue grew 1% sequentially and 16% year-over-year. The stronger dollar had a negative sequential impact on our revenue of about $2.5 million, and on a year-over-year basis the currency impact was favorable by about $5 million.

Revenue from North America grew 13% on a year-over-year basis and was up 1% sequentially. Resellers represented 18% of total revenue, down a point from the prior quarter.

We again performed extremely well on cost and gross margins in the quarter with cash gross margins up 83%, up slightly from Q4 and up a point from the same period last year. GAAP gross margin, which includes both depreciation and stock-based compensation was 72% for the quarter, consistent with Q4 and up one point from the first quarter of last year.

GAAP operating expenses were $106.5 million in the first quarter. These GAAP numbers include depreciation, amortization of intangible assets, stock-based compensation and restructuring charges. Excluding non-cash charges, our operating expenses for the quarter were $80.1 million, down about $4 million from Q4 and up 13% on a year-over-year basis.

Adjusted EBITDA for the first quarter was $118.1 million. That is up 18% from the same period last year and up 6% from Q4 levels. And our adjusted EBITDA margin of 49%, a record for Akamai, was of one point from the same period last year, and up two points from the fourth quarter.

For the first quarter, total depreciation and amortization was $33 million. These charges include $24.9 million of network related depreciation, $3.9 million of G&A depreciation, and $4.1 million of amortization of intangible assets.

Net interest income for the first quarter was $2.7 million, roughly flat with fourth-quarter levels and down $1.4 million from Q1 of last year, despite a higher cash balance due to lower interest rates on our investments.

Moving on to earnings, GAAP net income for the quarter was $40.9 million or $0.22 of earnings per diluted share. As a reminder, our GAAP net income includes several, primarily non-cash items including $21 million of stock-based compensation, including amortization of capitalized equity-based compensation, $4.1 million of amortization of acquired intangible assets, and $27.8 million of tax charges at an annual rate of approximately 40%.

As we continue to exhaust our NOLs, we expect to pay cash taxes at a rate of only about 6% for the year. However, as we talked about last quarter beginning this year we are including GAAP taxes when we report or normalized earnings each quarter. Again for Q1 that tax charge was $27.8 million. The supplemental metrics sheet posted in the investor relations section of our website provides a historical view of our normalized EPS on a fully taxed basis for comparison purposes.

Based on this methodology, our fully taxed normalized net income for the first quarter was $66 million, up 14% from Q1 of last year, and up 5% from Q4. In the first quarter, we earned $0.35 per diluted share on a fully taxed normalized basis. That is up $0.04 from $0.31 per diluted share in Q1 of 2009, and up a penny from $0.34 in Q4.

This was above our guidance range coming into the quarter, as the increased revenue growth and higher margins drove an outstanding bottom line result. Our weighted average diluted share count for the first quarter was 189 million shares.

Now let me review some balance sheet items. Cash generation continued to be very strong. Cash from operations for the first quarter was $87.8 million, or $0.37 of revenue. At the end of Q1, we had $1.1 billion in cash, cash equivalents, and marketable securities on the balance sheet. This balance included $244 million of highly rated federally insured student auction rate securities.

Capital expenditures, excluding equity compensation were $35.2 million, a bit lower than our plans coming into the quarter due to the timing of some expenditures that pushed into Q2.

During the quarter, we spent $21.9 million in share repurchases, buying back about 834,000 shares at an average price of just over $26. Approaching the one-year anniversary of the share repurchase program we have spent a total of $88.2 million buying back 4.2 million shares at an average price of about $21. And as Paul mentioned, our board has authorized an extension of our share purchase program, authorizing an additional $150 million over the next 12 months.

As with our existing program, we intend to fund it out of our strong cash generation and with the goal to offset dilution from ongoing equity grants. And finally, our days sales outstanding for the quarter were 58 days, down one day as compared to Q4.

With these Q1 results, following a strong Q4 we are even more optimistic about the prospects for accelerated growth. We witnessed an acceleration in volumes in media, and as a result we have seen a return to solid revenue growth in our media vertical. We have also seen continued traction with our value-added solution, as customers move more of their business transactions online and adopt cloud computing models.

And we executed our business model very well in Q1 with great performance on cost and expense management on top of the record revenues. Looking forward, we are becoming more confident in our ability to generate double-digit annual top line growth throughout the year and we are committed to making the investments that we expect will drive Akamai’s growth beyond 2010.

For the near term, we are expecting Q2 revenue of $236 million to $246 million. That represents between 15% and 20% year-over-year growth, accelerating from the 14% growth rate we saw in Q1. We expect the currency headwinds will continue on a sequential basis in Q2. Assuming current spot rates foreign exchange will have a negative impact of approximately $1.5 million compared to Q1, but a slight positive impact of $1.5 million compared to Q2 of last year.

We expect that cash gross margins will be approximately 82% in Q2 and GAAP gross margins including equity compensation will be approximately 71%. In Q2, we plan to increase our investment levels, given the positive growth outlook for the year. On the OpEx side, we expect to grow OpEx by about $7 million to $8 million on a sequential basis, as we continue to invest in R&D and go to market initiatives that we believe will yield important near-term and long-term benefits.

We expect adjusted EBITDA margins will be back in the planned range of 46% for the quarter as investments catch up with our top line growth. With the acceleration we have seen in media volumes and the increasingly large TV size events online, we are planning to ramp up our CapEx spending in Q2 to approximately $65 million. For the full year, we expect CapEx will be at the top end of our long-term model range of 13% to 16% of revenue.

