Akamai Stepping Up from CDN to the Cloud

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Akamai Technologies’ (NASDAQ: AKAM), acquisition of FastSoft Inc, a company that develops web acceleration software will enhance its already strong cloud infrastructure improving throughput for videos. FastSoft’s team will become a part of Akamai’s engineering group and will be based in Pasadena, California. Earlier this year, the company also acquired Blaze Software Inc, a site acceleration service provider and Cotendo Inc, another mobile and web acceleration service provider.  This emphasis on speed is important as the world transitions to cloud-based computing which needs speed to improve the user experience.  The cloud’s growing up and long latencies are no longer acceptable, especially in high bandwidth markets.

To compliment web acceleration, Akamai is looking for acquisitions in data security, specifically firewall technology. The added security layers are key to continuing to handle important event-driven data on networks like Verizon’s, for major global events or important news releases, while still providing nimble response times. It entered the security market last year when its annual sales were $1.16 billion. Top line revenue growth has been solid with annual growth in FY 2011 coming in at 13.1%.  The chart below has the growth by vertical.

<table> <tbody> <tr> <td> <p><strong>Revenue</strong></p> </td> <td colspan="2"> <p><strong>YoY Q1 Growth</strong></p> </td> <td colspan="2"> <p><strong>YoY Q2 Growth</strong></p> </td> <td> <p><strong>% Total</strong></p> </td> </tr> <tr> <td> </td> <td> <p><em>2011</em></p> </td> <td> <p><em>2012</em></p> </td> <td> <p><em>2011</em></p> </td> <td> <p><em>2012</em></p> </td> <td> <p><em>2012</em></p> </td> </tr> <tr> <td> <p><strong>Media</strong></p> </td> <td> <p><strong>14.6%</strong></p> </td> <td> <p><strong>19.4%</strong></p> </td> <td> <p><strong>10.6%</strong></p> </td> <td> <p><strong>19.4%</strong></p> </td> <td> <p><strong>42.1%</strong></p> </td> </tr> <tr> <td> <p><strong>Commerce</strong></p> </td> <td> <p>25.0%</p> </td> <td> <p>21.3%</p> </td> <td> <p>20.8%</p> </td> <td> <p>21.3%</p> </td> <td> <p>21.4%</p> </td> </tr> <tr> <td> <p><strong>Enterprise</strong></p> </td> <td> <p>31.0%</p> </td> <td> <p>18.3%</p> </td> <td> <p>27.7%</p> </td> <td> <p>18.3%</p> </td> <td> <p>13.5%</p> </td> </tr> <tr> <td> <p><strong>High Tech</strong></p> </td> <td> <p>-3.4%</p> </td> <td> <p>18.0%</p> </td> <td> <p>1.3%</p> </td> <td> <p>18.0%</p> </td> <td> <p>17.2%</p> </td> </tr> <tr> <td> <p><strong>Public Sector</strong></p> </td> <td> <p>16.6%</p> </td> <td> <p>23.1%</p> </td> <td> <p>11.4%</p> </td> <td> <p>23.1%</p> </td> <td> <p>5.8%</p> </td> </tr> <tr> <td> <p><strong>Total</strong></p> </td> <td> <p>35.3%</p> </td> <td> <p>19.6%</p> </td> <td> <p>12.9%</p> </td> <td> <p>19.6%</p> </td> <td> <p>100.0%</p> </td> </tr> </tbody> </table>

Media sales represent 42% of total revenue and these acquisitions and management’s statements make it clear that this is where they feel their growth is.  With the rise of embedded video, contextual advertising, which is what is driving Google’s dominance in ad revenue, this is a sound strategy as people shift away from broadcast media consumption and towards internet-based, targeted consumption.

While no talks have begun, Akamai is currently eyeing Zscaler Inc, to give them superior a Security-as-a-Service (SaaS) revenue stream. Akamai carries more than 20% of the global internet traffic every day and is the biggest content delivery network (CDN). Adding a full security suite to their CDN network only makes sense. 

 The worry for Akamai is margin erosion.  Gross margins have dropped from 83% to 80% between Q2 2010 and Q2 2012, while net margins have been falling slowly.  And because of this, and their relatively small size, Akamai has generated more buyout rumors than any other American company between 2005 and 2010. And while management has always insisted that the business is not up for sale, with a market cap of just $6.9 billion a company like Google or Apple could buy them and it wouldn’t even meaningfully impact their balance sheet.  But, the reality is that it is competition from Amazon (NASDAQ: AMZN) that has investors and analysts spooked.  Amazon makes a habit of making big headlines by attacking towards specific markets but it looks more like marketing than substance. The Amazon worry for both Akamai and Netflix makes for great headlines but it has a lot of work to do to play catch up to both.  Amazon Prime’s interface is abysmal, for example and unless Amazon begins spending a lot more of their nearly non-existent profits on improving it they won’t be stealing many Netflix streaming customers anytime soon.  While the content may be the same, sometimes convenience and a good interface is worth a few dollars; just ask iPad users. 

AT&T (NYSE: T) is most likely out of the CDN space after Akamai’s purchase of Contendo which was the platform that AT&T was using to become a player in the space after years of their network languishing.  They have cried uncle here and will now retrench towards providing dumb wire and wireless service.  For AT&T to fail to complete the T-Mobile purchase and then lose Contendo to Akamai has bottled them across two different, yet important markets.  

Now, the big issue is who is going to get AT&T’s business, Akamai or Limelight (NASDAQ: LLNW), now Akamai’s strongest competitor.  So, while AT&T was never much of a direct competitor, its customer base is now up for grabs. If acquiring Zscaler will blunt the advance of Amazon like it did AT&T then this would be a big win for Akamai.

While the Q2 earnings report was good, it is the future that has the stock under pressure.  The above margin-erosion worries and CEO Paul Sagan’s announcement that he will step down at the end of 2013 has investors looking for other opportunities. Under Sagan, Akamai has emerged as a dominant player in the industry with its sales quadrupling from $283 million in 2005 to $1.16 billion in 2011. Akamai is now a cloud computing service provider rather than just a CDN.

The company has not announced a replacement yet but analysts have predicted an outside hire with a powerful enterprise sales background.  Enterprise is a vertical that could use some attention now that they have shored up their media delivery future. Its primary market remains North America and Europe but Akamai is going to have to expand into China and India. Akamai is trading like a growth stock and the company is acting like one, adding to its cloud technology portfolio while attempting to hold the competition at bay.  All of these acquisitions have made both tactical and strategic sense for long term growth, especially if they outmaneuver Limelight for AT&T’s business.

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