- The increase in profitability was at least partly attributable to an accounting change.
- The fundamentals of the business suggest that shares are overvalued.
- The share price has seen a significant increase and a consolidation is becoming more likely.
Akamai's (NASDAQ:AKAM) shares surged 21% following the announcement of fourth-quarter profits that rose over 18%, which means that I got the catalyst wrong but the vector right. At this point, the shares are overvalued based on the fundamentals of the company.
The boost in profitability was partly attributable to an accounting change in which management extended the useful life of assets. Obviously, this is not a sustainable change in operating performance. Looking forward, I expect the profitability of the firm to revert back towards the pre-accounting change levels and to continue to deteriorate from there, as the company's premium pricing structure is challenged by competitive solutions.
While the outlook for the firm's financial performance is positive, the intrinsic value per share of AKAM is in the mid-20s. This is based on the fundamentals of the firm. Management is investing in SG&A and spending relatively little on R&D, which means that the rate of reinvestment isn't as high as it would be for the typical growth firm. Consequently, the model of the estimated intrinsic value of the firm places the share price much lower than the growth reflective market price.
- The acquisition of Prolexic Technologies, Inc., a provider of cloud-based security solutions for protecting data centers and enterprise IP applications from distributed denial of service attacks, was completed.
- The company priced a $600M convertible senior notes due 2019 offering.
- China and Indonesia are the top two countries from which observed DDoS attacks originated, according to the logged IP addresses. Also, the number of attacks increased in 2013 with the Enterprise and Commerce sectors being the most frequently targeted.
- Akamai was contracted to deliver live and on-demand video streaming for the 56th Annual GRAMMY Awards.
Akamai Technologies, Inc., provides cloud services for delivering, optimizing and securing online content and business applications. The increasing reliance on the cloud is driving demand for the company's solutions, as companies invest in technologies that deliver a high-quality experience. But competition from do-it-yourself telecom service providers puts pressure on Akamai's profitability.
For the year ending (in millions expect per share data):
Total revenue for 2013 increased 15% on strong demand for Media Delivery Solutions, and Performance and Security Solutions. The increase in total revenue was accompanied by an increase in gross profit, but a portion of the reduction in cost of revenue is attributable to an accounting change. Specifically, management increased the useful lives of assets thus decreasing the depreciation expense associated with those assets. In 2014, the forecast is for profitability to decline in line with its historic trend as personnel costs increase. Also, revenue is forecasted to increase 15% in 2014 and 12% in 2015 with a net income margin of about 16.5%.
For the year ending (in millions):
Cash provided by operations
The cash flow from operations growth was subpar in 2013 as the depreciation and amortization non-cash expense declined. Cash provided by operations could increase more than revenues in 2014, because the impact from the accounting change will have subsided. Management is likely to continue to invest in capital expenditure to support the long-term growth of the organization. Also, the estimate is for 40% of free cash flow to equity to be returned to shareholders, but that estimate is relatively uncertain.
Ending financial leverage
The liquidity and solvency positions appear to be rock solid. While the equity multiplier is trending higher, there is ample room to utilize debt obligations. Liquidity has declined, but from an excessive level to a more than ample level. Consequently, there is adequate liquidity for returning capital to shareholders or for acquisitions.
AKAM's quality of earnings was high during 2013. The estimate is that 2% of earnings resulted from accruals. Also, the company collected 98% of revenues in cash from its customers. Based on the cash component of earnings, earnings are forecasted to be persistent.
The outlook for the next two years is positive. Demand for media, performance and security solutions should continue to drive revenue growth, albeit at a slower pace. Competitive pressures and personnel expenses should continue to weigh on profitability. Free cash flow to equity is expected to increase by 43% over the next two operating years. The fundamentals of the business are bullish.
- The share price is likely to remain volatile and investors could lose a portion or all of their investment.
- Investors should judge the suitability of an investment in AKAM in light of their own unique circumstances.
- A decline in global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
- Cyclicality in IT expenditure may affect performance.
- The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
- Competition in product development and pricing could adversely impact performance.
- Incorrect forecasts of customer demand could adversely impact the results of operations.
- Higher interest rates may reduce demand for AKAM offerings and negatively impact the results of operations and the share price.
This section does not contain all risks related to an investment in AKAM.
Portfolio & Valuation
AKAM is in a bull market of primary and intermediate degree. Day traders would look to accumulate following minor bear markets. Swing traders would accumulate following a more substantial decline. Long-term investors would probably want to consider scaling back their position. Nonetheless, the market for AKAM shares remains bullish.
The expected return for AKAM is relatively high. For a one-month holding period, the expected return is 2.5% with a standard deviation of 12.06%. The expected return for one quarter is 7.35%. A 30% annual expected rate of return is unsustainable. This high rate of return is why the valuations suggest that shares of AKAM are overvalued.
BV: Base case
PE: Base case
Akamai is overvalued based on its forecasted fundamentals. At a share price of about $60, shares of the firm are trading well above the optimistic intrinsic value. There is an argument to be made for a higher intrinsic value based on the company's reinvestment rate, which would result in an intrinsic value of $75 per share. But I think the high SG&A expense replaces investment in R&D; thus, AKAM's fundamentals are close to their long-term sustainable levels. Profitability is unlikely to improve, but the growth rate is likely to slow, which the model incorporates.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.