We think this is a very positive sign about our confidence and the prospects for growth across all areas of our business. Given our revenue guidance of $236 million to $246 million in Q2, we expect fully taxed normalized earnings per share for the second quarter to be in the range of $0.32 to $0.34. This assumes a GAAP tax rate of roughly 39% or GAAP taxes of approximately $21 million to $24 million for Q2.

Overall, we are very pleased with how the business performed in Q1. Our value-added solutions continue to be significant growth driver and with accelerating traffic growth our media business returned to revenue growth as well. Given our strong Q1 financial results and balance sheet, as well as the trends we are seeing in the marketplace that continue to favor our uniquely differentiated services and delivery platform, we plan to continue making key investments in 2010 that will drive our growth for 2011 and beyond.

Now let me turn the call back over to Paul.

Paul Sagan

Thanks J.D. As J.D. mentioned, we believe there are exciting trends taking shape across our business, trends that I talked about on our last call, and emphasized at our investor day in December. We think we are still in the very early days of these positive developments, and we are already starting to see their impact on our business performance.

To reiterate, we believe cloud computing is revolutionizing IT, and driving more and more business processes online. Video distribution on the Internet is now fundamentally changing the media industry, and online advertising is transforming marketing strategies.

Let me begin with the market opportunity for optimizing enterprise cloud computing, improving the performance of mission-critical online systems and applications. This is an area where we are differentiated and highly valued by our customers. So we are increasing our focus here. More and more business functions are moving online, as end-users expect to access applications anytime, anywhere and from any device.

However, moving from a traditional enterprise IT model, the cloud introduces new performance and reliability challenges that are inherent in using the Internet. This is particularly true as computing resources are centralized and users are more and more global and mobile. Akamai’s cloud optimization services are designed to help businesses realize the full potential of their cloud strategies, without compromising on performance or security.

A great example is how Akamai’s cloud optimization solution benefits (inaudible) exchange service, by reducing connection times and increasing performance by 50% to end-users, including mobile users. In response to security concerns with cloud-based applications, we have seen strong demand for the Web Application Firewall solution we introduced in December. The service enables online businesses that require advanced security for their websites to access it from our distributed cloud.

One of our customers, a top luxury retailer, was looking to protect its sites and applications from information steps [ph] and downtime, while also meeting strict PCI compliance standards. With the Akamai Web App Firewall solution, this retailer was able to add an essential security element without additional internal IT build outs. And so our new cloud optimization solutions are leading us into new industry verticals and enterprise customers.

Already today we count as customers six of the top 10 global banks, five of the top 10 online brokerages, nine of the top 10 global pharmaceutical companies, 13 of the top automakers and the top accounting firms and we are stopping there, as we continue to develop new capabilities to improve the performance of our customers’ cloud-based initiatives.

Also getting a lot of attention these days is the online video revolution, and that is having a positive impact on Akamai’s business. Successful online models such as Netflix, Hulu, and iTunes [ph] are emerging for distributing recorded entertainment. These models are pushing the Internet forward as a new medium of choice for consumers looking for premium or HD content. Equally exciting are live events distributed over the Internet in HD, events such as the Masters and March Madness. These are demonstrating the web’s ability to reach increasingly large audiences in new and innovative ways.

Turning to the week of the Masters for example, we set the record for peak traffic on the Akamai network, exceeding 3.4 terabits per second. Put another way, on our busiest day, our network responded to more than 0.5 trillion request for content. That is trillion with a T. And that is a figure equal to serving content to every person on earth, every 20 minutes all day long. That is an impressive record, but one that we don't expect will stand for long.

Demand like this demonstrates why it takes Akamai’s distributed approach to deliver large events effectively. On that record day, we delivered TV like HD video streams from more than 500 locations in the US alone on behalf of a single major client. We don't believe any other approach comes close to matching our scale, quality or efficiency. And as the Internet continues to transform and revolutionize business around the world, we intend to further enhance the Akamai’s HD network.

Our strategy is to continue investing in this platform, so we can deliver our customers premium content to their end-users at scale, at the highest quality with reduced complexity and increased accountability.

Finally, in a newer area of our business using data to improve the performance of online advertising, we believe we are continuing to see an improving climate for advertising, and increasing acceptance of leveraging shopping data to power better add campaigns. We had a record number of new customer signings for our advertising decision solutions in Q1.

So in summary, we are very pleased with how Akamai performed this quarter. Five years ago, when we were about a $200 million business we set a goal for ourselves, one that seemed audacious to many at the time. We set out to reach $1 billion in annual revenues, something that very few independent software companies have managed to do. Even more boldly, we declared we will get there by the end of the decade.

While it is still early in the year, I think we have a good chance of achieving that goal in 2010 just as the decade ends. And as we try to achieve that goal this year, we are investing in the future for the next billion dollars in revenues. So as Akamai continues to help transform business online in the Internet itself, we are even more excited about the long-term.

Now, J.D. and I would be happy to take your questions. Operators the first question place.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Sterling Auty from JPMorgan. Please proceed.

Lauren Ye – JPMorgan

This is Lauren Ye for Sterling Auty.

Paul Sagan

Hi, how are you?

Lauren Ye – JPMorgan

Good, how are you?

