One of the fundamental rules in investing is that sometimes a company's stock price must drop significantly before it becomes a worthwhile investment opportunity. We have found such a company in Akamai (NASDAQ:AKAM).
Akamai is the world's leading CDN, or content delivery network, using its vast server farms all across the world to speed up the Internet worldwide. The issue with this business model is that Akamai is facing competition in the CDN space from the likes of Limelight (NASDAQ:LLNW) and Level 3 (NASDAQ:LVLT). But Akamai stock has fallen over 46% in the past year due to these concerns, and we think the worst case scenario is more than priced in.
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We bought Akamai recently because we believe that the stock has found a bottom, especially as investors price in these growth fears, which have not been as dire as the stock chart would suggest. Revenue at Akamai has grown at an average of 29.3% over the past five years, and the company is expected to post record GAAP EPS this quarter. But then, why has the stock tumbled so much?
In short, Akamai committed the sin many high-multiple, high-growth stocks commit. Growth slowed down just a tad. The company missed analyst's expectations for revenue by $0.8 million in the last quarter, and as a result, the stock dropped over 13%. (click here)
Going forward, we expect Akamai stock to outperform, for the following reasons.
- A fortress balance sheet. Akamai has $1.3 billion in cash ($6.90 per share), representing almost 28% of its market cap.
- Value-added services. Akamai has been quickly diversifying away from the CDN business. Enterprise value added services grew by 28% in the last quarter over the prior year as more businesses turn to cloud computing for their IT needs. (click here)
- New customers: On the call, CEO Paul Sagan stated that Akamai had a record number of new customers this quarter. While Akamai did renew certain contracts at lower price points, we feel that this has been more than priced in.
- International growth. Sales outside of North America now account for 30% of revenue, and growth in the Asia-Pacific region outside Japan is strong. Japan is facing macro-economic conditions that are slightly pressuring growth there, but not at levels that concern management. (click here)
- Lowered churn. J. D Sherman, Akamai's CFO, stated on a conference call that of Akamai's 147 net new customers, over half were using a value-added solution for the first time, and churn has stayed low, signaling customers are comfortable with Akamai. (click here)
Note that we did not specify a buyout as a reason to invest in Akamai. We never buy a stock on the basis of its appeal as a takeover target. If it is rumored to be one, so much the better. But we think it is foolish to buy a stock solely based on takeover speculation. Akamai has had more takeover speculation surrounding it than any other company in the S&P 500. The latest rumor is that Google (NASDAQ:GOOG) is looking to buy the company. While it would certainly be nice to have a buyout, we think at this level Akamai can outperform going forward as a standalone company.
We stress that Akamai at $24-$25 is a much different company than at $50. Expectations have come down dramatically, as has the P/E ratio. Akamai now has a P/E ratio of just over 23 and a forward P/E of about 14. Akamai trades at a price-to-book ratio of 2.5, a huge discount to the sector average. At levels of $50, Akamai's stock was pricing in far too rosy prospects. At $25, the stock is pricing in doom. The Reuters average price target is $31.39, representing upside of nearly 30% from current levels.
The first half of this year was a record for Akamai in terms of revenue, cash flow and profits. The long-term trends supporting the business have not abated. Internet traffic is growing exponentially, as is enterprise cloud computing and e-commerce. Akamai stands to benefit from all these trends, which is why we have bought the stock at these levels. Akamai's stock is pricing in a disaster for the company, yet the company's financial results do not support this. Expectations have come down to realistic levels, and while Akamai does have competition, it will not decimate earnings. The value-added services segment is seeing strong growth, and will support the company going forward.
We think Akamai is a long-term bet on the explosive growth of the Internet. Akamai continues to be a leader in the industry, and at this price, in our opinion, the stock is too cheap to pass up given the growth profile. Akamai means intelligent in Hawaiian, and to us, Akamai stock is a very Akamai investment.
Disclosure: I am long AKAM.