Akamai Technologies, Inc. (AKAM) Earnings Call Transcript & Summary

Thank you, everyone who's made it to day 4 here. And thank you Ed McGowan from Akamai for joining us this morning. My name is Keith Weiss. I run the U.S. software equity research team here at Morgan Stanley. Before we get started, please note that all important disclosures, including personal holding disclosures and Morgan Stanley disclosures, appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures or at the registration desk. So Ed, thank you for joining us.

Thank you, Keith.

I'm going to modify my opening question a little bit, given kind of the recent events over the past 2 weeks. So we head into 2020, we're excited about sort of 2020 being a good year for Akamai in terms of recent OTT launches, the Olympics, the elections, on sort of the core business side of the equation and security has been doing well. Do the events over the past 2 weeks, should that temper our expectations around some of the event stuff because that is Olympics potentially getting delayed. Is that going to be a big impact on the overall business. Sure the elections are still going to happen, but..

Yes. Good question, Keith. So obviously, if events get canceled, then it could have an impact. Now no event is overly material. And if you saw the Olympics go from Q3 to Q4, I've been hearing some talk about maybe it moves to October or something like that. It's just a shift out of Q3 to Q4. And with the Olympics, the way to think about that in terms of our revenue, we get revenue from the rights holders, you get revenue from the live television and there's a drag-along effect with some of the other verticals in the market. So it would have an impact, but it wouldn't be overly material. And certainly, a shift from one quarter to another, you just adjust your models, and it doesn't have a major impact on 2020.

Got it. And do you have any significant exposure to sort of like -- what is your exposure to China and Asia Pac. And we're hearing of supply chain impacts. But has there been any impact on your business?

Yes. So in terms of the supply chain, there could be some timing issues. If there -- we do have some component parts that come out of China. Most of our manufacturing is not done there in terms of our servers. We do a really good job of planning out in advance. So to the extent that this is a temporary shift, you may see some CapEx lower Q1, maybe it picks up a bit Q2, Q3. But we're not anticipating anything that would have a major impact on the business at this point. But obviously, if this goes on for many, many months, it could have a little bit of an impact. But right now, we don't see it as being a major impact, other than just shifting of CapEx from one quarter to another.

On the expense?

Yes.

And you're not seeing any demand-side impacts, either positive...

No, so....

I guess there is a potential for it to be positive.

Yes. So there is an interesting bull case here, you hate to talk about benefiting from something like this. But to the extent that you see businesses shut down and people working from home, schools being closed and people doing -- being kept up in their house, there is the potential for more internet usage. There's the potential for additional streaming usage, additional commerce traffic because people wouldn't want to go outside, they want to shop, similar to what you saw in Q4, right? That's probably the best way to think about it. We're not seeing it today because right now, that isn't a big phenomenon around the world in places that would have a big impact. But if you see things spread here to the U.S., Western Europe, India, you could see a benefit. In China, today we do not do the delivery of -- in China from Chinese customers or Chinese users in China. We only deliver out of China and then customers going into. So it would not have a big impact on us.

Got it. Got it. Completely separate from sort of any of the coronavirus events. But just more broadly speaking about geographic strength. International has been very strong for you guys relative to the U.S. Can you talk to us about sort of, one, why has international been kind of a strong region for you guys? And two, should that be durable as we head into 2020?

Yes, good question. I'd say there's really 2 things. One would be just what's going on outside of the U.S. in terms of people getting access to high-speed internet. And you saw that here in the U.S. years ago, that you just have a natural lift in traffic. So there's more opportunity. And two, would be on the competitive side. So we've made significant investments over the years in our infrastructure outside of the U.S. and also in our sales force. So we invested quite a bit, building up our sales force, especially across Asia, and we see less competition there. It's really hard, actually. It's hard to go in as a U.S. company and build internationally and get the right people, the infrastructure, the support system. It costs a lot of money to go do that. We've made those investments and they're starting to pay off. So in terms of the durability, it looks good. We still see outsized growth coming from outside of the U.S., we just made a big investment in Latin America, a very underserved market by the CDN industry in general, a very difficult market as well. But yes, I think we're in really good shape outside the U.S., and we're seeing growth in many countries. It's not just one particular country.

