Akamai Technologies Inc (AKAM) — Q2 2022 Earnings Call Transcript

Good day, and welcome to the Akamai Technologies Second Quarter 2022 Conference Call. 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.

Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the second quarter despite the ongoing challenges with the global economic environment and slower Internet traffic growth. Q2 revenue was $903 million, up 6% year-over-year and up 9% in constant currency. This result was driven by the continued rapid growth of our Security and Compute businesses, which when taken together, were up 30% in constant currency. These two business lines now account for 54% of our overall revenue. Q2 non-GAAP operating margin was 29%. Q2 non-GAAP EPS was $1.35 per diluted share, down 5% year-over-year, but up 0.5% in constant currency. As Ed will discuss later, EPS was negatively impacted by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $223 million in Q2 and it accounted for 25% of revenue. We've been leveraging our financial strength to make substantial investments in enterprise security and cloud computing. We've also used some of this cash to buy back additional stock. In the first half of the year, we spent $268 million to repurchase 2.6 million shares. This puts us on track to go beyond what's needed to offset dilution from employee equity programs this year. I'll now say a few words about each of our three main lines of business: Security, Compute, and Delivery, starting with Security. Our Security Solutions generated revenue of $381 million in Q2, up 17% year-over-year and up 21% in constant currency. Growth in security was driven primarily by our app and API security portfolio, which includes our market-leading web app firewall, Bot Manager, Account Protector, and Page Integrity Manager solutions. Our Zero Trust enterprise security portfolio, led by Guardicore, also performed well in Q2, with numerous significant customer wins. A leading global provider of financial data concerned about ransomware added Guardicore segmentation solution to the seven security products they already buy from Akamai. A major insurance company in France became a new customer for Akamai when they adopted our Guardicore solution to help meet European financial regulations. The sale, led by one of our carrier partners, is indicative of the excitement we're seeing for our Zero Trust solutions among our partners. In Australia's largest telecom provider, Telstra, expanded their business with us by adding our Secure Web Gateway solution to their portfolio of Akamai products. They told us, 'As part of Telstra's journey in delivering fit-for-purpose solutions, Akamai has been a key industry partner with network-based anti-phishing malware protection and content filtering. Telstra blocks millions of threats every single day, and Akamai is a key partner in that protection.' Overall, our Zero Trust solutions delivered $43 million of revenue in Q2, up 59% year-over-year in constant currency. This is an area where we're continuing to make major investments and where we anticipate significant future growth. Turning now to Compute. I'm very pleased to report that the revenue for our Compute product group was $106 million in Q2, up 74% year-over-year and up 78% in constant currency. As a reminder, the Compute product group includes Linode and Akamai solutions for Edge computing, storage cloud optimization, and Edge applications. A common theme that I heard when I met with executives from around the world in Q2 was their growing concern about being locked into contracts with cloud giants that are consuming large and rapidly increasing shares of their IT budgets. They want more choice in compute and are open to alternative clouds like Linode as a more efficient way to build, run, and secure their applications. As a result, many large enterprises have begun testing the Linode platform, including a major U.S. airline, one of the world's top gaming companies, and a global provider of weather data. Major media companies, in particular, expressed significant concerns with their growing use of the giant clouds. Not only are the costs high, in part because of the fees for moving data from cloud storage to a CDN for delivery, but they're also concerned about their increasing reliance on a direct competitor. As an example, I'm very pleased to announce that we recently signed a contract with one of the world's largest media companies to run a critical new workload on Linode. The service is live today, and we anticipate that it will generate millions of dollars of annual revenue as their usage grows over time. This is just the tip of the iceberg when it comes to our potential for future revenue growth in Compute. Cloud computing is a fast-growing, multi-hundred billion dollar market. And as we scale Linode to be enterprise-grade with points of presence and hundreds of locations around the world, we should be in an excellent position to capture a share of this market, particularly from companies that value our industry-leading security and delivery solutions and don't want to be locked into more expensive options. Our Delivery products generated revenue of $417 million in Q2, down 11% year-over-year and down 8% in constant currency. These results were clearly impacted by a continued deceleration in traffic growth among our largest media customers and by the lower unit pricing we provided as part of their recent contract renewals. It's important to note that Akamai remains the market leader in delivery by far. Moreover, customer churn in the first half of this year remained at record lows, and lost annual revenue from churned accounts in Q2 was even less than in Q1. We also saw some notable delivery customers move business to our platform in Q2 after trying out competing solutions. No matter which competitor they've been working with, they chose Akamai because of our superior performance and reliability. Like many companies, we're managing through a time of substantial economic headwinds and uncertainty with escalating inflation, the strengthening U.S. dollar, growing concerns about a global recession, escalating geopolitical tensions and conflicts, and a slowing of Internet traffic growth as the world tries to return to normal in the midst of a pandemic. As Ed will talk about shortly, I think it's prudent to assume that these headwinds will dampen our growth rates and profitability over the next several quarters, particularly in our Delivery business, which is being impacted by the challenges that many major media companies have recently reported. Given the enormous market opportunity in front of us, we will continue to focus our investment on Zero Trust enterprise security led by Guardicore and cloud computing, led by Linode. These investments, combined with the economic headwinds I just mentioned, will likely result in our operating margin remaining below 30% in the near term. We expect our margins to improve over time as our Security and Compute businesses continue to grow and account for a larger share of total revenue. In addition, we're embarking on several major initiatives to reduce costs and improve operational efficiency that should help return our margins to 30% or better in the medium to longer term. As Ed will discuss further, these initiatives include leveraging Linode to significantly reduce our cloud spend with hyperscalers, slowing the capital expenditures for our delivery platform, and optimizing our real estate footprint. While these are challenging times to be sure, I believe that Akamai is on the right track for long-term growth and success and that we're well positioned because of our unique global-edge platform, our market-leading security and delivery solutions, our new compute capabilities which provide great performance at an affordable cost, our premier enterprise customer base, and our strong financial position and profitable business model. Now I'll turn the call over to Ed for more on Q2 and our outlook going forward. Ed?

