Akamai Technologies, Inc. (NASDAQ:AKAM) Q3 2023 Earnings Call Transcript

Akamai Technologies, Inc. (NASDAQ:AKAM) Q3 2023 Earnings Call Transcript November 7, 2023

Akamai Technologies, Inc. beats earnings expectations. Reported EPS is $1.63, expectations were $1.51.

Operator: Good afternoon, and welcome to the Akamai Technology Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.

Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s third quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q.

The forward-looking statements included in this call represent the company’s view on November 7, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, I’ll turn the call over to Tom.

Tom Leighton: Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai delivered excellent results in the third quarter with revenue, operating margin and earnings all exceeding the high end of our guidance range. Revenue grew to $965 million in Q3, up 9% year-over-year. Non-GAAP operating margin was 31%, and non-GAAP earnings per share was $1.63, up 29% year-over-year. Ed will cover the key factors that drove our bottom line performance in his portion of the call. I’ll now say a few words about each of our 3 main product areas, starting with security, our largest source of revenue. Security revenue grew 20% year-over-year in Q3. The acceleration in security growth was driven in part by especially strong demand for our market-leading Guardicor segmentation solution as enterprises confront the ever-present threats from malware and especially ransomware.

CISOs and corporate Boards everywhere have seen the recent headlines about devastating ransomware attacks, including at 2 casino hotels in Las Vegas, a major manufacturer of cleaning products in the U.S. and at a multinational provider of systems for smart buildings. One of them reportedly paid $15 million to get ransomware out of their systems. Another is reportedly spending $25 million to deal with the after effects and a third has reported more than $100 million in losses from the attack. Customers who purchased our segmentation solution last quarter include a major global services provider, one of the world’s most recognized entertainment brands and a leading bank in Switzerland that renewed their segmentation protection with a significant upgrade.

We also saw strong demand for our market-leading web app firewall solutions in Q3, where we continue to win against competitors who are challenged to provide the levels of reliability and performance required by major enterprises. Customers who switched to Akamai, including a nationwide retail chain in the U.S. and a leading global manufacturer based in India, also told us that our competitors simply can’t provide the level of support and professional services that they need and have come to depend on from Akamai. Customers also value being able to purchase an entire suite of integrated security products from Akamai, a provider who they trust to keep them safe against a wide variety of attacks. For example, we’re seeing very strong interest in our new API security solution that we announced last quarter.

This new product is in its very early days, but we’ve already integrated it with our market-leading web app firewall solution to make it even easier for customers to implement. At the Black Hat security conference last quarter, Akamai API Security was named one of the 20 hottest new cybersecurity tools by CRN, a major trade publication for channel resellers. And as with Guardicore, you don’t need to be a CDN customer to benefit from this new solution. Turning now to cloud computing. I’m pleased to say that we’re on track with our product development, infrastructure deployment and conversations with customers about use cases well suited for the Akamai connected cloud. Since our last call, we’ve gone live with 7 more core compute regions in Amsterdam, Jakarta, Los Angeles, Miami, Milan, Osaka and Sao Paulo.

In addition to the 6 that we opened earlier this year and the 11 that we acquired from Linode, this brings our total to 24 core compute regions to serve Akamai connected cloud customers. Of course, there are other cloud companies with a few dozen data centers. But Akamai is unique in having these data centers interconnected to the world’s most distributed edge platform with more than 4100 points of presence across 750 cities and 130 countries. As one trade pub block and files recently wrote, Akamai is focusing on a future where scale becomes more about the size of the network versus the size of its data centers, more effectively powering modern applications. We agree. Akamai’s massively distributed edge network, 25 years in the making and managed by Akamai’s team of experts around the world is a key differentiator in our strategy.

We believe that next-generation applications will need next-generation cloud infrastructure, and we intend to chart the course for the next decade of cloud computing when more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. As IDC put it in July, Akamai brings the simplicity, affordability and accessibility of its cloud computing services to larger commercial customers on an architecture built for the next decade, not the last. The Akamai Connected Cloud will put containers and VMs closer to end users and bring enterprise workloads to locations around the world that are otherwise difficult for organizations to reach. Customers are responding to Akamai’s unique offering, and we’ve already gained cloud computing business across multiple verticals in every major geography, including a European streaming media company, a digital advertising company in Japan, a large financial institution in Indonesia, and e-commerce platform in Korea, major carriers in EMEA and Central America and a television network in South America.

