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AKAM > SEC Filings for AKAM > Form 10-Q on 9-Nov-2011All Recent SEC Filings

Show all filings for AKAMAI TECHNOLOGIES INC

Form 10-Q for AKAMAI TECHNOLOGIES INC


9-Nov-2011

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations

This quarterly report on Form 10-Q, particularly Management's Discussion and Analysis of Financial Condition and Results of Operations set forth below, and notes to our unaudited consolidated financial statements included herein contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management as of the date hereof based on information currently available to our management. Use of words such as "believes," "expects," "anticipates," "intends," "plans," "estimates," "should," "forecasts," "if," "continues," "goal," "likely" or similar expressions indicates a forward-looking statement. Forward-looking statements are not guarantees of future performance and involve risks, uncertainties and assumptions. Actual results may differ materially from the forward-looking statements we make. See "Risk Factors" elsewhere in this quarterly report on Form 10-Q for a discussion of certain risks associated with our business. We disclaim any obligation to update forward-looking statements as a result of new information, future events or otherwise.
We provide services for accelerating and improving the delivery of content and applications over the Internet. We primarily derive income from the sale of services to customers executing contracts with terms of one year or longer, which we refer to as recurring revenue contracts or long-term contracts. These contracts generally commit the customer to a minimum monthly level of usage with additional charges that apply to actual usage above the monthly minimum. In recent years, however, we have also entered into customer contracts that have minimum usage commitments that are based on quarterly, twelve-month or longer periods. Having a consistent and predictable base level of revenue is important to our financial success. Accordingly, to be successful, we must maintain our base of recurring revenue contracts by eliminating or reducing lost monthly, quarterly or annual recurring revenue due to customer cancellations or terminations and limiting the impact of price reductions reflected in contract renewals and build on that base by adding new customers and increasing the number of services, features and functionalities that our existing customers purchase. At the same time, we must ensure that our expenses do not increase faster than, or at the same rate as, our revenues. Accomplishing these goals requires that we compete effectively in the marketplace on the basis of quality, price and the attractiveness of our services and technology. Overview of Financial Results
The following sets forth, as a percentage of revenues, consolidated statements of operations data, for the periods indicated:


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                                                For the Three Months         For the Nine Months
                                                 Ended September 30,         Ended September 30,
                                                 2011           2010         2011           2010
Revenues                                        100.0  %       100.0  %     100.0  %       100.0  %
Cost of revenues                                 33.1           30.7         32.6           29.4
Research and development expense                  4.8            5.6          4.4            5.5
Sales and marketing expense                      19.3           21.9         19.3           21.7
General and administrative expense               18.0           16.9         16.9           17.1
Amortization of other intangible assets           1.5            1.6          1.5            1.7
Restructuring charge                              0.1              -            -              -
Total cost and operating expenses                76.8           76.7         74.7           75.4
Income from operations                           23.2           23.3         25.3           24.6
Interest income                                   1.0            1.1          1.0            1.3
Interest expense                                    -           (0.1 )          -           (0.2 )
Other expense, net                               (0.1 )         (0.5 )       (0.2 )         (0.2 )
Gain on investments, net                          0.1              -          0.1              -
Loss on early extinguishment of debt                -              -            -              -
Income before provision for income taxes         24.2           23.8         26.2           25.5
Provision for income taxes                        9.2            8.1          9.4            9.4
Net income                                       15.0  %        15.7  %      16.8  %        16.1  %

We were profitable for the fiscal year 2010 and for the nine months ended September 30, 2011; however, we cannot guarantee continued profitability or profitability for any period in the future at the levels we have recently experienced. We have observed the following trends and events that are likely to have an impact on our financial condition and results of operations in the foreseeable future:
During each of the first three quarters of 2011, we were able to offset lost committed recurring revenue due to customer cancellations, terminations or price reductions by adding new customers and increasing the number of services, features and functionalities, which we refer to as value-added services, that our existing customers purchase. A continuation of this trend, in conjunction with increased revenues from non-recurring revenue contracts, could lead to increased revenues; however, any such increased revenues would be offset if lower traffic reduces the revenues we earn on a non-committed basis or as a result of further declines in the prices we charge. If we do not offset lost committed revenue in this manner, our revenues will decrease.

During each of the first three quarters of 2011, unit prices offered to some new and existing customers declined, primarily as a result of competition from new and established competitors. These price reductions primarily impacted customers for which we deliver high volumes of traffic over our network, such as digital media customers. If we continue to experience decreases in unit prices for new and existing customers and we are unable to offset such reductions with increased traffic or enhanced efficiencies in our network or increased sales of value-added services to customers, our revenues and profit margins could decrease.

