Akamai Technologies Inc (AKAM) — Q3 2022 Earnings Call Transcript

Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Third Quarter 2022 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 8, 2022. 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'll 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, let me turn the call over to Tom.

Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the third quarter despite the ongoing challenges with the global economic environment and the effects of a strong U.S. dollar. Q3 revenue was $882 million, up 3% year-over-year and up 7% in constant currency. This result was driven by the continued strong growth of our security and compute businesses, which collectively grew 23% year-over-year and 28% in constant currency. These two business lines accounted for 55% of our overall revenue in the quarter. Q3 non-GAAP operating margin was 28%. And non-GAAP EPS was $1.26 per diluted share, down 13% year-over-year or down 7% in constant currency. EPS was negatively impacted once again by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $271 million in Q3, and it amounted to 31% of our revenue. I'll now say a few words about each of our three main lines of business, starting with security. Our Security solutions generated revenue of $380 million in Q3, up 13% year-over-year and up 19% in constant currency. The growth was particularly strong for our enterprise Zero Trust products, which were up 51% year-over-year in constant currency. Our Guardicore Segmentation solution continued to lead the way with several major customer wins. For example, one of the largest energy companies in the world adopted Guardicore to help protect against ransomware attacks similar to SolarWinds. A leading global developer of dietary supplements adopted our Segmentation solution to help meet European regulations and limit cybersecurity risk. And a major South American broadcaster deployed Guardicore to protect their reporting of election results. Our market-leading app and API protection products also performed well in Q3, with many wins against the competition. For example, the largest bank in Southeast Asia came to Akamai last quarter after suffering repeated outages from a competitor that had lured them in with low pricing. When the bank faced large fines from regulators for the extended outages, they realized more value in being back on Akamai's platform. One of the top banks in North America is in the process of bringing all of their traffic back to Akamai after struggling with outages at another competitor who also attracted them with lower pricing, but couldn't deliver the performance and reliability needed by a major enterprise. After testing our capabilities against competitors, one of the world's largest financial services companies expanded their relationship with us, contracting for ten of our products and services, including Bot Manager and Page Integrity Manager. A Fortune 100 food processor and commodities trader became a new Akamai customer last quarter after an anonymous threat drove them to seek better DDoS and web app protection than they were receiving from a competitor. And in Germany, an online advertising business with one of the country's busiest websites suffered severe account takeover attacks, load problems, and reputation damage before coming to Akamai for bot management and app and API protection. Given such examples, it's not surprising that Akamai's web app and API protection was named a leader in both Gartner's Magic Quadrant and in Forrester's Wave report last quarter. Our compute product group also performed well in Q3 with revenue of $109 million, up 72% year-over-year and up 77% in constant currency. We're continuing to make good progress on integrating Linode into our edge platform and on adding the capabilities and scale needed to support mission-critical applications for major enterprises. In particular, we've connected all of Linode's eleven existing locations into our private backbone, enabling us to provide lower latency, higher throughput, and improved egress economics. We've also expanded the capacity of these facilities and are in the process of adding thirteen additional sites, five of which are expected to go live in Q1 with eight more planned for Q2. As we discussed at our Analyst Day in May, we're also developing a lighter-weight deployment model that is suitable for distribution at a broad scale. This will enable us to get compute much closer to end users around the world. We plan to deploy several dozen of these lighter-weight sites next year, at which point we expect to compare well with the hyperscalers in terms of points of presence and proximity to both enterprise data centers and end users. Of course, we plan to have all of our compute sites integrated into Akamai's unique edge platform, which has over 4,000 locations for edge computing. As a result, we expect to be able to offer superior performance as well as a lower total cost of ownership for enterprise computing needs. We've also made significant progress on adding new and improved enterprise capabilities to our compute platform. We launched Database-as-a-Service with managed MySQL in May and managed Postgres in June. We released the next generation of our Kubernetes platform in Q3 to enhance performance and reliability. We expect to launch early versions of an enhanced object storage product as well as next-gen serverless capabilities next quarter. And we expect to become SOC 2 and ISO 27001 compliant this quarter with PCI compliance expected to follow in the first half of 2023. Although we still have much work to do, we're encouraged by the customer use cases that our compute platform began serving in Q3. One of the world's top development studios for gaming moved their matchmaking service to Akamai to help them with data processing and analysis. A large online legal services platform in India chose Akamai as part of their multi-cloud strategy after concluding that we could help optimize their cloud computing budget. And a large media workflow company in Germany is planning to migrate their apps from a hyperscaler to Akamai, calling our new capabilities a great addition, especially with the plans for a high number of distributed sites and the tight integration with Akamai content delivery. Over the past few months, I've spoken with many of the world's leading enterprises about our plans for cloud computing. Most tell me that they want more choice in cloud computing, and they often express concern about being locked into contracts with cloud giants that are consuming larger portions of their IT budgets, especially in cases when their cloud vendor is also a direct competitor. Customers also understand the value of leveraging a more widely distributed cloud platform and one that directly connects to Akamai's unique edge platform with over 4,000 points of presence. Turning now to our CDN business. Our delivery products generated revenue of $393 million in Q3, down 15% year-over-year and down 11% in constant currency. These results reflect continued deceleration in traffic growth among our largest customers and the impact of some large renewals that we completed in the first half of the year. As we said at our Analyst Day in May, we've aligned our pricing strategy with the slower traffic growth rates we've experienced this year. In addition to scaling back discounts upon renewal, we're continuing to decline business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this resulted in less revenue in Q3, it's enabled us to meaningfully lower our delivery network CapEx as we direct cash flow from our delivery business to our compute and security businesses where we have a higher ROI. As Ed will detail shortly, we're also taking several steps to reduce OpEx, including reducing our real estate footprint and limiting hiring to our most critical areas. Although we're facing the same challenging macroeconomic environment as other companies, I believe that Akamai is on the right path to long-term growth and success with our disciplined management of expenses and strong focus on opportunities for future growth such as cloud computing. Becoming a force in the enormous cloud computing market won't be easy, but I believe that it's something that Akamai can accomplish. Akamai has a strong track record of continuous innovation and business expansion. Along the way, we've achieved significant milestones that many thought were impossible. In our first decade, we pioneered the CDN industry, a multibillion dollar market, where we remain the leader by far. In our second decade, we created the industry for app and API protection as a cloud service, our second multibillion dollar market, where we are the leader by a wide margin. Looking ahead, Akamai is on the cusp of another major phase of expansion with our foray into cloud computing. Having already scaled content delivery and cloud security into billion dollar businesses, we now have an opportunity to do it again with cloud computing. In fact, I believe our opportunity in cloud computing is even larger than it has been for delivery and security. Cloud computing is a $100 billion market growing at a very rapid rate. We believe we're in an excellent position to capture a share of this business, particularly from companies that value our market-leading delivery and security solutions and that don't want to be locked into more expensive options with a cloud giant that competes against them. Akamai is a company that enterprises can trust to be their partner, to scale with their business and to provide the best when it comes to security, reliability, and performance. By adding compute to our unique edge platform, we can provide a full suite of cloud services that will help lower our customers' cost to build, run, deliver, and secure their applications. In summary, my confidence in Akamai's future prospects for growth and success has never been higher. In fact, my confidence in what I see ahead for Akamai has led me to take steps to put in place a 10b5-1 trading plan, not to sell, but to buy $3 million in Akamai stock over the next six months. We expect to announce the adoption of my plan in a formal filing later this week. Now I'll turn the call over to Ed for more on Q3 and our outlook. Ed?