In addition to direct sales, we’re seeing good traction in our cloud computing partner ecosystem, where we’re acquiring new customers by selling with cloud service providers and managed service providers. We’ve also partnered successfully with independent software vendors and SaaS and PaaS providers. In fact, we recently signed one of the world’s best-known SaaS providers and our second largest cloud computing deal since we acquired Lanone [ph] Turning now to content delivery. I’m pleased to report that we saw an acceleration of traffic growth in Q3. In addition, we acquired enterprise customer contracts from StackPath and Lumen Technologies following their decisions to exit the CDN market. As Ed will talk about shortly, the financial terms of the acquisitions were very attractive for Akamai shareholders.

In addition to the delivery business that we acquired, we’re planning to introduce these customers to our full portfolio of security and cloud computing solutions to help them power and protect their businesses online. In summary, we are very pleased by our performance in Q3. Our expanded security portfolio is deepening our relationships with customers. Our cloud computing plans are executing on schedule, and we continue to invest in Akamai’s future growth while also enhancing our profitability. Now I’ll turn the call over to Ed for more on our Q3 results and our outlook for Q4 and the full year. Ed?

Ed McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered a strong and very profitable quarter in Q3. In my remarks today, I’ll cover our Q3 results and then provide some perspective on Q4, share some details on our recent customer contract acquisitions and closed with our increased full year 2023 guidance. First, let’s discuss revenue. Total revenue for the third quarter was $965 million, up 9% year-over-year as reported and in constant currency. In the third quarter, Security revenue was $456 million, growing 20% year-over-year as reported and 19% in constant currency. Security revenue growth was primarily driven by continued strength in our segmentation product, which is now over $100 million on an annualized run rate basis and up 97% year-over-year.

I’ll note that during the quarter, we had approximately $6 million of onetime segmentation license revenue. Adjusting for that onetime license revenue, total security growth for the third quarter would have been 18% year-over-year as reported and 17% in constant currency. And segmentation revenue growth would have been approximately 62% year-over-year and 60% in constant currency. In addition to strength and segmentation, we also saw very strong growth in our flagship Web Application Firewall or WAF product family. This growth was primarily driven by stronger-than-expected adoption of new security bundles offered to new and existing customers that we introduced this year. The new security bundles include additional security entitlements such as more security policies, additional security configurations and more advanced rate control policies.

Many existing customers are seeing greater value in these new bundles and as a result, are spending more with us. Moving to compute. Revenue was $130 million, growing 19% year-over-year as reported and in constant currency. On a combined basis, our securities and compute business product lines represented 61% of total revenue, growing 20% year-over-year and 19% in constant currency. Shifting to delivery. Revenue was $379 million, declining 4% year-over-year as reported and in constant currency. It’s worth noting that delivery was aided by approximately $4 million in revenue from the selected CDN customer contracts we acquired from StackPath. International revenue was $467 million, up 11% year-over-year and up 9% in constant currency. Foreign exchange fluctuations had a negative impact on revenue of $3 million on a sequential basis and a positive $7 million benefit on a year-over-year basis.

Moving now to company profitability. Non-GAAP net income was $251 million or $1.63 of earnings per diluted share, up 29% year-over-year and up 28% in constant currency. These especially strong EPS results exceeded the high end of our guidance range by $0.11. — were driven primarily by higher revenues and continued progress on the cost savings initiatives we outlined over the last few quarters. As an example, we continue to reduce our third-party cloud spend by migrating internal workloads to our connected cloud platform. In Q3, our third-party cloud spend declined 26% year-over-year. Moving to margins. Our cash gross margin was 73%. Included in our Q3 cost of goods sold was approximately $5 million of transition services agreement or TSA costs paid to StackPath.

With customer contract acquisitions, TSA payments are used to cover the seller’s customer-related network and support costs during the migration period. I’ll provide further detail on expected TSA costs going forward in the guidance section in a few moments. Adjusted EBITDA margin was 43%, and our non-GAAP operating margin was 31%, 2 points ahead of our guidance, driven by our revenue outperformance and continued focus on driving down costs across the business. Moving now to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $2.1 billion, which includes the proceeds from the convertible debt raise we did during the quarter. As a reminder, in August, we issued $1.65 billion of senior unsecured convertible debt that will mature on February 15, 2029.