Thank you, Tom. As Tom mentioned, Akamai delivered another solid quarter in Q2. Q2 revenue was $903 million, up 6% year-over-year or 9% in constant currency. Revenue was in line with our guidance and was led by our Security and Compute businesses. As we mentioned on our last call, we expected significant foreign exchange headwinds to impact our revenue in Q2. The much stronger U.S. dollar negatively impacted our year-over-year growth rate by 3 points or approximately $29 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our Security and Compute businesses represented 54% of total revenue, growing 26% year-over-year and 30% in constant currency. Security revenue was $381 million and grew 17% year-over-year and 21% in constant currency, with continued strength from our Zero Trust business led by Guardicore. Guardicore delivered approximately $14 million of revenue in Q2. Security represented 42% of total revenue in Q2, which is up 4 points from Q2 a year ago. Compute revenue was $106 million in Q2, growing 74% year-over-year and 78% in constant currency. Linode contributed revenue of approximately $32 million in the second quarter. Delivery revenue was $417 million, down 11% year-over-year and 8% in constant currency. It's worth noting that while traffic on our network continued to grow, the rate of that traffic growth declined sequentially in Q2. As Tom mentioned, we believe that the current macroeconomic environment has had the greatest impact on customers in our media vertical, most notably in advertising and gaming. These challenges are most apparent in our delivery results. Also, as we talked about at our Analyst Day in May, we started to align our pricing strategy with the new traffic growth rates we have seen on our network over the last two quarters. In addition to scaling back discounts provided upon renewal, we decided to turn away some business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this will result in slightly less revenue, it will enable us to significantly lower our network CapEx as we focus on cash flow from our Delivery business to help accelerate our investments in faster-growing areas like Compute and Security. Sales in our international markets represented 47% of total revenue in Q2, unchanged from Q1. International revenue grew 6% year-over-year or 13% in constant currency. Finally, revenue from our U.S. market was $477 million and grew 6% year-over-year. Going now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 62%. Non-GAAP cash operating expenses were $292 million. Adjusted EBITDA was $388 million and our adjusted EBITDA margin was 43%. Non-GAAP operating income was $262 million, and non-GAAP operating margin was 29%. It is worth noting that our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange. Capital expenditures in Q2, excluding equity compensation and capitalized interest expense, were $104 million. This was much better than we expected, partly due to some Linode-specific CapEx that pushed from Q2 into Q3 as well as some savings from our strategy of being more selective on certain types of customer traffic. These savings were most apparent in our network CapEx, excluding Linode, which was only about 3% of revenue. GAAP net income for the second quarter was $120 million or $0.74 of earnings per diluted share. Non-GAAP net income was $216 million or $1.35 of earnings per diluted share, down 5% year-over-year and up half of 1% in constant currency. It's worth noting that foreign exchange negatively impacted our non-GAAP EPS by approximately $0.07. Taxes included in our non-GAAP earnings were $42 million based on a Q2 effective tax rate of approximately 16%. This was about 1.5 points higher than last year. Moving now to cash and our use of capital. As of June 30, our cash, cash equivalents, and marketable securities totaled approximately $1.3 billion. During the second quarter, we spent approximately $165 million to repurchase shares, buying back approximately 1.6 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 4 million shares or roughly 2% on a year-over-year basis. We ended Q2 with approximately $1.5 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Before I provide our Q3 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly 50% of our revenue coming from outside the U.S., foreign exchange continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $114 million impact on revenue in 2022 on a year-over-year basis. As I mentioned previously, foreign exchange also impacts our margins and earnings. We estimate FX will negatively impact non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.31 for the full year 2022. Second, we are incrementally more