Thank you, Tom. As Tom mentioned, Akamai delivered a solid quarter in Q3 despite a very challenging macroeconomic environment. Q3 revenue was $882 million, up 3% year-over-year or 7% in constant currency. The stronger U.S. dollar negatively impacted our year-over-year growth rate by approximately 4 points or about $39 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our security and compute businesses represented 55% of total revenue, up 23% year-over-year and 28% in constant currency. Security revenue was $380 million and grew 13% year-over-year and 19% in constant currency, led by another strong contribution from Guardicore. Guardicore delivered approximately $14 million of revenue in Q3. Security represented 43% of total revenue in Q3, which is up 4 points from Q3 a year ago. Compute revenue was $109 million in Q3, up 72% year-over-year and 77% in constant currency. As Tom mentioned, while we are in the early innings of our cloud computing journey, we are very excited about initial feedback from customers and the significant growth opportunity ahead. Delivery revenue was $393 million, down 15% year-over-year and down 11% in constant currency. Sales in our international markets were $421 million and represented 48% of total revenue in Q3, up 1 point from Q2. International revenue was up 2% year-over-year or 12% in constant currency. Finally, revenue from our U.S. market was $461 million, up 3% year-over-year. Moving now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 61%. Non-GAAP cash operating expenses were $291 million. Adjusted EBITDA was $368 million, and our adjusted EBITDA margin was 42%. Non-GAAP operating income was $243 million, and our non-GAAP operating margin was 28%. It is worth noting that on a year-over-year basis, our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange rates. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense, were $111 million. As we mentioned on our Q2 earnings call, our strategy in our delivery business is to be more selective on the peak traffic levels we will take on our network. As a result, delivery network CapEx, excluding Linode, was just under 4% of revenue in Q3. GAAP net income for the third quarter was $108 million or $0.68 of earnings per diluted share. Non-GAAP net income was $200 million or $1.26 of earnings per diluted share, down 13% year-over-year and down 7% in constant currency. It's worth noting that on a year-over-year basis, foreign exchange rates negatively impacted our non-GAAP EPS by approximately $0.10 in Q3. Taxes included in our non-GAAP earnings were $41 million based on a Q3 effective tax rate of approximately 17%. This was about 1 point higher than our guidance due to a more unfavorable mix between U.S. and foreign earnings. Now moving to cash and our use of capital. As of September 30, our cash, cash equivalents, and marketable securities totaled approximately $1.4 billion. During the third quarter, we spent approximately $163 million to repurchase shares, buying back approximately 1.8 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 5 million shares or roughly 3% on a year-over-year basis. We ended Q3 with approximately $1.4 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 Q4 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly half of our revenue coming from outside the U.S., the strong U.S. dollar continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $130 million impact to revenue in 2022 on a year-over-year basis. As I mentioned previously, the strong dollar also impacts our margins and earnings. We estimate FX will negatively impact our non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.34 for the full year 2022. Second, we have seen a lengthening in some of our sales cycles. We believe that is primarily reflecting the uncertain macroeconomic conditions that our customers are experiencing, and it is visible in many parts of our business. Finally, we continue to closely monitor our costs in light of ongoing inflationary and macroeconomic pressures across the globe. We have made good initial progress on our cost-cutting measures that we mentioned on our last call, which include real estate costs, where we sublease some of our underutilized office space in Q3, and we'll continue to look for additional savings going forward. Reducing our third-party cloud expense in 2023, where we look forward to making significant progress on shifting workloads to Linode. And lowering network CapEx associated with our delivery business, where I noted our continued progress on reducing spend significantly related to traffic delivery. In addition to these items, as Tom mentioned, we plan to be very disciplined with headcount and focus our investments on higher growth areas like cloud computing and security. In particular, we are closing over 500 open positions and re-tasking many other employees to work on compute. These closures went into effect today. And just a quick reminder about our typical fourth quarter dynamics before I turn to our Q4 guidance. As in prior years, seasonality plays a large role in determining our fourth quarter financial performance. We typically see higher-than-normal traffic for our large media customers and from seasonal online retail activity from our e-commerce customers, which are both difficult to predict, especially during this more challenging macroeconomic environment. With that in mind, we are projecting Q4 revenue in the range of $890 million to $915 million or down 2% to up 1% as reported or up 3% to 6% in constant currency over Q4 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q4 revenue compared to Q3 levels and a negative $44 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. This roughly 1 point sequential decline is primarily driven by increased third-party cloud costs and some compute-related data center build-out costs. Q4 non-GAAP operating expenses are projected to be $298 million to $306 million. We anticipate Q4 EBITDA margins of approximately 40% to 41%. We expect non-GAAP depreciation expense to be between $125 million to $126 million, and we expect non-GAAP operating margin to be approximately 27% for Q4. Moving on to CapEx. We expect to spend approximately $122 million to $127 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 14% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q4 non-GAAP EPS in the range of $1.23 to $1.30. This EPS guidance assumes taxes of $38 million to $40 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 158 million shares. And finally, for the full year 2022, we now expect revenue of $3.58 billion to $3.6 billion, which is up 3% to 4% year-over-year as reported or up 7% 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 margin to be approximately 28% and non-GAAP earnings per diluted share of $5.23 to $5.30. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16.5%, a fully diluted share count of approximately 116 million shares. Finally, full year CapEx is anticipated to be approximately 13% of revenue. In closing, we are very pleased with how the business is continuing to perform despite a very challenging macroeconomic backdrop. We are very excited about our future growth opportunities ahead. Thank you. Tom and I would be happy to take your questions.