Paul Sagan

Good.

Lauren Ye – JPMorgan

You had good experience with the media entertainment…

Paul Sagan

Lauren, you are kind of fading in and out a little bit there.

Lauren Ye – JPMorgan

Can you hear me better now?

Paul Sagan

Yes.

Lauren Ye – JPMorgan

Okay, great. Just had a question around the media and entertainment line, obviously you guys did really well there. Just wanted to kind of understand, how much of this upside is really HD versus which you mentioned that there might have been some events that were pretty strong, obviously they probably are HD as well that kind of pushed it over the top?

Paul Sagan

Sure. Well, one of the keys is a lot of it is HD, not everything. People are still delivering video at variable bit rates, and some of them more standard like we have been seeing for a number of years. But we're seeing increasingly HD video both for on demand higher quality things like movies and TV shows delivered that way and especially for live events, not just because of the picture quality, but because of the instant replay and the effectively built-in DVR or digital video recorder functionality that we provide right in the player. And I think that is very exciting.

So, it doesn't account for all of the upside. We saw strength across media, across software and high-tech. We saw it across e-commerce, but I think HD was a piece of the pleasant surprise, and I think will be a big driver for us over the next several years, because what we are seeing from customers is much greater interest at adopting the Akamai HD solution, faster than we had expected.

Lauren Ye – JPMorgan

Great. And then just my follow up…

Paul Sagan

Operator.

Operator

Your next question comes from the line of Mark Mahaney from Citigroup. Please proceed.

Mark Mahaney – Citigroup

Thanks. Two quick questions, first, could you just update us on the churn or the gross customer adds, and second the international growth just for FX was 5%, 6% year-over-year against a tough comp granted, but it is not the kind of double-digit growth, I think you would have like to see. Did you talk about the steps to get that growth faster in international markets? Thank you.

Paul Sagan

Yes, sure Mark. Yes, last quarter we disallowed talking about the broadly based churn and customer account numbers and kind of ironic that we then went and had a record quarter there with our – our gross new customers were up, our churn was actually below 3%, which are very low. But I still think the right way to look at the business is to break it down by vertical. We talked about in the commerce vertical, the signs that really do matter there. We are looking at the dollars coming in the door from brand-new customers, who are signing up to our value-added services, particularly DSA and APS, and that was up 40% year-over-year.

We saw the revenue from our value-added solutions go from 46% to 54% a total of our business from Q1 of ’09 to Q1 2010, and we continue to get really good up sell of our existing customers to the point now where 77% are buying at least one solution, and we continue to have really good traction there.

J.D. Sherman

One value added solution.

Paul Sagan

One value-added solution, correct. So I think we are very, very pleased with the signings that we saw in the quarter, particularly around the value-added solution. And then your question on international, you are right, last quarter, last first quarter we had a very large quarter in international, and so there are some tough compared timing type impacts.

I think also what you are seeing in international is something similar to what we saw in North America last year, particularly the economies there haven't recovered as fast. The digital media business has not turned like we have seen yet in the United States. So the results are a little bit dragged down by that, but we continue to really good traction of our value-added solutions over there. And I do believe that in the long term, and even in the relatively near term we will see an acceleration there, and international will continue to be our fastest growing geography.

Mark Mahaney – Citigroup

Thank you.

Paul Sagan

Operator.

Operator

Your next question comes from the line of Tim Klasell from Thomas Weisel. Please proceed.

Tim Klasell – Thomas Weisel

Hi, good afternoon everybody. Great quarter. Just wanted to touch a little bit on the CapEx, you are going up to the high end of your 13% to 16% range. What is driving that? Is it the media volumes, is it efforts relevant to cloud computing, and do you think that higher end, the 16% will be the sort of the go forward for maybe a few years as growth accelerates?

Paul Sagan

No. I think it is a little hard to make the long-term call. We have had a range, which we have been very successful staying within as part of our model, and we believe the model holds. We just see so much growth opportunity right now by geography around the world. By vertical, whether it is performance enhancements and application acceleration or the rapid adoption of HD and the size of audiences, customers are beginning to talk to us about delivering with high-quality video with interactivity. So we just think it is prudent to make sure that we're ahead of it so that we are not turning customers away or disappointing them.

And we think spending a little bit more than frankly grouping those purchases and getting even stronger possible discounts from our suppliers on the hardware side is a prudent step to take. I have gone through this before, but just for the benefit of people who may be new to the story, we are not making long-term multibillion dollar bets on some new manufacturing plant. These are quarter by quarter decisions. If we remain as upbeat, we can continue to expand capacity if we think that is a turn in any part of the world, we can pull back a little, and it is not a stranded resource.

So we think we are doing the right thing to stay a little bit ahead and encourage the network group to build out faster. But it is not a fundamental shift. It is not a fundamental shift in product type. It is just our consistent build for where we see demand, which geographies, which networks, with services around the world and making sure we stay ahead of the opportunity.

Tim Klasell – Thomas Weisel

Okay, great. And then just a quick comment on the margins in the media business, I know it is hard to separate them all out, but your feeling as that business accelerates that customers are getting a little bit less price sensitive and maybe margins are getting a touch better there?

Paul Sagan

You know, I think that this is a competitive field, and technology unit prices go down every year. We have always worked with that thesis, and it has been true for over a decade, and frankly our ability to drive our own unit pricing down, and share that with our customer, allows them to expand our use to things like HD. So I think that is just a given, and since I think we are at the 1% line today of exploiting the market opportunity. I don't worry about it, and if you look at how much video in the home today comes over the Internet, it is a little over 1%.

