Investors Sour On Akamai Earnings Report
Akamai Technologies is a company that delivers video on demand better then any business on the internet. Their technology allows them to allocate their resources in such a way that they can send internet viewers to the servers located closest to them, which vastly speeds up the delivery of the rich media that we love and crave on the net. With 2006 having shaped up to be, the year of video on the net, Akamai has benefited not just from organic growth, but has consistently brought on new business partners as well.
After reporting their 3rd quarter earnings, it’s clear that Akamai continues to demonstrate their leadership in this industry. In looking at their numbers, they earned revenue of $111 million, up 11% over just three months ago and up 47% compared to the same period last year. Their profits for the quarter amounted to almost $42 million in normalized net income, up over 17% from last quarter and an astonishing 90% increase over their normalized net earnings from a year ago. The company also increased guidance for the upcoming year during their conference call.
By all accounts, Akamai had yet another tremendous quarter and management should be congratulated for executing and extending their leadership in the VOD space.
Now normally, this type of wild growth would leave me frothing at the mouth with excitment. The VOD market is hot, young and Akamai is in an excellent position to lead the industry. Despite all of the possibilities however, these numbers aren’t the sweet spot that investors thought that they would be. Instead their most recent earnings report is likely to leave investors feeling very sour after many realize that much of Akamai’s potential growth has already been priced into the stock.
If you ask the average investor what Akamai’s stock is worth, they will tell you it’s around $50 as of today’s close. While theoretically this is true, in reality Akamai stock is really worth $7.6 Billion dollars. Over the last year, I’ve talked to many Akamai investors and have asked how they rationalize such an amazing valuation and they always point to the earnings as their justification for paying this much for a stock that makes less then a half a billion dollars in revenue.
Unfortunately for many investors though, they are in for a rude awakening tommorrow morning, when they realize for the first time that Akamai’s earnings, over the last year, have been artificially inflated by a special one time tax benefit from a year ago of $255 million.
If you take into consideration this one time tax benefit, Akamai’s real net income was actually down 95% from a year ago.
The reason why this is so important is because many companies trade based on a multiple of what their earnings are. More aggressive stocks deserve a higher multiple because theorhetically, over time, the growth should cause earnings to catch up. More mature stocks will typically get a lower multiple because investors aren’t expecting the stock to maintain double digit growth rates.
Based on the last 12 months worth of data before earnings, Akamai was trading at a P/E ratio of around 25. With the S&P trading around a multiple of 15, this isn’t an entirely unreasonable valuation for a stock like Akamai. In fact this is probably a low multiple for a stock delivering Akamai’s type of earnings growth.
The problem is though, that with this latest earnings announcement, the one time tax benefit will now drop off and with the new earnings in place, investors who haven’t been doing their due diligence are about to learn that they really own a stock trading at a P/E multiple of 122.
While the analysts and professional investors are fully aware of this one time tax benefit, the average investor certainly is not and at a P/E of 122, this valuation is more reminicient of the internet bubble then a reflection of Akamai’s true growth potential. With Akamai’s one time tax benefit now apparent to all investors, I believe that we are about to see a massive deflating of the video on demand bubble that’s been building over the past year.
To help put these numbers into perspective, lets assume that your daughter wants to open up a lemonade stand. Because you’ve agreed to subsidize the business by supplying the lemons and sugar, any revenue she takes in will be pure profit. What better profit margins could one ask for? Lets also assume that she hires her older brother to beat up competitors and create a monopoly, so that she can charge $2.50 per glass of lemonade. If she is able to sell 10 glasses a day for a full year, she would bring in around $8,200 in profits for the year. At a P/E multiple of 122, this would value her lemonade stand at $1 million dollars.
Now I don’t know about you, but I’m not ready to pay a million dollars for a lemonade stand and investors shouldn’t be willing to pay that much for Akamai either.
Of course Akamai’s business is a little more complicated then a lemonade stand, but a business should only be worth what it’s eventual exit strategy will be worth. The way I see it, a company can be acquired, they can issue a dividend and reward shareholders or they can buy back their own stock to enhance their value.
While growth companies aren’t expected to do any of this, as the VOD industry eventually matures, Akamai will need to demonstrate shareholder value by utilizing one of these methods. In looking at their balance sheet, you can see that they have about $741 million in net assets. If you value the company on a book basis then, they closed today at about 10 times their book. Far too expensive for any business to seriously consider taking them over no matter how hot their technology is.
With earnings now showing a multiple of 122, it would take years for Akamai to raise the cash necessary to buy back their business from shareholders. Considering that they earned just $65 million in profits over the last year, even at an aggressive growth rate, I don’t see this as a reality at these prices.
Assuming that they eventually paid out $770 million a year as a dividend (this would be twice their revenue from the last 12 months) it would still only amount to a little over a 1% percent dividend based upon their current stock price.
