Friday, November 16, 2007

Akamai Valuation

Akamai (AKAM) continues to be the premier accelerator of Web content and is growing profits rapidly. But its stock price has been all over the place this last year. Some investors will buy at any price when they feel Akamai is their transport to great wealth. Yet this high price-to-earnings stock gets subjected to periodic waves of fear, often driven by rumors of competitors cutting in on the business.

For background on what Akamai does you might try my Understanding Akamai blog entry. For summaries of Akamai's recent quarterly reports and analyst conferences see my main Akamai page.

Your standard data for how unstable a stock's price is, the 52 week high/low, today ended at $59.69 high, $27.75 low. So if you bought at the low this year, then sold at the high, you more than doubled your money. On the other hand that would make you a time traveller or a short-seller, because the low came in September after the high in February.

Looking at a chart of Akamai's price for the past ten years (See NASDAQ's AKAM chart), we see that Akamai IPO'd back in 1999 as one of those "it could be the next Microsoft" stocks. It went to well over $300 per share before reality set in. It went below $1 per share in the summer of 2002. I wish I had bought some then! [I have never owned Akamai stock.] But in 2002 there were lots of technology stock bargains and some of them were making a profit; Akamai was not.

The funny thing about a stock actually making a profit is that instead of being priced on hype the stock starts getting priced more on its earnings. Such stocks may have a sky-high price-to-earnings ratio, as Akamai had back as recently as December 2006, when its P/E ratio was 156.

What I am trying to say here is that different investors price stocks by different criteria. As a result there is no set price where Akamai should be. You should develop criteria for your portfolio, and do your own analysis, to decide whether a stock's price is too high or too low for you. I like to use a conservative pricing model. That minimizes the risk that I am buying an overpriced stock.

Today Akamai stock ended at $36.15. That gives the company a market capitalization (stock price times number of shares outstanding) of a shade under $6 billion.

In the last quarter GAAP (generally accepted accounting principles) earnings for AKAM were $24.3 million. That was up 6% from Q2 and 73% from Q3 2006, so I think we can use the number and still be conservative. Multiply by four and you have an annual net income of $97 million. Using that, dividing into the market capitalization, we get a P/E ratio of about 62, or a return on capital of just 1.6%. Of course you can do better with a CD. Investors are hoping that Akamai keeps growing its earning rapidly, so in 2 or 3 years, even if the stock price is flat, earnings will rise to 5% or more. Okay, what investors really want is for earnings to triple in short order and the P/E ratio to stay high, because then the stock price has tripled in short order (say within 2 years).

There are two main dangers in high P/E stocks. One is that earnings will flatten or even fall, taking away the justification for the high P/E. The other is that as the company becomes larger, investors will become reluctant to project as much earnings growth into the future, and the P/E will decline even with rapid earnings growth. So you had better have a really good reason to buy a stock if it has a high P/E ratio.

Akamai management and its favorite analysts and investors will say that you should not judge the company by GAAP earnings at all. Non-GAAP earnings are far higher. Non-GAAP earnings, in Akamai's case, amount to what they call "normalized net income." In Q3 that was $62.4 million. That is over twice GAAP earnings. If you use that figure, annualizing it as I did above, you get a "normalized" P/E ratio of 24.

Hey, that is cheap for a rapidly growing company. But how real is "normalized?" One test is cash flow. It is not an infallible test, but it is a good one to apply. According to Akamai Q3 cash from operations was $77.4 million, which is even higher than the normalized income.

I think other companies would like to cut in on Akamai's market, but they are trailing its leadership. The market for Web acceleration services is growing rapidly, so even if Akamai just holds onto its market share, it should grow rapidly in the next few years. Risk is not negligible, but it is well-outweighed by opportunity at this point. There is the usual macroeconomic risk that all companies have some exposure to.

I don't think it is crazy to buy Akamai at today's price. If I could see the future more clearly I might call it a bargain for a long term investor. Obviously it is a speculator's favorite, so it is likely to be volatile. Given other opportunities in the market, I think if you did not buy it at under $30 per share in September, you should not be doing more than nibbling at it here.

Remember, diversity rules.

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