It took 15 years to get there. I don't think it will take 15 years to double and double again. So there is plenty of volume to go after, and it is key that we are going to drive price down, and share some of that with our customers. One of the things that I think has been terrific over the last several quarters has been our ability to drive more business for customers to do more, and continue to improve the profitability of the business, whether cash gross margin, GAAP gross margin or just EBITDA. They were all up and strong this quarter. And at the same time, I think we were doing better job delivering value for our customers.

Tim Klasell – Thomas Weisel

Great. Thanks a lot.

Paul Sagan

Thanks Tim. Operator.

Operator

Your next question comes from the line of Michael Turits from Raymond James. Please proceed.

Michael Turits – Raymond James

Hi guys. A couple of questions, first of all any thoughts on your strategy for pricing, which you initiated about a year ago in terms of getting more aggressive on price. Are you pretty much through that? Do you feel like now that that is played out, and has that worked in the sense of both driving more demand out of your customers and also winning share? And I got a couple of follow-ups.

Paul Sagan

I think that one we dealt with before Michael. I think people, A, made more of it than there was a year ago. We were more aggressive in some cases. It was at the right time because it unlocked demand. We found some elasticity that we either missed or frankly it wasn’t there before. And I think it is regular course of business. Our customers want to do more, their businesses are improving, their monetization options are increasing and they are turning to us for quality, scale, reliability and security. And we are pricing it fairly, and I think that is working for both parties, us and them, and so, there is really I think much less to be made of what people thought was some declared radical new strategy.

Michael Turits – Raymond James

Second question is, this quarter you expected cash flow gross margins to be about flat, which they were. There are up a little. But you expected GAAP gross margins to be down a point, and it seems like you had less of an uptick in depreciation than you thought you would. Now you are increasing CapEx, and so although it seems like you are in a good direction as far as the EBITDA margin, should I be concerned that we are going to see one, two, three points more of increased depreciation per year, and that will drag down like even by net income margin?

J.D. Sherman

Michael, I think the reason that we saw an uptick there was really on the top line, the accelerated revenue growth helps the numerator there. And I think if we continue to see very solid growth on the top line, then basically our investments in the CapEx have paid off and that is not a big worry. If we see the top line start to level off, then we will have two pull back on our CapEx.

As Paul said before, we are making sort of 90 day decisions here. We are not making for one year or two year out type decisions, but the way I look at it or the way I would recommend that you guys think about it as an investment, because we see things starting to look very positive for us in the near term, and that bodes well for our top line as well as the model.

Michael Turits – Raymond James

Great, guys. Thank you.

Paul Sagan

Thank you, Michael.

Operator

Your next question comes from the line of Mark Kelleher from Brigantine Advisors. Please proceed.

Mark Kelleher – Brigantine Advisors

Great. Thanks. I was just wondering if you could address the possibility as HD ramps and the bit rates increase. Are there any bottlenecks in the network that are beyond your control? I know that was an issue for some of the initial HD deployments, but particularly in the last mile, are there any things that can catch you that are sort of beyond your control?

Paul Sagan

I think, one of the things that unlocked the potential for HD was the massive expansion of last mile broadband and end-users capable of getting several megabits a second, and we see that increasing, and creating more bottlenecks on the other side of the Internet across turning points, and in the first mile. And so as you know the Akamai distributed mile solves that problem as we did with some events recently delivering HD video from literally over 500 locations in the US alone for our customers.

So we actually think we are in exactly the right spot. There are certainly networks that get underprovisioned. We have seen that to some extent in some wireless networks, and the end-users with a disappointing experience. I think the challenge there is those providers either have to expand their capacity, or they are going to lose subscribers somewhere else. So you are right, we can't do better than the last mile in the ISP networks.

We partner with them to help them expand their capabilities and be more efficient. We do a lot for ISPs, but ultimately the last mile is only as good as the last mile that you are in and I think we are going to see consumers going more and more to the best network providers, who can give them a great first mile connection to the Internet. And our goal is to be in those networks and deliver its scale.

So there is no technical limitation. There certainly will be places with poorer performance in countries with slower networks. But by and large we have seen a dramatic improvement there over the last five years and we will continue to see it I believe going forward.

Mark Kelleher – Brigantine Advisors

Okay, great. Thanks.

Paul Sagan

Okay, thank you.

Operator

Your next question comes from the line of Todd Raker from Deutsche Bank. Please proceed.

Paul Sagan

Hi, Todd.

Brian Thackray – Deutsche Bank

Hi guys. It is Brian Thackray pitching in for Todd here.

Paul Sagan

Hi, Brian.

Brian Thackray – Deutsche Bank

First question, just to drill down a little bit more on the media side, can you give us maybe – help us quantify what percentage of video delivery today is higher resolution, and around that can you may be compare this adoption cycle and higher resolution compared to the previous cycle in ’06, ’07; are we tracking faster, slower than that, how should we think about that as we think about the adoption?

Paul Sagan

Yes, I don't have a scientific way to measure that. I can give it to you sort of anecdotally as we see it. I certainly think we are seeing more interest in HD faster from a broader set of customers than we saw before and expected. I think there was a long period where people were in the 300 kb, the 500 kb, 700 kb, and once in a while experimenting with something more. And it is pretty typical now, if it is a professional sports league or a studio or somebody with premium content, talking about much higher bit rate file making one and two meg and upstream formats available.