cautious on the outlook for traffic growth in Q3 and Q4. Based on our year-to-date trend, plus what we are hearing from other large Internet companies, we are anticipating a slower than usual traffic growth rate for the remainder of 2022. Third, as a result of the expected slower traffic growth rate and our updating pricing strategy that we noted earlier, we anticipate CapEx to be significantly below our previous outlook. Finally, as Tom mentioned, we expect the more challenging macroeconomic environment to dampen our revenue growth and margins in the near term. When combined with the impact of renewing eight of our top ten customers in the first half of the year, we expect Delivery revenue to decline at a slightly higher rate on a year-over-year basis for the next two quarters. As a result of these factors, we also expect margins to decline over the near term as well. We believe strongly in the long-term opportunities in front of us, especially in Security and Compute, and therefore, planned to continue to invest to exploit the market opportunity in these areas. That said, as Tom highlighted, we are embarking on several major initiatives to reduce costs and improve operational efficiency. Potential savings for each of these areas is in the tens of millions of dollars. Specifically, we are planning to do the following three things. First, significantly reduce our cloud spend with hyperscalers as we migrate internal Akamai workloads to Linode. Second, realize savings from our strategy of being more selective on certain types of customer traffic, which we expect will result in both lower capital expenditures and depreciation expense. And third, optimize our real estate footprint as the hybrid work experience becomes more permanent. Now turning to our Q3 guidance. We are projecting revenue in the range of $868 million to $883 million or up 1% to 3% as reported or 5% to 7% in constant currency over Q3 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q3 revenue compared to Q2 levels and a negative $36 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. In the short term, our gross margin is negatively impacted by our continued investment in Guardicore and the Linode-related headcount, as well as higher third-party cloud costs. However, we are confident that this is a short-term impact only. We expect our gross margin to expand to the high 70% long-term target model as we see continued strong growth from both Guardicore and Linode as we reduce our third-party cloud costs over time. Q3 non-GAAP operating expenses are projected to be $283 million to $291 million. We anticipate Q3 EBITDA margins of approximately 41%. We expect non-GAAP depreciation expense to be between $125 million to $128 million, and we expect non-GAAP operating margin to be approximately 27% for Q3. As mentioned previously, the near-term decline in operating margin is due to slower traffic and revenue growth, our annual merit-based wage increase, which become effective July 1, the negative impact from foreign exchange, investments associated with Guardicore and Linode and increased third-party cloud costs. As our Security and Compute businesses continue to grow and we reap the benefits of the cost savings actions I described earlier, we are confident that our operating margins will return to 30% and then grow from there. Moving on to CapEx. We expect to spend approximately $109 million to $119 million, excluding equity compensation and capitalized interest in the third quarter. This represents approximately 13% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q3 non-GAAP EPS in the range of $1.21 to $1.26. This EPS guidance assumes taxes of $37 million to $38 million based on an estimated quarterly non-GAAP effective tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 160 million shares. Looking ahead to the full year, we now expect revenue of $3.57 billion to $3.61 billion, which is up 3% to 4% year-over-year as reported or up 6% to 8% in constant currency. We continue to expect Security growth of approximately 20% in constant currency for the full year 2022. We now estimate non-GAAP operating margins to be approximately 28% to 29% and non-GAAP earnings per diluted share of $5.19 to $5.37. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16% and a fully diluted share count of approximately 160 million shares. Finally, full year CapEx is anticipated to be approximately 12% to 13% of revenue. In closing, while the macroeconomic backdrop has become more uncertain, we believe that we are in the right markets with differentiated products that remain highly valued by our customers. Thank you. Tom and I would be happy to take your questions.