Got it. Got it. Our forecast look for Akamai to see accelerating top line revenue growth in 2020 with improving operating margin. So a nice set up from our perspective. I want to dig into some of the drivers of that growth. The biggest one being security. Security has been a great story for you guys over the past couple of years. It's now over 30% of the overall revenue mix. Can talk to us about, one, the -- sort of, what's driving the security mix? And if I could sort of present kind of the bear case and sort of get your view on it. Akamai has done really well with DDoS protection and WAF, but those are relatively small market, thus, security has got to slow down. These guys have become such a dominant force in these relatively small markets. They can't possibly sustain this type of growth.

Okay. So it's funny, everybody underestimates the WAF and DDoS market, it seems to be getting bigger and bigger every year. If I look at just as a data point, the penetration of our customer base today as of the end of Q4, we talked about this a little bit on the call, about 55% of our customers today buy at least 1 security product. That's up about 7% from the prior year, and only about 28% buy 2 or more, which is up about 3% from the prior year. So there's still room to go with our core products. But you got to keep an eye on our innovation and what we're doing around security. We're coming out with one of the most exciting things for us this year is what we call our Page Integrity product. So if you think about our Kona Site Defender, our largest product today, protects the base page, protects the first-party content. The attackers have gotten a lot more sophisticated. And now that we've kind of shored that up, they're looking at other ways to steal information. And a lot of -- most pages, not everybody, but most pages have a lot of third-party content, links to different places. It doesn't take much to insert some malicious code into some of those links that could either infect your device with malware or could be pulling out information from the site itself, credit card information or personal information, credentials, et cetera. So this is a great add-on for a big problem that our customers have today, that goes right to the sweet spot, anyone who has bought Kona Site Defender for web application firewall, this is a nice add-on, just like what we saw with Bot Manager. And right now, Bot Manager is something, again, that's on top of KSD, that is our fastest-growing product. I think we've got more room to go in our installed base and also as we continue to innovate new products and try to stay ahead of this ever-evolving threat landscape.

Got it. Just maybe to take a step back. You talked about sort of the penetration of security into the existing installed base, and that's been the primary motion. Have you got to the point of where Akamai could lead with security products? Do you get new customers coming in the door with the security products? And if so which ones are they?

Yes, we do. It used to be perform and protect now it's protect and perform. So I would say, of all of our new customer bookings, the overwhelming majority are coming to us for security first.

Got it. Got it. And what are the landing products that they typically come in...

Typically, you -- we land with KSD, and expand from there. Obviously, we've got a whole suite of enterprise products that we're bringing in new customers from new verticals that we don't typically sell to, that are coming in with our zero-trust products.

Got it. And I wanted to talk about those zero-trust products. You've now gone into sort of access and identity and web security as well. That's even kind of further afield from kind of what your core customer has been. Can you talk to us about the traction that you've seen in that broader set of products? And what kind of new competitors that brings into your field to play?

Yes. So it's a fast-growing part of the business, still small, and we talked about on our last call, we'll break it out when we get to a run rate of $100 million, that's what we've done with our other products. And we're not quite there yet. We are seeing good traction in some verticals. There, you've got this suite of products, you start with access. So from a competitive landscape, you're competing against anybody who offers VPN, for example. We've got threat protection, so anyone who offers a threat protection. You're really going against the grain of on-premise to a zero-trust, where essentially internet becomes the network, for lack of a better term. We're coming out this year with a Secure Web Gateway, which will make us a lot more competitive with, obviously, the Secure Web Gateway vendors, but also with Zscaler, who is really, if you think about who we're most analogous to in terms of the direction we're going with zero-trust is someone like a Zscaler.

Got it. So today, you kind of protect the inbound. So it's access into -- with the web gateway now you're going to have the outbound side of the equation as well?

That's right. Yes. And we also have multi-factor authentication that we picked up some technology at the end of last year, we'll be coming to market with that much later in the year.

Got it. And can you talk to us about where we are with building up sort of a distribution channel focused around security, having the right sales guys in place, having the right partners in place to get the market to view Akamai more fully as a security vendor versus just sort of the CDN guys who do security on the side?

Yes. So great question, Keith. We've made some significant investments in what we call our advanced technology group. So think of that as an overlay sales team, for lack of a better term. But come from the industry that have relationships that know how to sell to the IT buyer. So today, we are thought of in the CISO suite as a trusted vendor who secures all web applications. But we're making the pivot now to protecting the employees, so the traditional IT buyer. It is a different buyer. So it is a challenge to get there, and we are working on not only building out that team, but also in building out partnerships with folks that have those relationships that can help bring us into the IT buyer.