And one of the interesting things is we are seeing that when it is available, often more than half the users are going to the highest available, and we are seeing that the engagement levels are much higher. So the live sporting events are very interesting because you can get a true AB comparison real-time, how long people stay at different bit rates. We have done some events recently and the engagement time or the amount of time people stay watching is often double or more the standard bit rate.

And so that just raises huge new monetization opportunities for the distributors of content producers, and I think that that is why so excited about it and we have been able to show them examples of that. And I think that that is a very powerful message in driving at least anecdotally faster interest and faster adoption. I think there is certainly plenty of standard bit rate video and I'm sure you have been to many websites, where that is all you get. So I think there is a long way to go, which is a great opportunity for us.

J.D. Sherman

I would just add Brian, I don’t think we’ve – while we are seeing that happen and interest is moving a lot faster than we thought, we still haven't seen that sort of inflection point that broadband adoption grow back in late 2006 or early 2007, that huge ramp up. I still think we are in the early sort of – maybe it is not the 1% point anymore, but it is certainly the 5% or less point.

Brian Thackray – Deutsche Bank

Great. And the incremental expenses you talked about J.D. for next quarter, can you give a little bit more color in terms of where they are going to be, maybe what products they are attached to?

J.D. Sherman

Yes, sure. This quarter we added about 90 people. Largely our expenses are associated with people. And 90% of those ads were in two places, go to market meaning sales, services and support and R&D. And we're going to continue to invest in there. I think we scaled pretty nicely it terms of network support and G&A et cetera. Obviously we will have to continue to grow in scale to handle more customers and more network traffic et cetera.

But our primary focus is building out our services and support in sales, particularly around value-added solutions and building out our capabilities in R&D to add additional functionality, again particularly around our value-added solutions, but also the HD network we are investing in heavily there.

Paul Sagan

Thanks. Operator.

Operator

Your next question comes from the line of Kerry Rice from Wedbush. Please proceed.

Kerry Rice – Wedbush Morgan Securities

Thanks a lot. Great quarter. Maybe another way to ask about gross margins, and you may have already kind of implicitly implied the sustainability of those or kind of what is driving the growth or the positive side in the number. Was it primarily, I don't know if you can break it down, was it primarily revenue, was it the reduction in unit cost or is there something else kind of as we should think about that, maybe related that to pricing in the industry. Because I assume that is still coming down, and with media and entertainment being a lower margin business, we could see some pressure there. So it seems like you were able to offset that pretty easily. And the last question, advertising solutions, can you, not necessarily to break it out or get much detail, but did that grow year-over-year or can you give any kind of insight into that business?

Paul Sagan

Sure. Let me answer that question first. It is obviously going to go down sequentially and it did, about $6 million sequential decline, but it grew very nicely sequentially, the fastest growing product area. Not surprising because it is also one of our newest and still smallest in terms of dollars.

Kerry Rice – Wedbush Morgan Securities

Year-over-year basis?

Paul Sagan

On a year-over-year basis. So, yes, we are really pleased with the continued traction we are getting with that solution. And back to your question about gross margins, I think there is two things going on fundamentally. One is we are doing a great job taking cost and expense out of the network and you know matching that with the price benefits or the cost benefits we are passing on to our end customers, and that particularly plays out in the volume driven areas of media, software downloads, et cetera.

At the same time, our mix is changing very dramatically towards the value-added solutions, and we have talked about how the value-added solutions, particularly DSA and APS are much more software like, and have much higher gross margins on average. So the results of those two things have been a – actually our gross profit margin on the cash line has actually crept up a little bit recently, and I think as we look forward to the year, we have talked not specifically about guidance, but we think we can sustain in that same kind of range based on those trends.

Kerry Rice – Wedbush Morgan Securities

Great. I guess – when I think about value-added solutions, have you guys thought about starting to break out kind of the mix of those value-added solutions, or I am assuming DSA is still primarily the biggest component of that, but any thoughts on that?

J.D. Sherman

Well, what we have started to do is talk about on a percentage basis where we are. It is something that we will dive into at least on an annual basis when we get to our investor day just as we did last year and give a little more granularity there.

Kerry Rice – Wedbush Morgan Securities

Okay, thank you very much.

Paul Sagan

Thank you.

Operator

Your next question comes from the line of Katherine Egbert from Jefferies. Please proceed.

Katherine Egbert – Jefferies & Co.

Hi, good afternoon. Very nice quarter. How much of your revenue now is non-variable, i.e. the platform fees?

J.D. Sherman

Well, it is not always platform fees, right. It depends on the structure of the deal, but we are still in the ballpark of, and of course there is the time element to this as well, right Katherine, but we are still in the ballpark of 70% coming into a quarter being non-variable.

Katherine Egbert – Jefferies & Co.

70% non-variable. Okay, great. And then on the CapEx, what exactly are you spending additional money on this quarter?

J.D. Sherman

Some of it is servers in the network, and some of it is drives in storage for cloud storage for our media customers. And then as you know, we capitalize a certain amount of our R&D as well.

Paul Sagan

But the ramp up is really capacity in terms of servers and storage in the network not on the R&D side so much.

Katherine Egbert – Jefferies & Co.