Can you discuss the revenue guidance for the third quarter, which is lower than consensus by about $10 million? Additionally, can you address the trade-off between margins and pursuing some of this delivery traffic? While EBITDA margins are roughly the same, growth at the top line is clearly slowing.

Jim, this is Ed. So in terms of the guide, there's really two pieces to it. The first one is obviously FX has gotten incrementally worse. That's probably about half of the delta. The rest of it is the slower traffic that we talked about. I think your question was specific to the trade-off that we're making. The first immediate impact that you get on that trade-off from taking less of that peak traffic as you save on CapEx. So that will make its way through the P&L through lower depreciation and obviously immediately through cash flow. And so the decision that we've made is obviously, as we talked about in May, as traffic levels have come down, the discounts that we offer upon renewal are lower. And in some cases, we've seen a small handful of customers that have the traffic. Their peaks are still growing at pretty significant rates, but their day-to-day traffic is not. So there's a formula that we go through in a trade-off that we made that I think makes a lot of sense for us, especially as I look at the types of returns we can get from the faster-growing areas like security and compute.

So the shift in general is towards a more asset-light business while focusing on other areas.

Yes. I mean, I would say, obviously, compute can be, I wouldn't call it an asset-heavy business, but it does have a fair bit of CapEx. We talked about our CapEx for Linode being about 2% of revenue in total. And obviously, it's going to be a little bit front-end loaded. We actually took advantage to try to spend a little bit more for Linode. Based on some of the conversations we're having, we're starting to see some good demand. And obviously, Tom talked about signing a pretty significant customer in the quarter. So what we're doing though, on the Akamai, of course, I call it the legacy Akamai delivery business is we are being a bit more selective in reducing CapEx. I made a comment that our network CapEx excluding Linode was 3%. That's typically around, call it, 8% to 10%, at least where it's been running over the last couple of years. So I think it's just a question of being more selective with certain types of traffic. It's really a handful of customers that have that type of traffic pattern. It's generally event-driven. And what we're seeing is it's just a better return to shift some of that investment in other places.

Great. And then just maybe just one for Tom. On Linode, can you just talk about some of the success you're having sort of selling that product into your existing customer base?

Yes. Obviously, very early days. We've got a lot of work ahead of us with Linode, as we've talked about. But it's great to land our first very large customer, putting a critical app. Actually, it's for transcoding user content onto the Linode platform. As I mentioned, that's just that app alone as it scales is worth several million dollars a year of revenue for us. And tip of the iceberg, this is a customer that spends many hundreds of millions of dollars a year on cloud computing. And that's just one customer. So a lot of good opportunity ahead, and we're making good progress on our roadmap for Linode.