The notes will bear interest at a rate of 1.125% per year payable semiannually. Finally, the net proceeds of approximately $1 billion from this offering have been invested in highly liquid marketable securities. These securities yield approximately 5.25% on a weighted average basis with maturities close to May 2025 as we intend to use these proceeds to pay off approximately $1.15 billion of convertible notes that mature in May 2025. We — for the third quarter, we spent roughly $113 million to repurchase approximately 1.1 million shares. We now have roughly $600 million remaining on our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buy back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself.

Before I cover Q4 guidance, I want to provide a quick reminder about our typical fourth quarter dynamics and add some color to our 2 recent transactions with StackPath and Lumen. As in prior year, seasonality plays a significant role in determining our financial performance for the fourth quarter. Typically, we see higher-than-normal traffic from large media customers and they pick up in seasonal online retail activity from our e-commerce customers. Both of these traffic patterns are difficult to predict. Q4 also tends to have higher operating expenses than in Q3, driven by higher sales commissions due to accelerator payments for sales reps who overachieved their annual quotas. As it relates to the transactions with StackPath and women’s, first, both transactions were acquisitions of selected CDN customer contracts, including over 200 net new customers to Akamai.

We did not acquire any other assets or liabilities at either company. Second, we expect the 2 transactions combined will add approximately $17 million to $20 million of revenue in Q4. Third, we expect to record approximately $13 million to $14 million of StackPath and lumen TSA costs in Q4. These costs will be recorded in our cost of goods sold and will have a negative impact of approximately 1 percentage point on gross margin, adjusted EBITDA margin and non-GAAP operating margin. Combined, the stack path of lumen TSAs will negatively impact our Q4 EPS by approximately $0.06 to $0.07. We do not expect to incur any material TSA costs in 2024. And finally, our expectations for these customer acquisitions remain the same as we disclosed previously for the full year 2024.

As a reminder, we expect the customer contracts acquired from StackPath to add approximately $20 million of revenue in 2024 and to be accretive to non-GAAP earnings per share by $0.03 to $0.05. And we expect the customer contracts acquired from women to add approximately $40 million to $50 million of revenue in 2024 and to be $0.08 to $0.12 accretive to non-GAAP EPS. With all that in mind, we are now projecting fourth quarter revenue in the range of $985 million to $1.005 billion or up 6% to 8% as reported and in constant currency over Q4 2022. We — at current spot rates, foreign exchange fluctuations are expected to have a negative $8 million impact on Q4 revenue compared to Q3 levels and a positive $2 million impact year-over-year. Taking into account the impact of the StackPath and Lumen TSAs for the fourth quarter, we expect cash gross margins of approximately 72%.

Q4 non-GAAP operating expenses are projected to be $305 million to $311 million. We expect Q4 adjusted EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense to be between $123 million to $125 million, and we expect a non-GAAP operating margin of approximately 29% for Q4. Moving on to CapEx. We expect to spend approximately $143 million to $153 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 15% of our projected total revenue for the fourth quarter. Additionally, our CapEx guidance includes the integration requirements to support the traffic for both CDN customer contract acquisitions. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS to be $1.57 to $1.62.

This EPS guidance assumes taxes of $50 million to $52 million based on an estimated quarterly non-GAAP tax rate of approximately 17%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.802billion to $3.22 billion, which is up 5% to 6% year-over-year as reported and 6% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $18 million impact on revenue in 2023 on a year-over-year basis. We are raising our security revenue growth expectations to approximately 15% for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a year of significant investment, we are estimating non-GAAP operating margin of approximately 29%.

With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $6.08 to $6.13. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17%, and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be 19% of total revenue. In closing, we are very pleased with how the business is performing in 2023 as we continue to invest for revenue growth and improve our profitability. With that, we now look forward to your questions. Operator?

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Q&A Session

Operator: [Operator Instructions] The first question is from James Fish of Piper Sandler. Please go ahead.

James Fish: Really nice quarter there. Understanding you’re selling Guardicore to the installed base primarily. But what are you seeing with selling outside of the installed base with security and compute and specifically within security. Is there a way to think about that drag along effect or how the Guardicore enterprise sales team are really dragging along the rest of the security or even compute portfolios into any net new customer wins. Really, the crux of the question is how is the sales process going outside of the CDN installed base?

Ed McGowan: Jim, this is Ed. I’ll start. Tom, you can jump in if there’s anything you want to add. So actually, it’s interesting, you started off by saying Guardicore is mostly to the installed base. Actually, we’ve done a really nice job of selling to new customers. One of the things that came over as part of the Guardicore acquisition is a pretty robust channel and pretty much every deal is done through the channel. As a matter of fact, I think we can do a better job of selling in the installed base and probably come up with some new incentives to incentivize the sales force to do that. So there’s a ton of room in the installed base because most of the growth in Guardicore has come from outside the installed base.