Capacity in what areas, what specific, because usually your servers are dedicated to a certain function when they are initially rolled out?

Paul Sagan

Well, it is actually quite flexible in terms of we deploy the servers out there, and we provision them real-time automatically, software-based to respond to the requirements and needs of our customers. So literally the same server that is delivering traffic for the HD network, one day may be serving Edge computing content you know in the next 15 or 20 minutes.

J.D. Sherman

And one of the keys in moving to the HD network on the HD fee standard is it makes more of the network available to be flexible and do more things.

Katherine Egbert – Jefferies & Co.

Sure. I guess my question was, what initially are these new servers targeted at?

Paul Sagan

Well, the driver for the capacity is clearly media volumes, and HD video. There is no question about that. The point there is it is not, we don't have to make a bet about this capacity here and then if something else takes off we have to respond differently. That is the beauty of our network. In some sense that media, that big footprint that we build out for these massive volumes in media, we can leverage to deliver our value-added solutions on top of that footprint.

J.D. Sherman

And so in fact as we grow the capacity, they can also do software delivery, and those volumes are growing, and as we expand the footprint there are more nodes getting more data on real time internet, congestion or conditions. So, on that day I talked about serving over half a trillion requests. The more locations we are in, and the more data points we get every second, the smarter our routing is not just for delivering jitter free video, but for accelerating SaaS function for some B2B corporate function as well. So the deployment gives us benefit across the board. The big catalyst is the growth of the volume business around media and software.

Katherine Egbert – Jefferies & Co.

Okay, great. And then just quickly last one, Paul you said $1 billion in revenue this year, I mean should we take that as guidance?

Paul Sagan

You should take it as me pointing for the fences and trying to get the team motivated to make the – to be there by the end of the decade. I think we are going to give you formal guidance on Q2, which we did, and then you could do your own calculations for the rest of the year. I see a way we could get there. We could do better. We could do worse, but it is certainly within our grasp to meet the goal we set out.

And then I think the other point is, we are now looking for the second billion in revenue as well, and that is why we are making the investments in all of these areas.

Katherine Egbert – Jefferies & Co.

Sure. Okay, congratulations.

Paul Sagan

Thank you.

Operator

Your next question comes from the line of Sri Anantha from Oppenheimer & Co. Please proceed.

Sri Anantha – Oppenheimer & Co.

Yes, good evening and thank you. J.D. in your prepared comments you sounded absolutely confident about double-digit growth, how much of that is predicated just on higher media and entertainment, as opposed to the opportunities that you folks are also seeing in cloud computing services?

J.D. Sherman

I think, the way I look at it, what we are seeing with our value-added solutions, which are a lot around the cloud optimization services. Those have been growing 20% plus for quite some time, and we see that continuing. In fact, as I talked a little bit about the demand particularly with our new customers signings, it is actually increasing. You know, it grew almost 40% which is faster than even our revenue growth in that area.

What is different and what we are seeing change and drive the acceleration is that media business primarily, which had slowed down in terms of growth. And even showed a couple of quarters of decline last year, we are seeing solid growth there driven by the return to very positive volumes growth.

Sri Anantha – Oppenheimer & Co.

And just one quick question. Paul, is it possible in any way to maybe give us a little more color. How the nature of the conversations are going with media and entrainment. I know people are focused on pricing and volumes, but as more content in some form or fashion is getting monetized here, are media entertainment customers more increasingly focused on the value-added services, which gives them better ways to monetize their content, or is there something else they are looking for from you guys rather than just the pricing?

Paul Sagan

The discussion we have had with them for over a decade is about scale and quality, and how do they find their audience, how do they get them to stay longer, and how do they monetize their content. And so whether that is the HD network and the built-in functionality like DVR, the ability to put multiple video streams in camera angles in a live event, and keep people there longer, so they see more advertising or interact with advertising. For media analytics that helps them to figure out to how to monetize better, both historically and real-time.

Our advertising decision solutions that raises the value of advertising for a certain set of our customers, or our digital media acceleration capability that takes the dynamic aspect of a media site and makes it more reliable and engaging are all the types of things that these customers talk to us about. And increasingly I think they are the value-added pieces on top of video, because that is how they are going to make money. And I think we have got a great portfolio and a growing portfolio of services that meets their expectations for how do they build profitable businesses.

Sri Anantha – Oppenheimer & Co.

Great. Thanks so much.

Paul Sagan

Thank you.

Operator

Your next question comes from the line of Sameet Sinha from JMP Securities. Please proceed.

Paul Sagan

Great. If we keep the questions tight, we will be able to fit them all in in our hour folks. Go ahead.

Sameet Sinha – JMP Securities

Okay, thank you. You had spoken about the cloud and cloud optimization. Is there a way to quantify how big that market is because if you look at the all of the projections for cloud computing, the broadly defined term goes into tens and billions of dollars, but the optimization fees, which you specialize in, how big would that be? And secondly, just on expenses, sequentially we saw G&A come down a little bit, sales and marketing come down quite a bit. Should we use that as kind of the baseline and then track it throughout the year?

Paul Sagan

Well, let me answer your second question. I would expect that we are going to have sequential growth probably across the board in all of our areas, but it is going to be highly focused in R&D and sales and marketing. So I don't have specific guidance for you by line item underneath the totals, but we will have some natural growth as the business grows in the G&A area et cetera, but the primary growth is going to be in engineering and in sales and services support.