Historically, we have experienced seasonal variations in our quarterly revenues attributable to e-commerce services used by our retail customers, with higher revenues in the fourth quarter of the year and lower revenues during the summer months. If this trend continues, our ability to generate quarterly revenue growth on a sequential basis could be impacted.

In the first three quarters of 2011, we experienced a moderation in the rate of traffic growth in our volume-driven solutions as compared to the first three quarters of 2010. If this trend continues, our ability to generate revenue growth could be adversely impacted.

During the first three quarters of 2011, we reduced our network bandwidth costs per unit by entering into new supplier contracts with lower pricing and amending existing contracts to take advantage of price reductions offered by our existing suppliers. Additionally, we continued to invest in internal-use software development to improve the performance and efficiency of our network. Due to the increased traffic delivered over our


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network, our total bandwidth costs increased during the first three quarters of 2011 as compared to the same period in 2010. We believe that our overall bandwidth costs will continue to increase as a result of expected higher traffic levels, partially offset by anticipated continued reductions in bandwidth costs per unit. If we do not experience lower per unit bandwidth pricing, or we are unsuccessful at effectively routing traffic over our network through lower cost providers, total network bandwidth costs could increase more than expected during the remainder of 2011.
In recent quarters, we have seen co-location costs increase and become a higher percentage of total cost of revenues due to the expansion of our network. Continuation of this trend may negatively impact our profitability.

For the nine months ended September 30, 2011, revenues derived from customers outside the United States accounted for 29% of our total revenues. For the remainder of 2011, we anticipate revenues from such customers as a percentage of our total revenues to be consistent with each of the first three quarters.

Depreciation and amortization expense related to our network equipment and internal-use software development costs increased during each of the first three quarters of 2011 as compared to the same quarters in 2010. Due to the purchases of network equipment during 2011, we believe that depreciation expense, as well as co-location costs, related to our network equipment will continue to increase during the remainder of 2011. We also expect to continue to enhance and add functionality to our service offerings, which would increase capitalized stock-based compensation expense attributable to employees working on such projects. As a result, we believe that the amortization of internal-use software development costs, which we include in cost of revenues, will be higher in 2011 as compared to 2010. All of these increased costs could negatively affect our profitability.

For the three and nine months ended September 30, 2011, our stock-based compensation expense was $15.2 million and $42.5 million, respectively, as compared to $18.6 million and $58.0 million, respectively, for the three and nine months ended September 30, 2010. The decrease in stock-based compensation expense for the three and nine months ended September 30, 2011 as compared to the same periods in 2010 was primarily due to management's assessment, as of September 30, 2011, that certain outstanding restricted stock units, or RSUs, with performance-based vesting conditions will not vest because the associated performance targets are unlikely to be met. We expect this trend of lower stock-based compensation expense to continue for the remainder of 2011 as compared to 2010. As of September 30, 2011, our total pre-tax unrecognized compensation costs for stock-based awards were $109.3 million, which we expect to recognize as expense over a weighted average period of 1.3 years through 2015.

As of September 30, 2011, we held $135.4 million in par value of auction rate securities, which we refer to as ARS. Based upon our cash, cash equivalents and marketable securities balance of $1.2 billion at September 30, 2011 and expected operating cash flows, we do not anticipate that the lack of liquidity associated with our ARS will adversely affect our ability to conduct business during the remainder of 2011. We believe we have the ability to hold these ARS until a recovery of the auction process, a buyer is found outside the auction process, the securities are called or refinanced by the issuer, or until maturity.

During the nine months ended September 30, 2011, our effective income tax rate was 35.7%. We expect our annual effective income tax rate in 2011 to remain relatively consistent in the fourth quarter of 2011; this expectation does not take into consideration the effect of discrete items such as those relating to stock-based compensation. In 2010, due to our continued utilization of available net operating losses, or NOLs, and tax credit carryforwards, our tax payments were significantly lower than our recorded income tax provision. We expect to utilize substantially all of our tax credit carryforwards in 2011. Once we have done so, the amount of cash tax payments we make will increase over those made in previous years.

Based on our analysis of, among other things, the aforementioned trends and events, as of the date of this quarterly report on Form 10-Q, we expect to continue to generate net income on a quarterly and annual basis during 2011 and 2012; however, our future results are likely to be affected by the factors discussed in the paragraphs above as well as those identified in the section captioned "Risk Factors" and elsewhere in this quarterly report on Form 10-Q, including our ability to:
increase our revenue by adding customers through long-term contracts and limiting customer cancellations and terminations;

offset unit price declines for our services with higher volumes of traffic delivered on our network as well as increased sales of our value-added solutions;


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prevent disruptions to our services and network due to accidents or intentional attacks; and

maintain our network bandwidth and co-location costs and other operating expenses consistent with our revenues.