Excellent. Nice quarter in a difficult environment. On that difficult environment point, I was hoping you could help with a little bit more specificity in terms of where you guys are seeing the macro impacts. It sounds like security is still holding up relatively well. And on the delivery side of the equation, there's some Akamai-specific impacts there. Could you give us some kind of detail in terms of where the risk factors are, sort of where the macro lies on a product and geographic perspective? I think that would be helpful. And then I guess on the CapEx side of the equation, you talked a little bit about types of business that you guys are not looking to take onboard on a go-forward basis, the very peaky workloads that perhaps were overly taxed in the system, if you will. Can that lead to a fundamentally different kind of CapEx intensity for the business on a go-forward basis? Or is it just too small to make a difference?

Keith, this is Ed. I'll address those points. Starting with the second question, regarding CapEx in the delivery business, we previously indicated at our May Analyst Day that it would be in the high single digits. Currently, we are operating in the lower single digits, just under 4%. This will certainly affect the delivery business in the short term. As the compute business expands, that will become the primary factor influencing CapEx. In Q3, we noticed an overall CapEx decrease to about 13%, which remains consistent for the year, making it less capital-intensive. However, as we develop our cloud compute business further, there will be additional CapEx for expanding into more locations, as Tom mentioned. We're also observing a significant decline in our delivery business, which aligns with our expectations. On your first question regarding the macroeconomic environment, we are encountering some challenges. As I noted in my remarks, we're seeing longer sales cycles and customers delaying upgrades for certain products, which is common across many companies, including us as we navigate our budget cycles. We believe this situation is temporary. There's also some pressure in our advertising-related sectors, particularly in Europe, where energy costs are a concern. We're monitoring this closely and have adopted a cautious approach in our Q4 guidance, considering seasonality and these factors.

Regarding energy costs, are you concerned about how they might affect your customers, or are you more focused on the potential impact on your gross margins going forward?

Yes, I'd say it's more on our customers and their customers, so how does the consumer behave. Obviously, retail is a driver of seasonality as is spending for media. So those two things could be impacted. And then obviously, with our customers, if you see shutdown in manufacturing and things like that, that's obviously going to have a ripple effect on GDP across Europe. So that's from that perspective. As far as our risk with energy, we do a pretty good job. The team has done a nice job with our colo negotiations. If you think about our costs, our server costs were pretty insulated from costs there on the bandwidth side that tends to be deflationary. Colo, there is some energy exposure, but the team has done a really good job of trying to lock in longer-term deals. We're not seeing that. It's possible that may start to affect us later into next year. But right now, we've got it pretty well under control.