Got it. Got it. And then maybe just to sort of wrap up the security side of the equation. You're expecting $1 billion-plus in revenues in the coming year, low 20s growth. How durable could that kind of 20%-plus growth rate be in security over time? Actually, I have 2 more questions. I asked that one first.

Sure. Well, so like I said, one of the things that we are really excited about is the page integrity product. There's a lot of innovation going on inside of Akamai, coming up with new additions. We're not just staying still here. That -- given the penetration we have in our current installed base, the fact that we're adding new customers with security first, adding new products. If we have any success with page integrity, like we did with Bot Man, which got to $100 million very, very quickly, you could see the potential for that to continue. On the other side, you've got the enterprise security, which is a much, much bigger market. And it's just -- we're just early days in the journey there. So if you were to think, "What do I have to believe to see that sustained?" It would be continued innovation and penetration in our installed base with our web security products. You'd then have to believe that we start to get some meaningful penetration on the enterprise side.

Got it. Last week with the RSA Conference, which, unfortunately, we were at, 3,000 vendors, hugely fragmented market. Everybody is sort of talking about sort of the latest and greatest thing that they're doing in security. M&A has been a big part of sort of how you've built out that portfolio on a going-forward basis, should investors think of Akamai as a continued consolidator in this space and sort of using M&A as one of the tools to build out your portfolio over time?

Yes. M&A is definitely going to be a part of our toolkit, without a doubt. We did -- so far in the security space, we tended to buy more technology and tuck it in. So I think Cyberfend we did it -- a deal we did a couple of years ago, was part of our Bot Manager version 2. So we took technology, tucked it in. ChameleonX acquisition, very small acquisition we did last year that will be part of our page integrity products. So I think you'll see us continue to do things like that. We'll continue to explore other acquisitions, obviously, valuations are quite rich in the security space, maybe a little rich today than they were a week ago, but still pretty rich. So we're very active shoppers with disciplined buyers. It could be interesting to find an asset that could get us more meaningful distribution in the enterprise space, where you pick up a sales force and -- relationships and things like that. Hard assets to find, but we're going to continue to look in the M&A world, for sure.

Interesting. Got it. I want to shift gears here to the media business. This is definitely kind of the part of the business that investors have most consternation about, which they think is sort of commoditized with continued downward pricing pressure. Although we're talking to 1 industry analyst, not pricing so low, it's hard to see if it's going any lower. It's just there's not enough decimal points to go over anymore. How does Akamai look to sort of differentiate their offerings in what's looked at as a very commoditized market? Are we too negative on sort of the ability to have a differentiated solution in media?

Yes. So I mean I think there's a couple of things there. One, quality, obviously, is the key differentiator. If you think about it, if you're in a market where pricing is essentially the same, right, across multiple vendors, quality is going to matter, quality is going to win. Scale is another thing. Scale is becoming a much, much bigger part of the equation. We're seeing customers now come to us saying, "I want guaranteed capacity." I'm launching in this particular part of the world or have these rights, how do I guarantee that I have this amount of capacity because I believe I'm going to drive this kind of demand. And then we talk about this all the time about having capacity in the places where the users are, is really important because the further away you are from the user, the more you are in the central parts of the internet, the worse the performance will be. So in a world where you've got, call it, pricing that's pretty efficient, and you've got a multi-CDN world, how you win is on quality and on scale. And also security is becoming a much bigger part of it. Now you don't necessarily need to -- you can have security separate, but it is becoming a much bigger part of the sales motion.

Got it. So that distributed network that's sort of the high quality. That's what would differentiate an Akamai from like an Amazon with a cloud front, large enterprise -- large public cloud vendors coming into your space?

Yes. Then also our traditional competitors tend to be in tens of locations where we're in thousands of locations. And that really matters, especially as you're going outside the U.S., you've got to be in the right city and the right network. You've got a much more fragmented telco market as you go outside the U.S., there's some pretty hard to reach places around the globe that we're very well built out in. And typically, as you see, the multi-CDN splits when we go outside the U.S., we do tend to get a bigger share because we have more capacity and can deliver better quality.

Got it. Within media, one of the opportunities that people get a lot -- really excited about is OTT. And we've seen some really cool OTT launches and a lot of them over the past year, and they say there's more to come. But there is an investor debate on whether OTT can really move the needle for Akamai. Can you get enough share of that traffic? Is that traffic going to be big enough to actually be a significant contributor to growth for Akamai, number one? And number two, what's the gross margin that you actually get that business back? Because it's highly competitive, even if it adds to the top line, is it any significant contributor on the gross margin dollar side of the equation?