Growth investors will tell you that my numbers are too low and that I’m not taking into account their years of 50% + future growth, but the reality is that there is very little upside from $7.6 billion unless you are prepared to wait at least 5 – 10 years for what could still end up being a minimal return. I believe this to be far too much risk to assume for too little potential return. If Akamai was a small cap stock, today’s earnings would have been very exciting indeed, but with the stock flirting with a large cap valuation, I see little for investors to be cheering about.
While I believe strongly that Akamai’s greatest growth years are ahead of them, I’ve yet to see a valuation model that supports a market cap of $7.63 billion dollars. With only $385 million in revenue and $63 million in earnings over the past year, Akamai’s market cap trades at a valuation that many companies who are already earning billions in revenue, still don’t even have. Saavy investors may have been aware of this tax issue for the last year, but many investors who have piled on over the last year will find this news very sour indeed. While I believe that when life gives you lemons, you should make lemonade, I believe even more in never paying $1 million dollars for the neighborhood lemonade stand. In looking at the role that Akamai plays in a portfolio, I think that investors would be wise to consider the risk that they may be over paying for unrealized potential.
Posted on October 27th, 2006 by Davis
Filed under: VOD
Thanks for this great review. I saw it first on Motley Fool. I am one of the investors who bought this stock recently and did not know about the one-time tax benefit. Thank you for pointing this out!
You’re looking at GAAP earnings which include amortization of intangibles, stock based compensation and other non cash charges. Akamai is trading off of pro-forma numbers and it also trades off future earnings expectations not TTM month earnings….so your 122 multiple is really closer to 40x 2007 consensus numbers (which likely have upside)….for a company growing earnings at 50%+ and ROIC’s of nearly 100% (back out intangibles) this is dirt cheap. If your looking for more valuation support build a DCF and you’ll see the rediculous free cash flow (and FCF growth) these guys are thowing off.
Also, of course their price to book value is low. All they own is a bunch of servers. Its the technology and software they’ve built around them that makes them worth 7 billion dollars.
I did check your PE valuation vs. CNBC-MSN MONEY , their’s is 131.9 and forward pe of 79.50. I think the risk-reward ratio is tilted to too much risk.
If one can only know how hot this VOD could be and for how long, then I could
put this one in my portfolio.
What’s with all these headlines that try to spell the gloom and doom for AKAM? I question if these reporters or their friends are not holding some short positions on AKAM, and with these bad headlines it will be easier to cover their shorts or get in AKAM after the shares have obviously been beaten down.
I think some of you journalists are just trying to scare amateur investors into selling on good earnings with your distorted focus and emphasis on just the net income numbers. (Either that or you guys need to bust out your econ books or talk to some CPAs.) And with the institutionals owning the vast majority of outstanding shares (and I expect they know better about these 1-time earnings or expenses), the individual investors hardly matter to the grand scheme of price movements.
Short of having insider’s information, do you want to know a good method for predicting/double-checking the health of AKAM’s growth? Monitor the earnings report of their big customers (i.e., Apple, MSFT, Comcast, Amazon, anti-virus companies, etc.), if they start reporting bad numbers then that will be the first signs that AKAM’s growth is slowing. Plus until Akamai’s revenue from Qtr to QTR drops back to back, the stock price will continue to rise. With the latest reporting from Akamai management, they are clearly telling the street that they expect an upward growth in revenue. And that is good news for investors. Even better if you got scared into selling while the share price dropped, but I think it is now another good buying opportunity.
Just want to add this too, AKAM is not selling bandwidth (just like Apple is not pricing their iPods based on the falling price of flash memories), they never did price their service based on commodity pricing of bandwidth, they are selling their expertise on intelligently delivering data packets to the end users over the Internet and pricing it accordingly. Sure these customers can channel some of their resources to build their own network to deliver the same content, negotiate the low bandwidth costs with ISPs and manage it in-house or they can focus on what they do best (run their own business) and pay to leverage Akamai’s global network and their years of expertise.
P.S. SEC should really look into not just if these reporters owns the stocks they write/cover, but if they have any positions on the stock at all(e.g., short or long positions).
@ John – So we shouldn’t be taking into account the fact that management is diluting their shares through their employee stock compensation plan? Isn’t that a big part of why Sarbanes-Oxley makes them report these net numbers? Why is it fair to ignore AKAM’s compensation costs, but not any other company on the street? Sorry I don’t buy it, when the average Joe goes to Google finance and the p/e reports 100+, I think that’s what investors should be looking at. If you want to compare net p/e ratios that’s fine too, but regardless this is an expensive stock. Maybe in a year when we look at their future p/e, we can talk about a more reasonable valuation, but the way I see it, if AKAM hits a grand slam, it will still take minimum of two years to even get close to justifying a $4 billion valuation. At $7 billion plus, this is far too much risk for far too little reward.