Can you just talk a little bit about the compute business? I recognize it was up a lot year-over-year after you closed Linode. It was up a few million quarter-to-quarter. What do you have to do to accelerate that business? Is it building out more resources? Is it just you're getting some larger customers? And sort of what are the thoughts there on what that could ultimately grow? It seems like with the opportunity, it could grow faster than the security business.

The compute business was already experiencing strong growth prior to our acquisition of Linode, and that acquisition has significantly accelerated our progress. Looking ahead, we believe substantial growth will come from tapping into the core cloud compute market, which currently exceeds $100 billion and is expanding rapidly. We are actively working on strategies to leverage this opportunity next year, which includes scaling operations, expanding our core compute regions, and introducing lighter-weight distributed computing regions. Our goal is to offer performance and integration into the Akamai platform that meets or exceeds current standards, which includes exceptional delivery, security, and edge computing at a lower total cost of ownership. For many of our customers, particularly in the media and commerce sectors, computing expenses often surpass those for delivery and security. They also face significant competition from large hyperscale providers. Thus, our focus for growth over the coming years will be on the core cloud compute market, particularly for mission-critical applications within major enterprises, as this represents a substantial market potential and is expected to drive significant growth for our compute services and the company overall.

I appreciate the questions. Obviously, I agree with you on deceleration in traffic overall, especially on the media side. But what makes you guys confident that you aren't losing traffic share of some of the media customers, especially as you're purposely not doing some of these large events, for example, or kind of the gaming peak traffic? And any sense to how much that's kind of impacting the media business this quarter in this year overall that we should kind of normalize as we start to think about for next year?

Jim, this is Ed. That's a good question. We are starting to see a bit of a recovery in traffic in September, which continued into October. However, overall, we've experienced a much lower traffic year compared to our usual levels. Regarding the specific customers, we're talking about a few large customers capable of driving significant peak traffic, and they all use multiple CDN providers. In this instance, we did lose a couple of million dollars, but it isn’t a significant impact on the year. Importantly, it allowed us to save about four points on capital expenditures, which is meaningful from an economic perspective. That said, these customers remain valuable to us; they've just reduced their peak traffic a bit. As their daily average traffic hasn’t grown as quickly, the economics no longer work for us in the same way. We decided not to let them peak as much as they did previously, which makes sense for our business strategy. Overall, a few million dollars is the amount to consider.

That's helpful. I appreciate that. Maybe following up a little bit on Keith's prior question around more specifically on the security growth, which slowed to about 15% when I normalize everything. What makes you guys confident that we're going to see an acceleration of this business back to that 20% all-in constant currency growth rate over the next couple of years? And is the impact today being more felt on the new business side, given kind of your comments along elongating sales cycles? Or is it you're seeing a slowdown in existing customers' expansion as well?

Yes, that's a good question. The 20% goal includes mergers and acquisitions, and we are about to compare year-over-year with Guardicore, which has been a very successful acquisition. We haven't announced any other acquisitions in security to fill that gap. Regarding the growth rate in security over time, global economic conditions are crucial. We also have several new products that are experiencing rapid growth. Besides Guardicore, bot management is performing exceptionally well, as is our new Account Protector solution. Page integrity management is also becoming increasingly important for companies aiming for PCI compliance in 2025, and they are already preparing for it. Although these areas are growing well, their revenue is not significant enough to make a substantial impact on the overall figures. Currently, the majority of our security revenue comes from application and API protection, with most of it being generated by our web application firewall, where we hold a strong market leadership position and are growing faster than the market and our competitors. However, the overall market is growing slowly. Therefore, we need to see an improved economic environment, sustained growth in rapidly expanding products, and ultimately, mergers and acquisitions, which are essential for achieving our 20% goal.

Great. With the sales cycle more elongated, can you give us a little more detail there? Is that across the board? Is it concentrated in any verticals? And give us a little bit more color on what's driving that. Is it more economic? Or is there anything to do with the mix with Linode and compute that's sort of making the suite of services take a little longer for folks to make a decision?

Frank, good question. So actually, I'll start with Linode. Actually, Linode in an environment like this, given what Tom talked about, we will be able to provide comparable services at a much better set of economics and actually think is an opportunity for us. So I would expect that as we go into next year, that should be a tailwind for us. On the headwind side, we are seeing across the board, certainly from a geographic perspective, that sales cycles are elongating. We've seen some deals push. Probably the easiest place to identify it is in Guardicore. Guardicore, as Tom mentioned, is still doing really well, but we have a dedicated sales team. So it's a little bit easier to track those deals as they're going through the pipeline. Those deals also sometimes tend to be a little bit larger. So it's a little bit easier to follow that. With our business, given it's a SaaS business and we've got recurring revenue contracts are constantly going through and renewing contracts, what you're seeing is some customers that are talking about, say, adding Page Integrity Manager or a Bot Manager or Account Protector, just pushing that off into the future as they go through their budget cycle. So we're not seeing as much on the renewal side from an upgrade perspective. So a little bit of slowness there. And then from the new customer acquisition perspective, I think pretty much every tech company you talk to these days is seeing it a little bit harder to attract new customers. So it's a little bit of a combination of everything as we've just been impacted by this economic impact here.