As a result, there is no assurance that we will achieve our expected financial objectives, including generating positive net income, in any future period. Our management's discussion and analysis of our financial condition and results of operations are based upon our unaudited consolidated financial statements included elsewhere in this quarterly report on Form 10-Q, which we have prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim periods and with Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended, or the Exchange Act. The preparation of these unaudited consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related items, including, but not limited to, revenue recognition, accounts receivable and related reserves, valuation and impairment of investments and marketable securities, goodwill and other intangible assets, capitalized internal-use software costs, impairment and useful lives of long-lived assets, tax reserves, loss contingencies and stock-based compensation costs. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time they are made. Actual results may differ from our estimates. See the section entitled "Application of Critical Accounting Policies and Estimates" in our annual report on Form 10-K for the year ended December 31, 2010 for further discussion of our critical accounting policies and estimates.
Recent Accounting Pronouncements
In December 2010, the Financial Accounting Standards Board, or FASB, issued an accounting standard update for business combinations specifically related to the disclosure of supplementary pro forma information for business combinations. This guidance specifies that pro forma disclosures should be reported as if the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period, and the pro forma disclosures must include a description of material, nonrecurring pro forma adjustments. This standard was effective for business combinations with an acquisition date of January 1, 2011 or later. The adoption of the guidance did not have an impact on our financial position or results of operations. In May 2011, the FASB issued amended guidance and disclosure requirements for fair value measurements. This guidance provides a consistent definition of fair value and ensures that the fair value measurement and disclosure requirements are similar between U.S. GAAP and international financial reporting standards. The guidance changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements. This standard will be effective for interim and annual periods beginning after December 15, 2011 and will be applied prospectively. The adoption of the guidance is not expected to have a material impact on our consolidated financial statements.
In June 2011, the FASB issued amended disclosure requirements for the presentation of comprehensive income. The amended guidance eliminates the option to present components of other comprehensive income, or OCI, as part of the statement of changes in equity. Under the amended guidance, all changes in OCI are to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive financial statements. The changes will be effective January 1, 2012 and early adoption is permitted. There will be no impact on our consolidated financial results as the amendments relate only to changes in financial statement presentation.
In September 2011, the FASB issued amended guidance that will simplify how entities test goodwill for impairment. Under the amended guidance, after assessment of certain qualitative factors, if it is determined to be more likely than not that the fair value of a reporting unit is less than its carrying amount, entities must perform the quantitative analysis of the goodwill impairment test. Otherwise, the quantitative test(s) are optional. The guidance is effective January 1, 2012 with early adoption permitted. The adoption of the guidance is not expected to have a material impact on our financial position or results of operations.
Results of Operations
Revenues. Total revenues increased 11%, or $28.3 million, to $281.9 million for the three months ended September 30, 2011 as compared to $253.6 million for the three months ended September 30, 2010. For the nine months ended September 30, 2011, revenues increased 13%, or $95.9 million, to $834.8 million as compared to $738.9 million


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for the nine months ended September 30, 2010. The following table quantifies the contribution to growth in revenues during the periods presented from the different industry verticals in which we sell our services (in millions):

                             For the                  For the
                        Three Months Ended       Nine Months Ended
                        September 30, 2011       September 30, 2011
                       as compared to 2010      as compared to 2010
Media & Entertainment $                 5.6    $                31.9
Commerce                               11.4                     33.3
Enterprise                              9.1                     25.9
High Tech                               1.5                      0.4
Public Sector                           0.7                      4.4
Total net increase    $                28.3    $                95.9

A significant portion of the increase in revenues for the three and nine months ended September 30, 2011 as compared to the same periods in 2010 was driven by increased sales of value-added services to customers in our commerce and enterprise verticals. The revenues from our media and entertainment vertical increased due to traffic growth and were partially offset by reduced prices charged to our customers. Revenues from our high tech vertical remained relatively flat as increased demand for value-added solutions offset the decline in software download revenues. The increase in revenues from public sector customers was primarily attributable to new contracts with government agencies. For the three- and nine-month periods ended September 30, 2011 and 2010, approximately 29% and 28%, respectively, of our revenues were derived from our operations located outside of the United States, including 18% derived from Europe during each of the three and nine month periods ended September 30, 2011 and 16% and 17% derived from Europe during each of the three and nine month periods ended September 30, 2010, respectively. No single country outside of the United States accounted for 10% or more of revenues during these periods. For the three- and nine-month periods ended September 30, 2011 and 2010, resellers accounted for 19% and 18% of revenues, respectively. For each of the three- and nine-month periods ended September 30, 2011 and 2010, no customer accounted for 10% or more of revenues.
Cost of Revenues. Cost of revenues was comprised of the following (in millions) for the periods presented:

