Sell the Shovel and Forget the Gold
Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
During the Klondike Gold Rush there were two ways to get rich. You could spend your days in the cold, searching for gold, or you could sell shovels. Selling shovels isn't very exciting, but it is a safe and secure way to consistently make money. Akamai Technologies (NASDAQ: AKAM) has taken this philosophy online. It runs one of the world's best content delivery networks (CDNs) and provides the infrastructure that modern companies need to profit online.
Why Invest in a CDN
Developing a world class network of servers and data centers isn't cheap. A CDN provider like Akamai does the hard work of building out its network and then charges customers for its use. Only the largest companies like Google are able to front the capital and personal costs to make their own quality CDN network.
Video is eating up more Internet traffic and increasing bandwidth needs. At the same time, consumers don't want to wait for sites to load and simply abandon slow websites. Companies are moving more of their computing into the cloud. While this helps decrease costs, it also gives more computing power to hackers. Akamai deals with all of these issues by helping companies deliver their content quickly through their CDN, and filter traffic to help defeat malicious attacks.
Level 3 Communications (NYSE: LVLT) is similar to Akami. Level 3 stores and processes customer data with their collocation and data center services, then helps to transport that data with their transport and fiber division. The company owns over 35 thousand miles of subsea cable. In the past decade it has had a number of issues as it tried to expand through acquisitions and subsequently diluted its stock.
In order to regain profitability, Level 3 Communications is trying to place more emphasis on the enterprise sector. This should help it get out of the commoditized wholesale sector and offer more value-added services. Still, the company is a work in progress. Apart from its subpar return on investment of -3.8%, its EBIT margin of 6.3% and total debt to equity ratio of 7.71 do not inspire confidence. It is easy to hope that Level 3 Communications is able to turn things around, but years of negative momentum are hard to erase.
Internap Network Services (NASDAQ: INAP) makes the majority of its revenue from its datacenter services, but it also offers IP services on the side. Its IP services division holds the company's CDN services, and it looks like Akamai is eating Internap's lunch. Internap's IP services are declining. Given the pricing pressures in the CDN world and large capital requirements, Internap's 2012 sales of $274 million place it at disadvantage relative to Akamai's 2012 sales of $1.374 billion.
Internap's profit margin of -2.2% and EBIT margin of 1% place it in a marginally better position than Level 3 Communications. Internap's balance sheet is much cleaner with a total debt to equity ratio of 0.83, but the company is still struggling to define itself in a profitable manner. 2014 isn't looking too bright, and it is expected to lose money.
Akamai operates a world class CDN and is a quality investment. The company has consistently produced free cash flow, has a clean balance sheet with a total debt to equity ratio of 0, has a profit margin of 16.3% and boosts an EBIT margin of 24.7%. The company's huge network helps it to maintain its dominance as bandwidth and security needs continue to increase.
Level 3 Communications and Internap's inability to produce free cash flow is a major warning sign. The CDN world is filled with tough competition and price cutting. Akamai has been able to maintain a substantial customer base and an extensive network. Level 3 is still stuck in the past and its wholesale contracts drag it down. Internap is an interesting player to watch with its growing datacenter business, but it doesn't offer the same dominance or margins as Akamai.
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