This is on for Fatima. So just maybe a follow-up in regards to the September and October recovery on the delivery side you're starting to see. Can you maybe give a sense of which end market cohort is really driving that momentum? And then when you're going to negotiating tables in regards to pricing and other contract terms, can you also give us a sense of how that has been developing?

Sure. Yes. So in terms of the traffic sort of getting a little bit healthier, I would say, coming out of the summer months, media is probably the vertical that it's most obvious in. So we're starting to see that across video, a little bit in gaming. Gaming is still overall very, very weak compared to what it's been in the future, but a little bit of an uptick here in the gaming vertical over the last couple of months. And then your other question, can you just remind me again? I forget.

Sorry, just in terms of pricing and other contract terms as you guys go to the negotiation table.

Yes. So one of the things we talked about is, obviously, like in the media division in particular, media verticals in particular, as we see traffic levels decline or not grow as quickly, I should say, we typically would give a discount commensurate with what you see in the traffic growth rate. So obviously, as traffic growth rates are not growing as quickly, we are lowering our discounts that we're providing to our customers, and we're starting to see that make its way through the system. It will take a while for it to really impact the growth as we go through our renewal cycles, but I am seeing that the pricing declines are certainly moderating a bit.

Okay. Got it. And then maybe just a follow-up on the lighter-weight development. Do we have any #1 customers in the beta testing phase? Also, what milestones should we be looking for?

Yes. And what's the question about the lighter-weight deployment?

Yes. Just in terms of, are there any customers currently in the beta phase or testing out the product and how has that feedback been? And then are there any milestones we should look out for?

There are customers currently using Linode, and a major reason for their continued use and planned expansion is the deployments we offer. The benefit of our lighter-weight deployments allows us to enter markets and regions where establishing a large core compute data center is challenging. We anticipate having more than double our current number of core compute data centers next year, along with several dozen additional lighter-weight distributed locations for computing. While these locations may not have extensive storage, that's not necessary as that can be handled in core regions. This is a significant factor for many of our larger customers who are collaborating with Linode, conducting proofs-of-concept, and in some instances, already operating mission-critical applications. The proximity of these lighter-weight regions to enterprise data centers and end users around the globe enhances performance. This positions Akamai to compete effectively with the hyperscalers in terms of performance. Additionally, we have our edge deployment with 4,000 locations supporting edge computing alongside delivery, which contributes to a lower total cost of ownership. Therefore, the lightweight distributed regions are crucial for many of our current and prospective major enterprise customers on Linode.

The first one, you mentioned it a bit ago relating to your long-term guidance and M&A on the security front. Just a question around how would you describe the pipeline of opportunities for M&A in the security market? And as part of that, maybe any capabilities which are top of mind as you think about adding to the platform?

Yes, we have a large pipeline, and we generally do. We're constantly looking for appropriate acquisitions. As Ed said, we're very disciplined buyers, though. And the market as a whole is still highly priced. I think the realities of what's going on in the global economy haven't fully set in yet. That may take another year. And so because we're very careful buyers, we're being very selective there. I think there's a variety of capabilities that would be interesting as tech tuck-ins. And occasionally, we'll make an acquisition with a product adjacency. I think Guardicore has been a fabulous acquisition. They're the market leaders now in segmentation, making Akamai the market leader there. And I think that's the most important defense an enterprise can have. You can buy every company's Zero Trust offer, and malware is still getting into enterprises. And the real key is to identify it quickly and proactively block it from spreading. And that's how you limit the damage caused by ransomware and data exfiltration attacks. And that's what Guardicore does. And so I think very important strategic product with enterprise security and Zero Trust. But over time, I think there'll be other capabilities that we'll be interested in, in terms of broadening the portfolio.

Got it. Now just a philosophical question for you, Tom. Over the years, you've taken steps to continue to grow the business and expand Akamai into new verticals. But the stock really hasn't responded in the way that I think you would have liked, just given some of your prior comments. My question for you is, as you think about executing the long-term vision for Akamai, do you believe being a public company is the right setting for you to achieve that long-term vision?

Yes, I believe being a public company is beneficial. I think our stock is currently undervalued, which is why I plan to purchase more shares. Over time, our stock has appreciated, and I see significant potential for future growth as we expand Akamai. I'm particularly enthusiastic about our prospects in the compute market, which is vast. Looking ahead, it's likely that security will become our largest product line next year, marking a significant advancement from our origins as a CDN company. In the next three to five years, compute could potentially surpass that as our largest product line. There are numerous opportunities for sustained growth, and we maintain a disciplined approach to costs, which allows for bottom-line growth in earnings per share. We have also been repurchasing our equity to lower the number of shares outstanding, presenting a strong value proposition for Akamai's public shareholders.