And then to your first question, I will take a shot at it. You know, the cloud – there are a lot of people deploying cloud computing very broadly, and give very big numbers. The way we think about cloud optimization is how we are helping our customers deploy cloud solutions or deploy into a cloud based model the applications that they are running today in a more centralized data centre model. And customers today spend a lot of money optimizing the way their applications work in that model and there is a lot of cost savings to be had there.

So we kind of focus on the parts of the market that – where customers are spending money to optimize solutions today. And that is probably a $2 billion to $3 billion market to define narrowly and then you know, obviously you can have even broader discussion as you go further out into the cloud optimization world, and get into the billions of dollars.

Sameet Sinha – JMP Securities

Okay, thank you.

Operator

Your next question comes from the line of Mike Olson from Piper Jaffray. Please proceed.

Mike Olson – Piper Jaffray

Great. Thanks very much. Talking about the kind of the second billion of revenue, you know, you've said in the past that you have 95 of the top 100 e-commerce sites using VAS. Is there any change in how you'll kind of go about tackling the next 100 e-commerce sites? Is that size of that opportunity for next 100 drop off significantly or is the opportunity for Akamai really similar to what it has been with the top 100. And then secondly, as part of that, VAS was 54%, where does that kind of top out as a percent of the mix? Thanks.

Paul Sagan

So, I think you mean DSA dynamic side acceleration?

Mike Olson – Piper Jaffray

Yes, value added solutions.

Paul Sagan

Right. So that is right. A little over 50% overall with commerce being the biggest piece of that. I think there are two great parts to commerce. First, as e-commerce has just grown overall, the second 100 and the third 100 sites are becoming big enough, big enough online businesses that we think that they can benefit and pay for our services.

So we are going after the next 100 and the 100 after that with the original suite of services, but we think we can help them sell more and improve the ROI, but we are not done that the first 100 either, where we have over 90 of them. We’re adding functionality, we're adding features like web application firewall, where we even go sell and raise the wallet share that we get, and we have a roadmap of additional features.

Some will just be enhancements that they will get with their current service, but many will be new services that we believe will help them sell more and have more successful online business. So we are going to focus on continuing to add value and hopefully getting paid more from our existing great customers set and going to the next 100 and the next 100 after that with the current offers in e-commerce to help them grow and be more successful online. And we think that that's a great category from us. It is just starting to benefit for example, from our advertising decision solutions and our ability to help online retailers find more in market customers and drive sales that we are going to get. Otherwise, for example, we’re very optimistic about that portion of the business.

J.D. Sherman

Then, as far as the sort of share of our business that that will become, it's hard to say long-term because it depends also on how volumes grow in our media business. The nice way to grow the share will be to have both parts of our business growing very rapidly. We are at 54% now. That's up seven or eight points from where we were this time last year. I wouldn't be surprised if we are talking about sort of 60% type number by year-end, but we'll have to see how all the pieces play out.

Mike Olson – Piper Jaffray

Thanks.

Operator

Your next question comes from the line of Donna Jaegers from D.A. Davidson. Please proceed.

Donna Jaegers – D.A. Davidson & Co.

Hi guys. Great quarter. Just to try to drill down a little bit more. You have had a number of press releases recently about the software as a service contracts that you have been getting for web – for optimization. Can you give us sort of what is the average size of one of those contracts?

Paul Sagan

We've done some customer relations. We’ve also done a number of partnered ones where we are being embedded or providing a solution as they grow. So to some extent as they sign on more customers their business grows and they’re effectively sort of a channel. So I don't think there is one answer for what the size of those customers. It really depends on the use case and whether they are a single customer or they are really our way to get to many others.

J.D. Sherman

Yes, it's hard to say, it's hard to give an average in that that would be meaningful, because we have some very large deals with very large SaaS guys and relatively small deals with SaaS guys who are, you know, not as big, and their user base is not as big.

Donna Jaegers – D.A. Davidson & Co.

Okay. Can I try to pin you down on one other thing? On HD, obviously I had people calling me about the Master's and just look at the dogwood tree; you can see every blossom on it. How much did that – as far as revenues, did that add $3 million, $4 million? Can give us a little more specifics on how much that might have added to the quarter?

Paul Sagan

So, sorry. We won't comment on specific customers. One thing we have said for one, I think this is also important is, you know, in our side no single event is that important to the result. We certainly care about every customer. We want everyone to go well, but no single event is a large piece of our quarterly revenue. But I won't give you obviously the specific revenue for a customer…

Donna Jaegers – D.A. Davidson & Co.

All right, thanks.

Paul Sagan

It is a nice little question, but can’t go there. I'm not sure how you modeled it anyway, because no way to really calculate how many events per quarter per year. One thing we always have is there are always a few for a quarter. They’re always pretty interesting, but there is sort of regular course and speed of our business right now.

Donna Jaegers – D.A. Davidson & Co.

Okay, thanks.

Paul Sagan

Thanks Donna.

Operator

Your next question comes from the line of Derek Bingham from Goldman Sachs. Please proceed.

Derek Bingham – Goldman Sachs

Hi, gentlemen. Congratulations. Two just quick financial related ones, J.D., first just on the headcount, you said you added 90 people in the quarter. Is that the kind of pace you expect in Q2, and kind of as we go through the year? And then also you mentioned what you think the cash tax is going to be this year. Any view right now on how that's going to flow into calendar 2011 in terms of cash tax?