@ Chim Juice – My record speaks for itself, I’ve always disclosed any conflicts and always will, my long time readers know this. Since you are obviously long AKAM, I’ll cut you some slack, but look at my history before making such crazy allegations. Furthermore, even if I did own a short on AKAM (which I don’t) your beef shouldn’t be with me, but with my argument, if you can give me a business model that justifies a $7 billion + valuation then I’m all ears, in the meantime if you want to take unsubstantiated shots at my ethics, that’s your right, but it won’t hold much weight with the readers who have been following my coverage of the VOD and tech market for the last three years. It’s easy to blame the messenger, but what about the message?
Thanks for the reply.
Remember that 80% of AKAM’s stock is owned by institutions so the “average” investor isn’t looking at Yahoo finance. These analysts have always accounted for stock based compensation well before SOX came into effect. If they didn’t we would have seen quite a big tumble in the market this year as numbers came in this year w/options expense. Stocks ultimately trade on free cash flow…earnings are just a normalized way of looking at free cash flow…Again I encourage you to build a free-cash flow model, and I think you’ll start to see the 7 billion number make sense.
I don’t really understand your comment “Maybe in a year when we look at their future p/e, we can talk about a more reasonable valuation” The reason the multiple today is high, is because 1,2,3 years from now the 87 cents in earnings (consensus numbers) becomes $2, $3 $4 in earnings. Most analysts are pricing Akamai off their one or two year earnings or free cash flow number and then applying a multiple to that number based on their expectations for growth beyond their forseeable view. We can argue what multiple is justifiable, but the idea I’m getting at is that a stock doesn’t become worth more or less just becuase we wait a year. As future expected growth slows, the multiple will compress, but the earnings base will be larger. The reason Akamai is trading at 7 billion dollars today is because there are implicit expectations for what Akamai will return well beyond 2008. The institutions that control 80% of the float are the ones really trying to figure out what the earnings potential of Akamai is.
Don’t get me wrong–I enjoyed your article.
Just because “everybody’s doing it” doesn’t make me anymore or less interested. I’m a contrarian by nature and if I’m going to take the type of risk that Akamai involves, I’m going to look for a smaller cap company to do that with. $7 billion+ is just too hot no matter how attractive the growth.
We can disagree on how to look at the earnings or the future earnings or the future future earnings, but I’m going to stand by my opinion that the valuation is too high. A year from now we can follow up and see if I was right or wrong, but for now I won’t pay these multiples for growth that is still several years away.
If there was a chance to make a 10X return on my money, I’d be much more open to assuming the inherent risks with Akamai, but at $7+ billion what’s really the upside vs. how much could potentially go wrong?
As to my comment about waiting until next year . . . IF Akamai executes and IF they continue their guidence and IF they can get to a point where $200 – $300 million in earnings is a realistic possibility, then I’d like the stock at TODAY’s prices. I don’t see them coming anywhere close to that level next year or even the year after, but someday in the future Akamai MIGHT be worth $7+ billion in anticipation of their future earnings, just not today. If it runs up as their earnings continue to come in, then I’m not interested in the stock. Opportunity is a lot easier to replace then cash.
We can agree to disagree on the valuation and on whether or not the average investor is using Yahoo finance for their due dilligence or if they are paying to get the high priced analyst research, but if my post demonstrates anything it’s that this is clearly not a black and white issue and with Yahoo Finance now showing a P/E of 125, I think a lot of retail investors are going to be shell shocked when they realize that they don’t own a company with a p/e of 25.
I won’t follow the herd, but I will agree with you though, that Wall Street loves this stock. Clearly there are people far more qualified then I who’ve fallen very much in love with it. Of the 14 analysts that rate it, only one has a sell. I can’t vouch for your 80% number, but it wouldn’t surprise me if it’s right. It is worth noting though that based on the 13 million shares that traded hands on Friday, there were at least a few institutions who took some profits. If that trend continues, you can bet that Wall St. will take a second look at this as well.
I think your analysis is all wet! First of all, 79% of the float is in the hands of institutions, and they have not overlooked anything so obvious as this large one time event. It may be true of the odd, poorly informed, retail investor who failed to see the obvious, but in the big picture those few are insignificant as a price mover.
The potential here is awesome, as is the continued regularity and dependability of the huge year over year growth. Check out the free cash flow and how much of new revenue drops directly to the bottom line. The multiple is for growth – large steady growth.
I too believe that the way this has been reported in the headlines “earning slump” etc. is terribly misleading. I keep track of the writers I can trust and who back up their headlines with meaningful explanation. You will not see a stampede of institutions or insiders waiting in line to sell this stock – quite the contrary – they will be picking up any stock from the poor retail investors you (and the several misleading headlines) managed to scare into selling.