I hate to harp on it, but the sales slowdown, can you just give us a little more color maybe when you started to see it? Is it continuing? Maybe what the lag is in terms of sales and revenue showing up? Just I'm trying to get a sense of what next year's revenue growth could be. I guess, at a high level, are we looking at 2 or 3 more quarters of flat from what we know now? Or at a high level, can growth be better next year than this year at this point?

We began noticing the sales slowdown this quarter, meaning Q3, and it seems to be continuing into Q4. It's challenging to predict how long the economic slowdown will persist. Most of our business operates under contract, so new signings don't significantly affect our performance in any single quarter. However, over an extended period, it could slightly dampen growth. When you're modeling our projections, keep in mind the impact of foreign exchange rates. The dollar has strengthened throughout the year, which presents a considerable challenge from an as-reported standpoint. If you look back to the beginning of the year, this could translate to several hundred million dollars in revenue or around $0.40 of EPS, along with a couple of points of operating margin. This foreign exchange issue could pose a more significant threat to growth, particularly given our strong international performance. We will provide an update on our guidance next year during our Q4 earnings call in Q1, so I won’t be issuing any guidance at this moment, but I hope this information helps you better understand the situation.

On FX, some of your largest competitors, particularly in cloud, but even on the kind of CDN security space, people had a bundling kind of charge in dollars pretty regularly. And some of your other smaller, one in main competitors in Linode has raised prices quite a bit here lately. Have you thought about maybe switching over the pricing in dollars? Or do you do much of that? And have you taken any pricing steps to increase prices?

Yes. Most of our international business is priced in local currency, which is why we see a significant impact. Generally, it's challenging to change a customer's payment currency once they've been using one. Regarding price increases, we are not considering that at this time. Raising prices can be risky, and we are currently looking to adjust our cloud spending due to suppliers increasing prices or not providing adequate discounts with volume increases. We believe that implementing price increases could backfire in the long run. Therefore, we do not plan to change customers from paying in local currency to dollars.

In the U.K., you're 20% below your peers in the last 9 months of price reduction effectively. But my last question is, Linode, is your OpEx and CapEx run rate enough to transition Linode and grow Linode?

Yes. So if you think about where the investments are going to be, and that's where we're primarily investing our headcount is in Linode and also in security. And Tom also mentioned that we'll be moving some of the people that have skills that are transferable. If you think about building out, scaling up a CDN, there's a lot of transferable skills. So we'll be able to move some folks that have talent into that group as well. So that won't put any pressure on the bottom line, but we will be spending some money and continuing to grow because we think the opportunity is significant. And then on a CapEx perspective, we will be building out to take in consideration, moving our own workloads as well as the future demand, and we'll give you an update on that at the next call.

I have two as well. I guess maybe on the first one, if you could just talk about the edge business, the Linode asset. And I guess, maybe the question I struggled with a fair bit is, can you grow this business on the cloud infrastructure side without sacrificing operating margins over the next several years? Or is that growth in Linode on the edge side going to come at lower margins inherently?

Yes. So good question. I think we bring some pretty interesting synergy. I just mentioned on the last question how we've got a lot of skill sets in-house that can do, say, network build-outs, for example. We don't have to build out a separate team to do network build-outs. We've got engineering talent in-house. We also have a big enterprise sales force in place that Tom talked earlier in one of the earlier questions about the spending of some of our larger verticals and the relationships we have with those customers who are spending probably 10 to 15x more on cloud computing than they are on CDN. So there's a significant synergy that you get there. And then also with our network infrastructure that we have built out, Tom talked about connecting our backbone to the existing Linode centers. That drives a significant cost benefit. So I think that actually, we could have very attractive operating margins, similar to what I showed on the IR Day. We get pretty good operating leverage, just like we did with the security business. So long term, our goal is to get back to 30% or higher in operating margin. And I think as we scale that business, we should be able to do it.

Got it. And then, I guess, maybe I'd just stick to that theme around Linode. Are there certain use cases that make Linode more attractive more so the top 3 cloud providers that are out there? I guess I'd just love to understand, when you folks walk into a customer pitch, what are the reasons want to use Linode versus some of the peers that might provide a cloud solution at least cheaper? Maybe that would be really helpful. Like what are the 2, 3 reasons that you think stands out?

Yes, let me address that in the context of where we'll be next year. We are currently focused on expanding our capabilities and functionality. By this time next year, I believe our reach will surpass that of the hyperscalers, as we will be closer to more enterprise data center users. This proximity will enhance performance. We will also be integrated with the Akamai platform, which has 4,000 points of presence for delivery, security, and edge computing, providing us a significant advantage. As Ed mentioned, this integration will also significantly reduce our egress costs, making our total cost of ownership an attractive feature of Akamai. Akamai is recognized for its scalability and reliability, especially when there have been notable reliability issues with some of the hyperscalers. Our competitiveness lies primarily in the performance we offer, with the exception of the extensive range of third-party applications available as managed services on the hyperscalers, which can result in vendor lock-in. For enterprises looking to avoid such lock-in while seeking better performance at a lower cost, I believe Akamai will be highly competitive. It's also important to consider the relative scale of the hyperscalers; if we can capture even 1% to 2% of market share in a multi-hundred billion dollar industry, that would be very significant for us. Additionally, in sectors where we excel, such as media and commerce, our clients often face competition with some hyperscalers. With the rising costs from hyperscalers, this creates challenges, particularly when they are paying hefty fees to a company that is also acquiring media rights. This dynamic gives us a competitive edge since we don’t compete with our customers; instead, we support their growth and foster trust in our partnership.

