There aren’t many companies that can accelerate their revenue in such a challenging macro environment. Akamai (NASDAQ:AKAM), is one of them. The company delivered great results in the 3rd quarter of 2023, beating analysts’ expectations on both the top and bottom lines. Revenue grew 9% year-over-year to $965 million, driven by strong performance in security and compute solutions, which represented 61% of total revenue and grew 20% year-over-year. EPS increased 29% year-over-year to $1.63, well above the consensus estimate of $1.5. The stock has gained over 40% since last year, outperforming the S&P 500 index (see below).
Investors appear positive on Akamai’s growth prospects, as the company continues to transform its business with a focus on security and compute solutions. In this article, we will explain why we are also positive on Akamai and why we think it is a great buy.
Akamai Has Become A Leader Security Company
Akamai has evolved beyond a CDN provider into an edge compute company that delivers a comprehensive suite of edge capabilities, from networking to security to compute, on a unified platform. The edge computing market is projected to grow to $317 billion by 2026, according to IDC, and the company is well-positioned to capture this huge opportunity. The market size is substantial but also very competitive and Akamai’s edge compute strategy is to offer customers an integrated and unified platform that covers all their edge needs. This strategy gives Akamai a competitive edge over its competitors, who often lack the same level of edge presence, performance, and security.
One of the most impressive aspects of Akamai’s transformation is how it has become a leading cybersecurity vendor in a relatively short timeframe. Its edge security solutions are very comprehensive and include web application firewall (WAF), distributed denial-of-service (DDoS) mitigation, bot management, zero trust access, identity and access management, and secure web gateway. Akamai’s security revenue grew 20% year-over-year in Q3 2023, reaching $456 million, 47% of its total revenue. As a result of its successful business transformation, the company has been recognized as a leader in the edge security market by several industry analysts, such as Gartner, and IDC (see below)
Segment Revenue Analysis
In this section, we want to analyze the revenue performance of Akamai’s segments and provide a projection for its Q4 earnings.
The company’s security revenue reached $456 million in Q3, up 20% year-over-year. The security segment has shown a robust growth momentum, with a quarterly growth acceleration (see below). Management expects 15% growth for the full year 2023, which implies that the momentum will persist in Q4 as well. As per our model, we expect the security revenue to reach $496 million in Q4, growing 24% year over year. This projection is based on the strong security demand that we are seeing in the market and the growth trajectory of the Akamai’s security business.
Akamai’s compute revenue increased 20% year-over-year in Q3 and has been showing consistent growth for the past few years. Management expects a similar growth rate for Q4 and believes that this segment will maintain its growth momentum as customers will migrate more of their workloads to Akamai’s edge compute regions. However, we also want to caution that there is some risk here, as the company may face some competition from the hyperscalers in the compute market. The current outlook is optimistic, but we will keep a close eye on this segment when Q4 results are announced in a few weeks. Based on our model, we project the compute revenue to reach $137 million in Q4, growing 22% year-over-year (see below), which is slightly above Akamai’s Q4 guidance for compute.
Akamai’s delivery segment, which offers content delivery and optimization services, has been facing headwinds for the past three years. Its revenue declined 4% year-over-year to $379 million in Q3, due to the macroeconomic challenges and the consumer slowdown in its key sectors like ecommerce, entertainment and gaming. Also there is some consolidation going on in the CDN market, as some smaller rivals exited the market and Akamai took advantage of it (acquired customer contracts from StackPath and Lumen Technologies). We expect the company to retain its leadership position in the CDN market and to resume its revenue growth in the long term. Based on our model, we estimate the delivery revenue to decline to $383 million in Q4, down 8% year-over-year, (see below).
To sum up, we are confident that Akamai’s edge security and computing offerings have a huge and expanding potential, as more enterprises will depend on edge computing for faster and more reliable data and AI processing. We also expect its delivery segment to stabilize as the economy recovers from the inflationary environment. See below the total revenue trajectory and Q4 revenue estimate which is $1,016 million.
Increased CAPEX Impacted Margins but Will Drive Growth in the Long Term
Akamai has been investing significantly in its compute and security businesses, which has lowered its gross margins in the past few years (see below). In Q3, its gross margin dropped to 60%, a 1% decrease from Q3 2022. However, this is not a permanent trend, as the company has finished building its compute data centers and is implementing various cost savings measures.
Akamai’s non-GAAP operating margin rose to 31% in Q3, a 3% increase from the same quarter last year. This was due to the ongoing cost saving efforts across the business. However, the company anticipates a lower non-GAAP operating margin of around 29% for Q4, mainly because of the customer transition costs from StackPath and Lumen contract acquisitions.
We think that Akamai’s higher CAPEX spending was a strategic move, as it enabled the company to tap into the growing markets of security and compute. We also think that its cost saving measures are long-lasting, as they take advantage of the company’s size and scale. Therefore, we expect Akamai to increase its profitability and cash flow in the long term.
Akamai is scheduled to announce Q4 earnings on February 13th, 2024. Analysts expect the firm to report an EPS of $1.61 and revenue of $999 million.
Our view is that the company will beat the earnings expectations, as we expect the revenue acceleration to continue. Based on our segment revenue analysis, we expect Q4 revenue to be $1,016 million (10% year-over-year)
Our main buy thesis for Akamai is that its valuation should reflect its successful transition from a CDN provider to a high-growth cybersecurity company. When Akamai’s valuation is compared to those of other cybersecurity companies, it becomes evident that its stock is trading at a steep discount to its peers. Akamai’s forward P/S ratio is only 5.5, while the median forward P/S ratio of its cybersecurity competitors is 14.5, implying a 65% undervaluation (see below).
We believe that the market will eventually recognize this dislocation, and reward Akamai with a higher valuation multiple. As it continues to grow its revenue and earnings from its security and compute segments, we expect the company to narrow the valuation gap with its peers.
The Hyperscaler Risk
The main risks that Akamai faces is the competition from the hyperscalers, in its compute segment. The hyperscalers have several advantages over Akamai, such as their scale, resources, customer base, and ecosystem. However, they are not necessarily the best choice for edge computing, since they are mostly centralized in core data centers, which means they have higher latency and lower reliability than Akamai’s distributed edge network.
Akamai’s management is confident that the company can differentiate itself from the hyperscalers by focusing on certain verticals and use cases where it has a competitive edge. These include media, gaming, entertainment, e-commerce, and financial services, where Akamai’s customers demand high performance, low latency and high security. The management also claims that it can provide compute solutions more cost-effectively than the hyperscalers, by leveraging its existing edge network and data centers, and avoiding the high fees and lock-ins.
We think that Akamai’s compute solutions have a strong value proposition due to their integration with its other services, security and delivery. They are part of a holistic edge cloud platform that delivers greater value than its individual components. By focusing on the right verticals, it will be able to increase its edge market share in the long term.
We believe that Akamai’s valuation is attractive, as it doesn’t reflect its business transformation and growth prospects. Akamai’s revenue growth is accelerating, driven by its security and compute solutions, which have growing market opportunities. The cost savings measures and scale advantages will also boost its profitability and cash flow.
Compared to its cybersecurity peers, we think that Akamai’s stock is undervalued. We recommend buying the stock at current levels, as it provides an attractive opportunity for investors.