Tom Leighton: Yes. And I would just add to that, that there is good drag along with Guardicore and for example, Enterprise Application Access, one is considered north-south, the other East West, both are really important in terms of keeping malware out and identifying when it gets in and really blocking the spread. So it’s good that way, too.

James Fish: Helpful, guys. And just a follow-up, Tom, you had actually started to allude to it a little bit. But as we think about those lumen and Exacto [ph] contracts, I guess how much wallet share do you have in aggregate of these new customers? Or what’s the overall opportunity for those specific customers beyond just that CDN revenue that you bought?

Tom Leighton: Yes. Well, obviously, there’s a CDN revenue, which is what transfers, but we’re going to be looking to sell our security and compute solutions into those 200-plus new customers. And I think there’s some good opportunity there.

Operator: The next question is from Fatima Boolani of Citi.

Fatima Boolani: Good afternoon. Thank you for taking my question. Tom, maybe I’ll start with you. I want to have a broader conversation with regards to some of these contracts that you’ve been acquiring, it’s setting up to be a little bit of a pattern. So look, you’ve been doing delivery for the better part of 2 decades here. So I wanted to get your kind of longitudinal perspective on what you’re seeing in the marketplace and the market backdrop that’s sort of pointing more and more towards consolidation in the delivery here. And then ultimately, I wanted to get your perspective on how you think this is going to impact some of the pricing dynamics and ultimately, your pricing power in the delivery space. And then I have a follow-up for Ed, if I may.

Tom Leighton: Yes, I wouldn’t call it a pattern. It’s been a long time, really since we’ve acquired a competitor or a competitor contracts. This is a situation where 2 of the many CDNs out there decided to discontinue their operations. And they wanted — now they’re still remaining as companies, obviously, and they wanted to have their customers have the best possible experience as they exited the CDN space. And so they approached Akamai as the leader by far in CDN and made very compelling financial terms for the transaction. So it makes a lot of sense for our shareholders that we take on these customers. And also, it’s a good opportunity as we mentioned, to sell them security and compute. So really good for shareholders. It’s not something that we’re actively doing trying to go buy other CDMs. But every once in a while, there is an opportunity that is compelling for shareholders.

I don’t see any fundamental change in the marketplace the hyperscalers and a dozen – 2 dozen other companies are selling delivery services. So I don’t think there’ll be any fundamental change there or change with pricing. Separately from this, of course, you know that we talked about Akamai as being more conservative with pricing, as we talked about, we’re not taking some of the spiky traffic, if the pricing doesn’t make sense because we’ve been focusing more on the capital deployment into our compute offering, which we see enormous potential future growth for…

Fatima Boolani: Perfect. Thank you. Ed, I was hoping I could parse out some of your prepared remarks with respect to the third-party cloud spend that you’re effectively in-sourcing. I believe a couple of quarters ago, you may have ballpark that figure at about $100 million. So please correct me if that recollection is correct. And also just wanted to get a sense of how far down the path you are in this in-sourcing of third-party cloud spend on your Connected Cloud platform. Thank you.

Ed McGowan: Yes, sure. That’s a great recollection, thought me you’re correct. That’s about $100 million or actually north of $100 million. So we are still in the earlier innings of the journey. However, we’ve made a lot of progress, and the team is doing a great job. So we expect to see that the savings continue to ramp. I’m very happy to say that we’re slightly ahead of where we expected to be, and we have a lot of confidence that we’ll be able to drive the type of savings that we expect to throughout next year.

Fatima Boolani: Thank you.

Operator: The next question is from Magellan Brooks [ph] of Bank of America. Please go ahead.

Q – Unidentified Analyst: Thanks for taking my question. Just want to dive into security a bit and see are the trends differing between international and domestic in terms of what products are getting better versus not? And then one follow-up question after that. Thanks.

Tom Leighton: I don’t think there’s a fundamental difference. The attacks are global in nature and the same attacks we see here domestically. We see in pretty much all of the major geos. And yes, you do see a little bit more attacks where there’s hotspots wars taking place or political tensions, there’ll be more attacks, but the nature of the attacks is similar. You got a denial of service attacks, you got ransomware. You’ve got application layer attacks, more recently, AI attacks. So — and that happens everywhere because there’s no reason it should be in one geography versus another.