Sonak Kolar here on for Mark Murphy. Tom, can you get a bit deeper on the new pricing strategy, particularly around delivery? Have you noted any incremental changes in customer retention or churn levels as a result of some of these pricing adjustments, specifically around some of the inflationary environment pressures driving price sensitivity in the market?

Yes. This is Ed. No, we haven't seen anything notable. Like if anything, we're actually starting, like I said, to see some bit of a moderation in the pricing declines. So we haven't seen anything on the churn side.

Got it. That's very helpful. And then a quick follow-up. Would you say some of the macro pressures that you've called out have intensified in Q3 relative to Q2? Or has it remained fairly in line with some of the pressures that you called out during the last earnings call?

Yes, I'd say it's intensified a bit in Q3.

I don't want to overemphasize security growth. However, when we exclude Guardicore and analyze it at constant currency, it appears that organic growth has declined by about 5 points from Q1 to Q3. Could you provide insight into the impact of macro factors versus the slower growth of some larger maturing products that has contributed to this roughly 5-point deceleration over the last couple of quarters?

Yes, it's challenging to determine the macro impact. I'd estimate it might be a point or two. The core issue, as Tom mentioned, is that while we lead in the web application firewall sector, our market isn't expanding as quickly as some of our other areas, and it's still not at scale. The real concern is that, although our newer products are growing at a faster rate, they aren't sufficiently compensating for the slower growth of our larger products. Okay. And then on Linode, I don't know if you gave it. Could you share how much revenue Linode did in the quarter? And then last quarter, given the commentary today about the increase in cost of the hyperscalers, last quarter, you talked about moving your hyperscaler spend over to Linode internally. Have you started that process yet? And if not, when do you plan to do so? Yes, I'll take the first one. Linode added about $33 million this quarter. Tom, why don't you talk about the movement?

The migration of our cloud spending to Linode is well underway. We have already completed some of the work, and the majority of the migration is expected to occur from the first to the third quarter of next year. By the end of next year, we anticipate that most of the migration will be finished.

I believe my colleagues have mentioned this a few times. I want to revisit the topic. Based on my assessment, we are clearly overspending on Linode in relation to its revenue. You've made significant progress in reducing CapEx from a delivery perspective to about 3% to 4%. However, as we look ahead and see that about two-thirds of our revenue will come from compute security, CapEx will be negligible since we will be utilizing existing infrastructure. What does the expected CapEx structure of this company look like a few years down the line?

Sure. I'll address that. Tom, feel free to add anything. As we shift from Linode's primary focus on small and medium businesses to enterprise workloads, we're dealing with much larger demands. Our spending is now around $100 million and increasing quickly, which is significantly larger than Linode's previous scale. Looking at capital expenditures as a percentage of Linode's existing business isn't the best approach at this moment. We're in a build phase, and you'll notice capital expenditures are gradually increasing as we gain better insight into demand and develop plans to transition existing workloads from hyperscalers to our platform. Therefore, if you use capital expenditures as a metric, it may not accurately represent our situation. It's actually a positive indicator of our expected customer demand and our confidence in successfully migrating workloads. In the coming quarters, expect to see increased capital expenditures in Linode, followed by revenue growth and cost savings. The growth rate will play a crucial role; as revenue potentially doubles, the capital expenditures will naturally represent a higher percentage. Eventually, it should stabilize in line with anticipated revenue growth. For instance, if we reach a long-term growth rate of 20%, capital expenditures will likely be in that range.

I'm sorry, I didn't understand the last comment of 20% growth in Linode, the CapEx was...

No, no, no. So I was using that as an example. What I was saying is we'll give you detailed guidance on what we're going to do next year, but we're in a building phase now where Tom talked about getting into many new centers we're building out for our own demand and also what we're hearing from our customers. So what I was saying is if you're looking at CapEx as a percentage of Linode, it's not the right way to be thinking about it because we're going after a much different business, right? We're going after big enterprise workloads. So there's a build phase where you have to build out ahead of the demand. And then you'll start to see the revenue come our way. And as you get to scale, like many years out when you get to scale, you can start thinking about as a proxy that roughly speaking, your CapEx would approximate what your future demand is. So if you, say, have a long-term run rate of 20% or 30%, your CapEx will be somewhere in that range. But in the near term, it'll be higher than...

This is Charlie Erlikh on for Will. I just wanted to ask a two-parter on the comment that you guys are going to basically take some resources from delivery and put them into security and compute headcount-wise and hiring-wise. So the first part is, how do you feel about competition for talent in the security business and the compute business maybe relative to a few months ago? Kind of what does that hiring environment look like in those two businesses? And then part 2 on the delivery side, how should we interpret that comment as far as trying to turn around that delivery business and just sort of what should we expect from that business as far as trends going forward?