J.D. Sherman

So, I'll answer that one first. I do think, you know, there is always timing impacts in any year on the tax rate, and obviously we have to deal with that. I do believe that will be you know, sort of 39% or lower this year on tax rate, and I think over time as our business shifts into more international that tax rate will come down sort of gradually over time. There won't be a step function, but we will have a gradual decline in our tax rate over time. We are never going to be the kind of company that has a sort of a 10% or 12% tax rate, because we don't make anything that would shift offshore, but what we will be able to do is just manage that a little bit better as our business shifts internationally.

Derek Bingham – Goldman Sachs

But, does it bleed into next year at all or is it just as soon as the year begins, suddenly you are paying full cash taxes?

J.D. Sherman

Oh, I see on cash tax, yes, you know, you make an estimate, you start paying based on where you think you are going to come out, and based on the way we see this year playing out we will be through our NOLs this year. We’ll be a full cash taxpayer in 2011.

Derek Bingham – Goldman Sachs

Okay, all right. And then headcount, is that –

J.D. Sherman

Sorry, headcount, yes. So, yes, we added about 90 people this time. I actually think that if anything will ramp that up a bit in the second quarter, we tend to have – significant hiring happens towards the end of school years and second quarter is a little bit slower. In the third quarter during the somewhat months, but I do think we’ll ramp that up a little bit.

Paul Sagan

You know, probably up in Q2, down in the summer, and then we’ll see about Q4 when we get there.

J.D. Sherman

Yes.

Operator

Your next question comes from the line of Jeff Van Rhee from Craig-Hallum. Please proceed.

Jeff Van Rhee – Craig-Hallum

Great, thanks. Hi guys, just one remaining question. As you look back to the February call, you were pleased with Q4 and yet very hesitant about Q1, obviously it's turned out to be much, much better, can you talk to the progression through those months when you really started so see that visible improvement and how it progressed from February to now where we are sitting here now at the end of April?

J.D. Sherman

Yes, I mean, you know, our business is – the nice thing about our business is the recurring revenues. So you can start to see the bill but, you know, there are a lot of variables in the business, and so it was hard to say exactly how things were going to look after seeing January or even February results but you know, it looked after even you know, that January results came in that was going to be a strong quarter and we kept that momentum up through the quarter.

Jeff Van Rhee – Craig-Hallum

But you wouldn’t say – it was just a steady build through those intervening months, there wasn't any real hockey stick once we got into March and just that surge continued into April. I mean, any other color would be great.

J.D. Sherman

I don't think there is any hockey stick or any one event or anything like that. You know, the really nice thing and the hardest hottest thing to predict obviously is what happens after you see a very large seasonal quarter in Q4, and to see some sequential growth off of that, particularly as our advertising business declined naturally was, you know, a pretty good surprise.

Jeff Van Rhee – Craig-Hallum

Okay, great. Congrats on next quarter.

Paul Sagan

Thank you.

Operator

Your final question comes from the line of Mark Clark [ph] from FBR. Please proceed.

Mark Clark – FBR

Hi guys. I have two questions for you. First with respect to the growth in MP and volumes space, do you attribute that more to Akamai taking market share or to the overall growth in just consumer consumption that is benefiting the (inaudible) as a whole. If it's a combination of the two, can you give us kind of a composition? And the second question is in the value-added service market and I guess, specifically host side delivery in DSA, can you talk about the competition in that market and what you are seeing? And I know that limelight once again is deterioration of its host side [ph] delivery product and you have other smaller CDMs [ph] like Nintendo that are focused on DSA. So, I'm kind of curious what you are seeing in that market with regards to the competitive makeup. Thanks.

Paul Sagan

You see a lot of press releases.

J.D. Sherman

You’ll have to ask them about their traction, because we don't see them with our customers. I think it's one thing to talk about when you do this as a hosting company, I think it is really different to accelerate, people contact applications and handle their mission-critical businesses online, when billions of dollars are at stake, and we have spent 12 years working with our customers to deliver their sites reliably and to optimize the performance of their applications and building proprietary technology using a distributed model.

And other people are in the hosting business, in the mirroring business and trying to run a backbone to figure out how to appear their content through the congestion on the Internet, and it just doesn't work very well. We saw that in spades with live sports. Recently we see it with e-commerce and we see it with acceleration, and so, you know, fundamentally we take a different approach. We think our customers recognize it and other people take a different approach, which we don't think really applies to what we do. So it's – we don't think it's the best of breed solution, and we think that's why we've done so well. Other people will come out with other solutions, and frankly they will have to prove the ROI to their customers. Anyway, thanks for the call.

Paul Sagan

And let me answer quickly the M&A part of that.

J.D. Sherman

I would do it really quickly because we’ve gone over an hour, and we told people get them out of here.

Paul Sagan

Yes, so, Michael, I think over the last three or four quarters we had some nice wins in the M&A space, but I think largely what we're starting to see now is the organic volume growth that those wins started to or have sort of led to.

Paul Sagan

All right. So with that one, we’re little over our time. Thank you all for dialing in. It was great to give you an update. We’ll see you back here in another quarter. Bye-bye.

Operator

Ladies and gentlemen this concludes the presentation. Thank you for your participation in today's conference. You may now disconnect. Have a great day.

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Source: Akamai Technologies, Inc. Q1 2010 Earnings Call Transcript

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