Stock Pick of the Week: Akamai Technologies Inc (AKAM) – Very Dangerous Rating

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.

RED FLAGS:

  1. 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).
  2. 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.
  3. 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.
  4. Off-balance sheet debt of $128mm or 7% of Net Assets.
  5. 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.

See my blog for all of my Stock Picks and Pans. Samples of some recent picks: Buy MSFT and buy IBM. Short CBG and short VMC.

Note: Stock pick of the week is updated every Tuesday.

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