Okay. So in terms of it being a big contributor, I think, over time, it certainly could be, right? We're starting to see decent growth in traffic. The CDN business is growing again, which is good. And I think there's some pretty interesting things to watch this year, just throughout industry in general, right? You've got someone like Disney, who is going to be taking what they did here in the U.S. and expanding internationally. How is the international market going to adopt that? You've got 2 new players coming into with very powerful brands coming into the U.S., what does the consumer do? Is the consumer spending less time on traditional television and consuming more? Are they just moving between one and another? So this, I think, is a very interesting and pivotal year to see what happens as you get more powerful brands like NBC and Time Warner and Disney, all competing for eyeballs and dollars, et cetera, how does that shape? Does it drive additional traffic? Or is it just shifting from one to another. So that's going to be something that we really need to watch. If it is adding new traffic then sure, that could absolutely help us and could be a decent part -- decent grower for us over time, especially as these companies expand into new markets and add new subscribers. You asked about gross margins. Interestingly enough, I just didn't exercise where I was looking, I asked the same question. I said, "Are we making money on these?" and the answer is yes. One of the things that's fascinating, I've been with the company for almost 20 years now, prices have always come down. If you look at our margin and our margin has been consistent. And that's because we've been able to do a phenomenal job of driving down our input costs, right, driving down bandwidth costs. We get a lot of free traffic from our carriers because we add a lot of value by bringing so much traffic. We built out our own backbone in certain places and not use third-party transit. We get a lot more efficiency out of our machines. So yes, you do get gross margin dollars from some of these big OTT launches, lower than what you would see in security, but you also get pretty high operating leverage. I don't need to add a lot of people as traffic grows for any one of these big OTT providers as they expand internationally, come to market with a new offering. I'm already -- I already have a support team that's supporting a lot of these folks. So I get pretty good operating leverage off of that lower gross margin in the media business.

Got it. Last question on media, I'm going into speed around since we have 6 minutes left. Is there a risk of sort of the DIY sort of trend, as these OTT vendors get bigger and bigger and maybe start to consolidate that you see a similar kind of trend of them doing more and more of the stuff in-house?

Sure. And it's always a risk, right? I mean our biggest competitor is do it yourself. It always has been and always will be. That said, the posture of these folks is to do multi-CDN. So it would go against the philosophy of having multiple options. And even some of the do-it-yourself providers today still uses us. So it is possible that some of that traffic, I would say, more likely the phenomenon would be that in the rotation might be some of their own DIY, and it will vary by different supplier -- of different customers, excuse me. Some of them want to build it themselves. Some of them have no interest. It certainly economically wouldn't make a lot of sense, but to the extent that they want to have more control and have maybe there's some things they can do with the carriers, who knows. But yes, it could be a part of it. But my guess today is that if it happens, it would be more a part of the rotation rather than completely remove CDN from the mix.

Okay. Got it. Switching to web performance. And focusing on kind of web performance ex security, just kind of the core performance side of the equation. It's long been kind of the stalwart within sort of the Akamai income statement, steady grower, good kind of margin business, steady pricing within that, we're hearing about a lot more competitors. Private companies that have come public and still private companies in that space talking about being more competitive with Akamai. And even sort of some of the big public cloud vendors coming more and more into that performance space. Is -- are you guys going to be able to hold price and performance the same way that you have historically?

Well, there's always been price pressure and performance. It tends to not be as noticeable because you've got lot less traffic. But if I look at the percentage declines year-over-year. Outside of a bit of acceleration in the commerce vertical that we've talked about, it has remained fairly consistent. But we've always had price pressure in the web business. And I expect that we still will. One thing that could potentially -- we'll have to keep an eye on is our -- as a result of this virus you end up having other verticals like your travel hospitality, et cetera, come under financial pressure and does that put additional pressure on the business. But we've always had competition, always had price pressure and there's really nothing dramatically different this year than there was in the past.

Got it. You guys have released a zero overage, kind of all-you-can-eat kind of models within performance. How has that changed the competitive environment? And does that help on the pricing side of the equation? I mean I guess that...

