CDN Players: Akamai and Limelight Networks
Listen in on interaction and ideas between our Minyanville professors...
The following is an informal debate between Prof. Fil Zucchi and Prof. Adam Katz about Akamai and Limelight Networks, published here for the benefit of the Minyanville readership.
Fil: Hey Adam, I see you guys follow Akamai (AKAM) – any thoughts there?
Adam: Here is a memo we put together on this subject:
"We get abstract channel information on a lot of companies, Limelight Networks (LLNW) included (they're based here in Phoenix), and we have considerable depth in those spaces in which we have strong conviction. While we can and do add insight for our clients who play in CDN, it is not an area of primary focus for us.
Specific to CDN, I believe we have understood the space better than most in that there is (and will continue to be) pricing compression on both sides of the equation. There are an increasing number of players (private companies), the barriers to entry are not terribly high (the AKAM/LLNW lawsuit is an indication of how difficult it is to protect IP in this space), and there is the strong potential for some of the large content distributors to start building their own CDN networks.
For example, LLNW recently announced that they won versus AKAM in the recent bake-off at Microsoft (MSFT) (the stock popped as a result of the headline but they did talk about this on their last earnings call). What's more telling is our understanding of why MSFT did the deal with LLNW… LLNW positions itself in the marketplace with large enterprises that may, at some point, want to in-source their CDN, by saying that customers can always in-source and just license their technology if need be. It creates more transparency and leaves room for more flexibility down the road. AKAM's architecture does not speak to the licensing model very well.
The issue is that at the most local levels, LLNW's technology exists at the ISP's local POP, whereas AKAM must place hardware at far more end points, specifically each of their customers endpoints. Both models incorporate dedicated carrier traffic, but LLNW's software can mix in peer-to-peer traffic, when cheaper. Not only is the AKAM cost of ownership higher upfront, but the ongoing cost of maintenance is much higher. AKAM will argue that their architecture allows for better, faster, more secure delivery; however, I think that the MSFT announcement dispels some of that FUD. AKAM has tremendous sunk costs that need to be recouped or may at some point need to be written down if they don't find a way to prove their claims and regain some momentum.
We do not have a macro piece on this issue because while it's a high growth area, there are a lot of risks to the business models of the top players and therefore, we have no intermediate to long-term thesis regarding the secular health of these business models. In our opinion, it is too early in the game to take a bet on any one player at these valuations."
Fil: Interesting. There is no doubt that competition is increasing and prices are starting to fall. Here is where I'd disagree:
1. Even with increasing competition there are very few legit players in the space.
Adam: I agree.
Fil: 2. I don't see P2P being used for "mission critical" content anytime soon.
Adam: The point is that LLNW architecture can make the distinction therefore uses less total bandwidth which we are all now realizing is indeed a finite resource.
Fil: 3. Prices are hurting right now, but they are not likely to continue falling at this rate for more than a few quarters, and the CDN market as a whole is likely to continue growing faster than long term price pressures.
Adam: As bandwidth becomes more expensive, it creates an environment where these guys get squeezed by both customers and suppliers. I don't think it's fair to blindly assume that the 40% or so anticipated growth rate in the space will a) hold and b) surmount those two forces leaning on price compression.
Fil: The risk of rising bandwidth costs is an issue that's been nagging me and plays right to our thinking that parts of the IP network may be close to getting a pretty significant hardware facelift. But my sense has always been that the CDN's model is to improve on those bandwidth costs. To the extent that bandwidth prices rise across the board I would think that CDN's would be able to pass that along, since the alternative for the customer is to go it alone and pay even higher prices. However, I wish I were more comfortable about that, because if I am wrong I think you are right that margins might get squeezed.
Adam: This is a great perspective, and one that I had not given a lot of thought to. However, I would caution that the CDN's will have to carry some bandwidth as inventory so to speak and they do run this risk of that inventory losing value if a major hardware/software refresh cycle temporarily depresses prices. The point is, this potentially a two side knife but you're 'with us or go it alone' theory is definitely valid and appreciated.
Fil: 4. I just don't see Google's (GOOG) and MSFT's models as benefiting from getting into competition with focused CDN players.
Adam: They aren't going to compete, they may just in-source it. If they do, they will likely not want to start from scratch and LLNW has more licensable architecture from what I understand (although I will offer the caveat that on this point my contacts might be biased).
Fil: 5. Mega content distributors will likely lean toward bringing CDN in-house but those are probably marginally profitable contracts anyway.
Adam: This is the crux of the issue though. It is indeed a volume game. Plus it's the mega distributors that illustrate how well your technology scales.
Fil: Yes, it is a volume game to a large extent, but as you go down in customer size, my understanding is that pricing has been actually pretty stable and hence better margins. Because of that I think a metric that may need to be kept in focus in future quarters is "new customer adds".
Adam: This is another good point. However there has really to date, been one viable player in the space. Competitive forces have not yet been tested.
Fil: 6. At less than 20x P/CFO valuation seems pretty dirt cheap relative to even worst current growth estimates (AKAM won't pay taxes 'till 2010-11).
Adam: I wouldn't go as far as to call it dirt cheap but I am much more comfy with the stock here down in the low 30s than the mid 50's on a valuation basis.
Fil: 7. Bigger picture, the amount of content that requires managed distribution right now relative to what is likely to be five years out reminds me of the dynamics of the network hardware space in the early 1990's, and AKAM looks to me like the Cisco (CSCO) of the group.
Adam: The barriers to entry to get into the network hardware space were much more considerable in my opinion. I consider this to be one of the most important risks to the space.
Fil: You may be right about the relative barriers to entry, although the intellectual prop. investment of these companies is no small deal. Also, IMHO, the sweet-spot for new competitors to emerge was when gross margins were ripping. It's much more difficult for new companies to make it a go if they have to emerge in an environment of shrinking profit margins; I'd be very surprised if we see any new legit competitors enter the fray.
Adam: There are some new competitors out there in the private sector. Both AKAM and LLNW will dismiss them as being legit in the same way that AKAM will say that LLNW is a non-issue. I think we agree that AKAM's claim is by no means a 'given.' In that same vein, I think that LLNW's success to date in defending the infringement lawsuit by AKAM is an indication that the IP is, at least to some unknown degree, at risk. I think it's the reason we need to make it a point to understand with specificity both model and strategy. Logic is telling me that unless AKAM grows some teeth in the courtroom that LLNW has the model with more longevity because again, it provides licensing flexibility. LLNW has conceded to the need to view the world that way to stay competitive. I have not heard that from AKAM. The fact that it is in denial about this issue is one of the biggest red flags in my mind against the management team. Some are arguing that LLNW's team bobbled the last earnings call by taking down Street expectations for the year due to margin issues, but to me, that shows integrity (in real time, not after the fact). Just shows no good deed goes unpunished!
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