We closed this position on July 28, 2011. A copy of the associated Position Update report is here.
Akamai Technologies Inc (AKAM) is one of November’s Most Dangerous Stocks. And like all of our Most Dangerous Stocks the company has (1) Misleading earnings = accounting profits are positive and rising while true, economic profits are negative and falling and (2) High Valuation = very high expectations embedded in the current valuation.
- Misleading Earnings: AKAM reported a $1mm increase in GAAP earnings while our model shows economic earnings declined by $10mm (a difference of $11mm or 7% of reported net income).
- Very Dangerous Valuation: Stock price of $47 implies AKAM must grow its NOPAT at over 20% compounded annually for 15 years. A 15-year growth appreciation period with a 20%+ compounding growth rate sets expectations for future cash flow performance quite high.
- Asset write-offs of $2,000mm or 102% of Net Assets – this means that management has written off at least $1 of assets for every $1 on the current balance sheet. Writing off assets is the opposite of creating shareholder value as it reflects management’s inability to derive any profits for the investments it makes with shareholder funds.
- Off-balance sheet debt of $128mm or 7% of Net Assets.
- Outstanding Stock Option Liability of $212mm or 3% of current market value.
Overall, the Risk/Reward of investing in AKAM’s stock looks Very Dangerous to me. There is lots of downside risk given the Misleading Earnings and Red Flags while there is little upside reward given the already-rich expectations embedded in the stock price.
Our report on AKAM has detailed appendices for you to see how we perform all calculations. The primary cause of the difference between economic versus accounting earnings is that AKAM’s NOPAT fell faster than its invested capital. See Appendix 4 to learn how AKAM’s NOPAT fell last year while Net Income rose and was inflated by non-operating income. See Appendix 5 for details on AKAM’s Invested Capital and how off-balance sheet debt and asset write-offs are added back to provide a more accurate reflection of the capital invested in the business. Appendix 7 (in the return on invested capital section) shows how declining NOPAT Margin but rising invested capital turns result in a decrease in ROIC (from 5.0% to 4.7%) and Economic Earnings, which fell by $10mm while Net Income rose by $1mm.
In a business where investors make money by buying stocks with low expectations relative to their future potential, AKAM fits the profile of a great stock to short or sell.
Note: Stock pick of the week is updated every Tuesday.