I'll take the first question. It's still a competitive market for hiring. We've been very pleased to see our attrition rates take a major drop over the last quarter. We had stayed at low attrition rates through COVID, well better than market, ticked up a little bit in the first half of the year, but now again down to, over the last 3 months, very low attrition. We have very successful recruiting. Akamai is considered to be a great place to work as measured by the various studies that are done and also employee satisfaction surveys that we do. So people really like working at Akamai. We have really great employees, very smart. We set a high bar for who we recruit. And of course, everybody wants to hire those people. And pretty much everybody wants to hire Akamai employees. But our retention rates are good. I would say our success in hiring is good, but it's a competitive market out there. And Ed, do you want to talk about the delivery business?

Certainly. When considering the delivery business and its potential for turnaround, there are four key factors to keep in mind. First is the renewal aspect. We have recently gone through a significant period of renewals, which won't be as prominent next year. While some renewals will always occur, it's uncommon to have eight of our top ten customers renewing simultaneously. The second factor is pricing; we have discussed before that we are reducing the discounts we offer. The third factor is traffic. We're beginning to see some early positive signs, though the internet's growth rate has dipped below 30% this year, which is a shift from the 30% growth we’ve seen for many years. However, it's reasonable to expect a return to more standard growth rates soon. Lastly, we may benefit from being in the compute space, as some customers with large operations on hyperscalers, despite offering their own content delivery networks, come to us for superior performance. As we continue to add customers and explore new markets, we have the chance to expand our delivery business by leveraging our position in the compute sector.

Sliding in before the final. Nice. So I wanted to go back to the commentary that you've made about the outlook for the upcoming quarter, particularly in the security space. If I adjust the numbers for the contribution from the acquisition of Guardicore, I'm getting an as-reported growth rate of around 9%. And I'm wondering, given your commentary about more difficult conditions and a little larger currency translation year-over-year in the fourth quarter, whether in fact you're expecting the security business to slow to that level in your guidance?

Yes, Alex, this is Ed. I'll take that. We don't provide specific guidance for individual products within the quarter. Currently, the foreign exchange impact, as you mentioned, is around 6%. The as-reported growth is 13%, while in constant currency, it's 19%. So if you consider that, with a 9% assumption, it brings you to about 15%. Since we are comparing against the Guardicore acquisition and just had a 15% organic growth rate, if you exclude Guardicore's contribution in Q3, that seems reasonable. To clarify our guidance of 20% in constant currency, it’s likely in the range of 14% to 16% in constant currency. I can't predict future foreign exchange rates, but if they remain steady like this quarter, the math should work out as described.

So I have a similar question. Based on the Linode comments, it seems that growth has actually accelerated from about a 15% baseline growth rate to around 20% when adjusting for the Linode acquisition. On an as-reported basis, that's quite good considering the currency situation. Could you elaborate on the geographic aspect of the Linode business and the degree to which currency has influenced that? Additionally, as we examine the baseline growth rate, it appears to be accelerating. Can you share whether this is a result of the investments you are making in marketing or if this growth is sustainable going forward?

Sure. I'll start by discussing the currency situation with Linode. When we acquired Linode, their revenue was primarily in U.S. dollars, which means they weren't billing in local currencies. As a result, there aren't significant currency challenges linked to the Linode part of the business. However, for the non-Linode compute business, we do face the usual dynamics. Regarding our marketing investments, I believe we can maintain our current spending levels, and I do not anticipate a substantial increase in marketing expenses next year. We are making slight increases, but nothing major. On the sales side, we are adding some sales personnel, particularly specialists to support our sales team, but this will not involve a significant investment. We feel our sales team can be effectively trained, and we're also revising our compensation plans to include extra incentives for compute sales. Overall, I think these changes will fit within the normal expense levels we have been operating at, and I do not foresee any major investments in that segment of the business.

If I could slide in one last one, since I'm the last guy here. As the mix shifts here, how do you expect the mix shift between the segments to start impacting the overall margins?

Yes. If you refer back to the IR Day slides, there was a question earlier regarding the leverage we gain from the compute business. As the rapidly growing sectors of security and compute comprise a larger share of our overall business, we should see some operating leverage. This won't occur immediately, but will develop over time. Additionally, we mentioned the situation with increased capital expenditures ahead of revenue, which is another factor to consider. You may have noticed that I've mentioned some pressure on the gross margin line. I view this as a temporary issue. We will see a reduction in the gross margin line as we transition some of our third-party costs and manage the associated build-out expenses, such as colocation agreements and network build costs, which are somewhat front-loaded. As revenue increases, we anticipate some improvement in the gross margin line too. As Tom noted, security is expected to be our largest product line, offering higher gross and operating margins. Consequently, we should begin to see the benefits as our product mix evolves towards these two lines over time.

And thank you, everyone. In closing, we will be presenting at a number of investor conferences and presenting at events, road shows and other things throughout the rest of the fourth quarter. Details of these can be found in the Investor Relations section of akamai.com. So thank you for joining us. And all of us here at Akamai wish continued good health to you and yours, and have a nice evening.