Akamai Price Justified?

Akamai (AKAM) has made and lost investors and speculators vast sums of money over the years, going back to the original Internet bubble of the late 1990s. Yesterday the stock closed at $37.10, giving it a market capitalization near $6.58 billion. It had a trailing Price to Earnings (P/E) ratio just over 35 (per NASDAQ), considerably higher than most technology stocks currently. That indicates either that investors expect substantial profit growth in the future, or that speculators have bought into momentum and are ready to get out quickly if the momentum turns. Or both.

Akamai's core technology accelerates the delivery of Web pages and media. This is critical to e-commerce sites, where people may go elsewhere or fail to make a purchase if a page downloads slowly. It is also crucial to video and audio playing without stuttering. Building on that, Akamai offers its enterprise partners other key Internet cloud technologies, notably security.

Look at the quarter results and analyst conference of July 25 and you will see that Revenue was $331.3 million, up 4% sequentially from $319.4 million and up 20% from $277.0 million year-earlier. But GAAP net income was $44.2 million, down 8% from $47.9 million year-earlier. GAAP EPS (earnings per share) were $0.24, were down 4% from $0.25 year-earlier.

So GAAP profits did not climb y/y the way you would expect a company with a P/E of 35. Akamai reported non-GAAP "normalized net income" of $78 million or $0.43 per share, up 3% sequentially and 23% y/y. EBITDA was $143 million, flat sequentially and up 13% from year-earlier. Cash flow from operations was $150 million. $67 million was spent in the quarter to repurchase stock. Capital expenditures were $56 million.

Clearly Akamai bulls are looking at revenue growth and cash flow growth, rather than GAAP numbers. Akamai has a rather high non-cash stock-based compensation expense, $25.6 million in the quarter, and depreciation and amortization, $50.1 million in the quarter. That accounts for most of the difference between the grim GAAP profit lack of growth and the outstanding non-GAAP growth rates.

Revenues and profits depend primarily on the dynamics between Internet data growth and drops in pricing. According the Akamai, pricing drops are not primarily due to competition, although Akamai has competitors who are forced to compete on price. Rather Akamai drops prices on a regular basis to encourage data growth. In the long run this helps its customers and yet grows Akamai profits. There is no sign that the amount of data sent over the Internet will stall anytime soon as the use of mobile devices and video expand. There is also an ongoing expansion of the customer base to lower-income users around the world.

Guidance for Q3 is for increased income and a slight contraction in non-GAAP EPS. Internet traffic is seasonal, with lows during summers, but a lot of people used the Internet to watch the Olympics. The better guide to Akamai performance is growth over periods of a year or longer.

For most investors AKAM has probably reached the point where the high P/E is getting hard to justify, given the other choices in the market. I originally bought AKAM during a slump when it was clearly undervalued, and because of its volatility I have traded in and out more than I like (I am a buy and hold guy). Given Internet trends, and Akamai's move into security and other cloud services, I think over the longer run Akamai will become considerably more profitable, but there is some P/E height at which I would dump the stock. Then again, if the P/E dropped below 25, I would be a buyer again.

Since I've made a deal out of P/E ratios as buy and sell signals, I should note that you can get different P/Es by looking at GAAP vs. non-GAAP and different time spans. As a check, note the non-GAAP EPS for Q2 was $0.43. A year's EPS at that rate would be $1.72. Divide into $37.10 and you get a P/E of 21.6. Which is a much safer sounding number than NASDAQ's trailing P/E calculation of 35. On the other hand the GAAP current P/E would be $37.10 / 4 x $0.24, or 38.6, which sounds much more pricey. You might want to think deeply about Akamai's reasons for reporting non-GAAP numbers before you trade this stock.

Disclaimer: I am long AKAM and won't trade in it for 5 days after this article is originally published.