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VIDEOAkamai Quarter Review: Options Trading Rises on Takeover Rumor
By
Fil Zucchi
Aug 24, 2010 10:20 am
Takeover speculation could fade, however, and Akamai's ultimate success will likely come from value-added services.
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Akamai (AKAM): The company reported the quarter just about when I was coming off the 18th hole on the Old Course at St. Andrews, and at that point the last thing I was concerned with was Akamai. With the benefit of hindsight, and a stock price $10 higher than where it traded post report, I can confidently say that the after-earnings swoon was utter idiocy. I realize that the recent pop has come on the shoulders of takeover speculation, so, should that fade, here's my thinking on the quarter:
The disappointment had to do with the lower margin results and higher Capex spending. One commentator summed it up by suggesting that Akamai's business model isn't sustainable because it eats its free cash flow to pay for its Capex, and that's an inescapable dynamic. So I'll repeat the same mantra I offered up years ago, when I suggested that Akamai's ultimate success was going to come from its value-added services (VAS), NOT from the dumb reselling of bandwidth. Sure enough, today VAS account for more than 50% of revenues, and more than 70% of its customers purchase VAS in addition to core CDN management. VAS require constant R&D investment but carry margins in the 90% range. What "hurt" this quarter's margins was a "spike" in network investment, the hardware to support the exponential explosion in data traffic. I put both "hurt" and "spike" in quotes because margins were down a whole 100bps and the spike in Capex moved that line from the prior range of 14-16% of revenues, to 17%.
Now consider this: The growth in the amount of data being moved on the Internet just because of video transmissions is at the embryonic stage; that is, this baby hasn't even been born yet. As it's born and eventually grows, the size of the traffic will be such that margins even in this lowest-of-margins business will likely increase. Meanwhile, the overall management of content distribution, data analytics, advertising distribution, cloud computing, application acceleration, and anything else that will move over the Internet, will only get more and more complex and Akamai's VAS will become effectively indispensable -- at 90% margins.
Or here's another way to look at it: ISPs are spending the bulk of their ad dollars to convince you that their Internet service is faster than the next guy's. Meanwhile, the only thing that will make the service truly fast, is if the content they deliver is properly managed and accelerated; 100bps margin misses are for the birds.
International Game Technologies (IGT) and BlackRock (BLK): The two have nothing in common except that they're relatively new names to my book, and I'm playing them the same way, i.e. by selling long-dated, out-of-the-money puts to buy long-dated, out-of-the-money calls. Here's the thinking: Both businesses stink right now. Capex is the last thing casinos care to spend on, and low rates and a flat yield curve are the bane of a bond manager's existence.
But everything has a price, and things eventually do change. International Game Technologies pretty much owns the slot-machines market, has good cash flow, and has a balance sheet that can be easily LBO'ed. As long as it doesn't cost me much of anything to wait, I'm perfectly comfortable taking a flier on it with downside risk of owning the stock in the single digits. Similarly, BlackRock and Pimco own the fixed-income asset management space, and while it may not make them much money now, selling the $125 puts (below BlackRock's book value) to buy the $170 calls at a credit, seems like a pretty low-risk proposition. Other candidates I'm scouting for similar plays (as a way to press existing longs) are Microsoft (MSFT), Core Labs (CLB), and BlueCoat Systems (BCSI).
Pre-Paid Legal Services (PPD): With the FTC closing its three-year-long investigation into Pre-Paid Legal Services' marketing practices for the Identity Shield product, one of the catalysts that pulled me back on the dark side of this name went out with a whimper. The outcome did surprise me, as I truly thought the Feds were finally on to Pre-Paid's "products." Granted, the investigation didn't address the laughable nature of Pre-Paid's core legal services offering, but if the FTC hasn't figured out that scam by now, odds are it never will. Meantime, the SEC investigation into Pre-Paid's accounting practices is still out there; and the business continues to deteriorate. One of the cardinal rules of trading is to abide by the thinking that gets you into a position. Following that, discipline would dictate that I shelve my short and forget about this toughest of all trades. But being only human, stubborn, and a glutton for punishment, I'm going to stick around until it drives me totally nuts. Then, of course, I'll toss in the towel.
And with that, it's back to the daily grind of the most exciting show on earth.
Positions in PPD, AKAM, BCSI, MSFT, BLK, CLB.
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