AKAM - Downgrade from Buy to Hold
YHOO - Maintain at Sell
In the Computer Hardware/Software industry, we were a fan of Akamai at the beginning of the year, but we believe the stock is nearing a top currently in valuations. Yahoo has remained a Sell for us all year, and we continue to be very worried about the company's future as an investment.
For Akamai, we downgraded the stock's price target slightly after operating margins came in under expectations in the last quarter and remain below 2011 levels. Revenue looked great in the company's latest quarter, but profit margins remained suppressed. We believe that the company is now pricing in its cloud-service revenue growth at the correct level. The company's cloud infrastructure was undervalued at the beginning of the year, but with PE at 38 and future PE at 22 now, we believe the valuations are looking at the top of the levels we like. One area that could be very interesting for Akamai is its work with Riverbed (RVBD). We believe the "Steelhead Cloud Infrastructure" -- which the companies tout as "...a solution that combines the best of breed in public Internet optimization with the best of breed in private wide area network (WAN) optimization" -- is probably the best revenue growth potential for Akamai moving forward, but we are concerned about such a strong dip in profitability. If we can see operating income return to 25-26% in 2H12 or 2013, the stock could start to see more upside. At this time, most of the annual gains have been achieved.
Yahoo continues to be a concern for us. Operating incomes continue to be weak, even when one eliminates the company's recent restructuring charges. Operating margins seemed to be back on track in 2011, but they have dipped back to the 12-14% range as we expected. At this point, the company has a future PE of 14.5, which does show some value capabilities. Yet two main issues are keeping our price target in check: high capital expenditures and cloudy growth prospects. The company has done a great job at reducing capital expenditures this year to under $500M, but it is still at a very high level of operating income. Industry leaders like Apple (AAPL) and Google (GOOG) have 7% of revenue tied up in capital spending versus 10% for Yahoo, which is at its lowest levels.
At the same time, we believe that Yahoo will need to increase CapEx again in order to bring new attractive growth products online, which will increase that level. The only other way for the company to do this is to use cash or add debt, which also hurts the equity value of Yahoo stock. Why do we believe this is necessary? The growth prospects for Yahoo are cloudy. The company sold a large chunk of its best asset (its share in Alibaba). Additionally, Yahoo had dropped in market share of search for 11/12 months as of the end of September. That drop means less ad revenue, and we believe the company has to do something to right this ship. Marketing is not enough, in our opinion, and Yahoo will require new features (most likely through acquisition or through expensive R&D). Display revenues are the key here, and while those are up a bit, we believe that over the next 12 months, those display revenues will be squeezed by Yahoo's competition. For example, if Facebook (FB) does have success in launching a broader search aspect of its website (as we expect), it hurts Yahoo even further.
Outlook was delayed by Yahoo in the past quarter, and we believe it remains cloudy. When one invests, we want to invest in something that is clear. Hope that Yahoo can turn around it declining market share is just that -- hope. At this point, our outlook is very conservative. We believe this is a much smarter approach than expecting great returns without seeing any sign that they are possible. Akamai's outlook looks more promising, but at the same time, the market seems to have priced in a lot of this promise already.
Return on Equity
Return on Equity
Akamai's profitability has fallen in the first half of 2012 in operating margins, but not in gross margins. Much of this is due to increased R&D costs as well as SG&A, which have decreased operating margins. Still, the company's operating margin is healthy, but the drop in profitability did cause us to decrease our expectations for the year. If those margins stay depressed, the stock will definitely have some trouble moving much higher. Costs have not risen, as evidenced by the company's flat gross margins, so the issue could easily be resolved if SG&A declines.
As we can see, Yahoo has much lower profitability than Akamai and lags its entire industry. Operating margins have fallen very strongly, and are now below 10%, which is low for a computer software/hardware company. ROE has improved slightly, which is a positive sign for Yahoo. Right now, though, we see Yahoo as continuing to struggle as competition remains strong and could press margins even further.
Akamai's valuation definitely appears to be quite toppy. Average value we look for is 18-20 on PE and 14-16 on future PE. Below those levels represents good value, so Yahoo does show better value in that regard. However, we see more risk for Yahoo attached to that value than we do with Akamai's overvaluation, as discussed above.