Shadyoakresearch's  Instablog

There isn’t a soul in the world who doesn’t believe that Internet traffic will grow over the next few years so the growth prospects for Content Delivery Network (“CDN”) provider Akamai is enticing. But since the start of 2011, investors have dumped the shares of the company over concerns of pricing power and growth potential. But I believe investors are overlooking the additive growth into the company’s revenue model. The company’s contracts are setup that there is a base monthly fee for Akamai’s services regardless of how much traffic is actually consumed. Consider this similar to paying a gym membership; you pay regardless if you actually lift a weight. You are essentially paying for the right to go whenever you want. The unique aspect of the CDN contracts is that any usage above the monthly minimum is charged additional fees, or bursting fees on top of the monthly fee. I can only assume that when the company signs the contracts with the customers, the base monthly fee, and maybe slightly more growth is priced to allow Akamai to earn a rate of return. Any incremental usage is revenues that are essentially unexpected. This type of model allows investors to monitor potential revenue surprises.

Luckily for Akamai investors, the evolution of Netflix’s business over the Internet has become a hot topic debated by analysts and even professors. Popular hedge funds have also taken notice of the company’s challenges prompting public responses by Netflix management. The beauty of all this chatter is that it has put Netflix on the defensive to release statistics that show their Internet adoption is growing. Netflix often will provide this information in their quarterly management assessments and they even have a blog that will provide interesting tidbits. Click here for the 3rd quarter 2010 management’s discussion, it notes that the percentage of subscribers who watch “instantly” or streaming content, have increased from 37% in Q209 to 66% in Q310. This coupled with subscriber growth increasing from 10 million to almost 17 million in the same time period. Not only is Netflix adding more users, but the users are increasingly watching content online. Commentary from  Q4 2010 and Q1 2011 also demonstrated Netflix’s desire to go streaming with its increased online licensing deals. This trend can only help Akamai earn additional revenues. Investors should watch Netflix closely for any information provided by the company that could give a clue of further Internet adoption.

Investment analysts released research a few months ago that showed many large corporations, including Google and Pfizer, hold billions of cash in overseas accounts which are subjected to a repatriation tax as high as 35% if brought back within the US. To battle back, over 30 of the biggest companies formed a coalition called Win For America which are trying to convince lawmakers to create a temporary waiver on any repatriation taxes. With unemployment over 9% and the country’s economic growth languishing, the law makers have recently warmed up to the idea.

So if the thought of corporate holiday gains traction, how can investor’s best capture any short term cause and effect? The idea of available cash strikes thoughts of increased dividends or stock buybacks but lawmakers will likely impose restrictions on the cash so its not directly distributed to investors.

We believe that the most likely scenario for this cash is companies will use it for mergers and acquisition type transactions. Instead of trying to pick the acquired companies, we believe a more broad based approach would be to invest in the M&A banks. So which banks to choose? The smaller, boutique M&A groups are intriguing as any incremental business has a greater effect on earnings due to company size. On the other size, the majority of the companies supporting Win for American are larger corporations who tend to stick with bigger M&A firms with greater resources.

Listed below are a few stocks we believe are worth a detailed look:

Goldman Sachs (GS) – Corporate America seems to like to be associated with Blankfein and company. It sure helps the company when Warren Buffet publicly announces that one of its investment bankers is the only banker he would deal with. That banker has since left the company, but the positive perception has not.

JP Morgan (JPM) – The resurgence of JPM’s investment banking group can be seen through the past six months as they have been advisors in some of the biggest acquisitions, including the recent acquisition of Skype by Microsoft and AT&T with T-Mobile.

Evercore Partners (EVR) – The small boutique firm also advised AT&T on the T-Mobile deal and Schwab’s acquisition of OptionsXpress. The company is debunking the myth that you need to be large to be involved in big deals.

Microsoft’s stock has trailed the broader market for the greater part of a decade, and more noticeably was not invited to the appreciation party the US market has witnessed since the spring of 2010. Ballmer and crew have taken big steps in the past to jump start their stock price when faced with an underperforming stock. Their biggest bet was a massive $3 per share ($32 billion in total) dividend in 2004. The company ended their most recent fiscal quarter with over $50 billion in cash and short term investments which is similar to the over $60 billion the company held the quarter before the 2004 dividend. The main difference between this year and in 2004 is that the company states most of its cash (~$42 billion), is held in overseas bank accounts subjected to repatriation taxes if brought back to the United States.  

Even with the $8.6 billion Skype acquisition announced this week, we believe that Microsoft is primed for another distribution to shareholders.  Although we don’t believe the company has the ability to make another massive distribution, a la 2004, but rather a hefty increase in their quarterly payout is more likely. One of their tech brothers, Intel, just announced that they are increasing their dividend by 16%, the second time in the past six months. Intel’s dividend will now yield roughly 3.6% on an annual basis compared to Microsoft’s 2.6%. Microsoft will most likely feel the pressure from investors to follow Intel’s move. But can the Company afford to do so? And what kind of yield can we expect?

Microsoft generates about $6 billion per quarter in free cash. With that kind of cash generation, coupled with the existing $7 billion in US held cash and short term investments, we believe a payout increase of $.10-.12 per share is probable. This increase would result in an additional $800 million per quarter and total dividend payments of $9.5 billion annually. This increase would give them a dividend yield of 4.6%. Even with this increase, the company would still generate about $10-12 billion in free cash that can be used for other investments and provide more than enough financial comfort.

We believe that the most likely announcement of this dividend will be closer towards their fiscal year end in June or July of this year.

We welcome any comments or discussion points.