360 Degrees of Akamai

According to Akamai's Web site, the company has 15,000 servers in 1,100 networks in 69 countries. The company's technology delivers content from an origin database to end users, thus reducing the need for in-house technology for companies expanding to the Web.

Akamai is well positioned, with 40 resellers of its products to capture a large percentage of the infrastructure business required to deliver digital content over the Web. One of the big drivers of Akamai's products is content, such as video and music sold over the Web that can be downloaded into a portable device such as an iPod. With more than 14 million iPods sold by Apple (AAPL Quote) in the fourth quarter, and the number of song downloads from iTunes surpassing 1 billion since April 2003, Akamai is experiencing an enormous expansion of its addressable market.

With its iPods, Apple is a high-profile Akamai customer. The two companies affirmed their partnership in the fourth quarter when they agreed to extend their current contract. With most of the demand now coming from the music side, we believe higher adoption and use of video iPods -- which were released in October -- will have a meaningfully positive impact in the coming year.

In addition, the company stands to benefit from increased adoption of Web-based retailing by offline retailers that don't have the technological know-how to operate their own Web sites in a cost-efficient manner.

According to data from comScore, which monitors and rates Web traffic, Wal-Mart (WMT Quote) has catapulted to the No. 3 position among most-visited Web sites among retailers, behind only eBay (EBAY Quote) and Amazon (AMZN Quote). Target (TGT Quote), a Wal-Mart competitor, comes in a close fifth, ahead of even Apple. We interpret this as proof that online retailing is becoming a critical component of retail sales, and we predict more retailers will join companies such as Wal-Mart and exploit affordable marketing access to mass consumers.

Akamai announced fourth-quarter revenue of $82.6 million and earnings per share of 16 cents vs. analyst expectations for $78.9 in revenue and 15 cents a share in earnings. Despite these solid results, we believe 2006 will be even better. Akamai added 80 customers in the fourth quarter, vs. 52 in the year-ago period, and now has 1,910 customers.

Gross margins could head higher in 2006 from the fourth-quarter levels of 30.2%. As research firm Deutsche Bank points out in a recent note, Akamai did not receive revenue from several deals signed in the fourth quarter, but did expense sales costs associated with the deals. Therefore, the revenue recognized from these new deals will come with higher margins.

Akamai is forecast by analysts to grow its EPS by 34% in 2006 to 70 cents from 52 cents, and another 30% in 2007 to 91 cents. Its revenue could reach $350 million in 2006, which would mark 75% total growth from 2004 and 32% year-over-year growth.

The company also has a solid balance sheet, with nearly $300 million in cash and debt of $200 million, which is convertible at $29.40 and costs the company $2 million a year in interest payments. However, Akamai's $105 million in 2005 EBITDA (earnings before interest, taxes, depreciation and amortization) covers its interest payments a comfortable 50 times, and the company's cash balance should continue to grow, with only $40 million to $50 million in capital expenditures likely in 2006.

Even so, we believe current valuation reflects lofty growth expectations. The stock is trading at nearly 12 times analysts' 2006 sales forecasts and 50 times analyst earnings estimates for 2006. While Akamai is forecast to grow EPS by 79%, and therefore trades with a PEG ratio (price/earnings ratio divided by year-over-year earnings growth rate) of less than 1, the recent drubbing of Google (GOOG Quote) following a roughly in-line earnings report is evidence that the market will not pay high multiples for anything less than perfection. This creates what we view to be an unfavorable near-term risk/reward scenario that requires patience.

We are adding Akamai to our radar screen, and will wait for our $25-a-share price before adding the stock to the model portfolio.

What's the next stock to get the "360 Degrees" examination? You decide. Select from these choices and look for the column next week.
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