Yes, yes. So we're just coming up to the anniversary. We launched this last year at our customer conference. And so now you're starting to renew some of those deals. What it really did is it took one of the big objections off the table that our customers had with us, which is, "I want a predictable spend." And we started hearing that over the years -- and this is on the website, not on the media side. On the media side, you wouldn't do a zero overage deal, it wouldn't make sense. There's just too much volume. But on the website, we did hear customers saying, "Hey, I want a more predictable spend, how can you do that?" This is a creative way of doing it from a margin perspective, there's not a lot of traffic, so there's not a lot of cost there. It does -- if you are paying x dollars for all of your traffic, it doesn't make sense to go split and pay more. So we do see less splitting now or it's not necessarily splitting of traffic, it tends to be more domain-specific, where a couple of domains may go to a competitor, main site goes to us. The objection there is off the table, why would you go and do that now? And certainly, helping to provide a more predictable bill for our customers is something that they were anxious about and that solves it.

Got it. I want to make sure we touch on the margin side of the equation. You guys have seen really nice improvement in operating margins, just about got to your 30% goal almost about a year early, still a little bit of room to go within there. Most of the operating leverage has come on the G&A line. So 2 questions. One, is there more room to go on that G&A line? And number two, are there efficiencies to be seen either on the R&D or sales and marketing side of the equation that could continue that sort of upward expansion of operating margins?

Yes. So we've improved margins from what, 24% back in '17 up to -- we guided to 30% this year. So significant improvement. I'm really happy with the team kind of rallying around that. It's not easy. We have to make some tough choices. But the other thing that we've been able to do is continue to invest in research and development and in sales. And we want to do that. We don't want to sacrifice growth. And we have gotten a lot of leverage out of G&A, and there's still room to go, constantly rationalizing our real estate footprint. We put in a procurement function that's been driving an awful lot of savings. We have -- our biggest cost is our employee base. So every year, we need to wring synergies out of the business, and we're going to continue to focus there. We made some investments in some IT projects that are starting to pay off. We're doing a lot more transactions with fewer people. And we want to continue to do that.

Got it. And then last question for me, we've got a minute left, on capital intensity. Historically, there have been ebbs and flows in the capital intensity at Akamai, but that's really been about your investment cycles and they've all kind of varied around a similar type of level. As we see more mix shift to higher-value areas like security. Is there a chance to like fundamentally change the capital intensity profile of Akamai?

Sure. I mean I think if you were to kind of model out 5 years from now or whatever, pick a date in the future, and if today 1/3 of our business comes from security, if that was 50% or greater, it got -- it has a much lower capital-intensive posture to it. And also the security business benefits from the fact that we're building out for media, gives us the scale to handle massive attacks. And it's just the performance benefits, that sort of thing. So yes, it's possible over time. Certainly, in the near term, with the demand in OTT and what we're seeing in gaming, you expect to continue to see kind of the capital intensity like we see today. But over time, sure, it could change if the mix changes significantly.

Got it. We're going to sneak in 1 question from the audience.

This doesn't seem to be on.

It's fine.

If I were to characterize the challenge for Akamai is [indiscernible] sales process [indiscernible] also the other [indiscernible] with other people [indiscernible] [ global ] via web interface, no call required, no [indiscernible] and also a lot of information [indiscernible] underlying technologies still challenges security. Kind of wrapping that all up, how do you manage that pivot to a more seamless sales cycle? And more importantly providing exposure [indiscernible] without necessarily [ talking to someone. Is that the underlying? ]

Sure. Yes. No, it's a good question. And we are making a lot of investments in the area of DevOps, for example, providing more APIs, more information, training people on how to use our system, making it easier to use and consume. You know what we found? With certainly the larger customers, they do tend to want to see a person on site. There is this notion of, "I don't want to ever talk to a salesperson." et cetera. We don't see that with the larger market. We also don't chase the low end of the market either. The SMB market, we don't go after. That's where you tend to see a little bit more of that where it is that seamless web interface, just spend a lot of money on marketing, drive people to your site, you don't talk to anybody. You click a few buttons and you're on. Our system is very sophisticated, highly programmable, and it does require a lot of tuning, but you get a lot of benefits out of it as well. But we are making investments to do that, but you do hear from our customers that they would like to have more control, to be able to do certain things, whether it's getting reports on a more timely basis, being able to purge their traffic -- purge their content faster, things like that. And we're making significant investments there and moving the dial.

Excellent. Unfortunately, that takes us to the end of our allotted time, but thank you very much for joining us.

Thank you, Keith. Appreciate it.