                                                 For the Three Months            For the Nine Months
                                                 Ended September 30,             Ended September 30,
                                                  2011           2010             2011             2010
Bandwidth and service-related fees            $      21.8     $   19.6     $      63.5          $   56.7
Co-location fees                                     33.7         25.2            96.3              68.2
Payroll and related costs of network
operations personnel                                  3.9          4.0            11.3              10.4
Stock-based compensation, including
amortization of prior capitalized amounts             2.2          2.5             7.3               7.6
Depreciation and impairment of network
equipment                                            24.8         20.0            71.2              54.9
Amortization of internal-use software                 6.9          6.5            22.4              19.3
Total cost of revenues                        $      93.3     $   77.8     $     272.0          $  217.1

Cost of revenues increased 20%, or $15.5 million, to $93.3 million for the three months ended September 30, 2011 as compared to $77.8 million for the three months ended September 30, 2010. For the nine months ended September 30, 2011, cost of revenues increased 25%, or $54.9 million, to $272.0 million as compared to $217.1 million for the nine months ended September 30, 2010. This increase was primarily due to:

increases in co-location costs as we deployed more servers worldwide;

          an increase in depreciation expense of network equipment and
           amortization of internal-use software as we continued to invest in our
           infrastructure; and


          an increase in amounts paid to network providers for bandwidth due to
           higher traffic levels, partially


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offset by reduced bandwidth costs per unit.
Cost of revenues during the three and nine months ended September 30, 2011 also included credits received of approximately $2.7 million and $5.6 million, respectively, from settlements and renegotiated contracts entered into in connection with billing disputes related to bandwidth contracts. During the three and nine months ended September 30, 2010, cost of revenues included similar credits of approximately $2.3 million and $4.5 million, respectively. Credits of this nature may occur in the future; however, the timing and amount of future credits, if any, are unpredictable.
We have long-term purchase commitments for bandwidth usage and co-location services with various network and Internet service providers. For the remainder of 2011 and for the years ending December 31, 2012, 2013, 2014 and 2015, we estimate that the minimum commitments related to bandwidth usage and co-location services under agreements currently in effect are approximately $37.0 million, $51.3 million, $8.6 million, $0.3 million and $0.1 million, respectively. We believe that cost of revenues will increase during the fourth quarter of 2011 as compared to each of the first three quarters of 2011. We expect to deploy more servers and deliver more traffic on our network, which would result in higher expenses associated with the increased traffic and co-location fees; however, such costs are likely to be partially offset by lower bandwidth costs per unit. Additionally, for the remainder of 2011, we anticipate increases in depreciation expense related to our network equipment and amortization of internal-use software development costs, along with increased payroll and related costs, as we continue to make investments in our network with the expectation that our customer base will continue to expand.
Research and Development. Research and development expenses consist primarily of payroll and related costs and stock-based compensation expense for research and development personnel who design, develop, test and enhance our services and our network. Research and development costs are expensed as incurred, except certain internal-use software development costs eligible for capitalization. During the three and nine months ended September 30, 2011, we capitalized software development costs of $8.8 million and $28.1 million, respectively, net of impairments. During the three and nine months ended September 30, 2010, we capitalized software development costs of $8.4 million and $22.1 million, respectively, net of impairments. These development costs consisted of external consulting expenses and payroll and payroll-related costs for personnel involved in the development of internal-use software used to deliver our services and operate our network. Additionally, during the three and nine months ended September 30, 2011, we capitalized $1.8 million and $5.2 million of stock-based compensation, respectively, as compared to $1.9 million and $5.4 million during the three and nine months ended September 30, 2010, respectively. These capitalized internal-use software costs are amortized to cost of revenues over their estimated useful lives of two years.
Research and development expenses decreased 5%, or $0.7 million, to $13.5 million for the three months ended September 30, 2011 as compared to $14.2 million for the three months ended September 30, 2010. For the nine months ended September 30, 2011, research and development expenses decreased 9%, or $3.8 million, to $37.1 million as compared to $41.0 million for the nine months ended September 30, 2010. The decrease during the three and nine months ended September 30, 2011 as compared to the same periods in 2010 was due to higher capitalized salaries and a decrease in stock-based compensation, partially offset by an increase in payroll and related costs as a result of headcount growth.
The following table quantifies the changes in the various components of our research and development expenses for the periods presented (in millions):

                                                      For the                      For the
                                                 Three Months Ended           Nine Months Ended
                                                 September 30, 2011          September 30, 2011
                                                as compared to 2010          as compared to 2010
Payroll and related costs                    $                 1.2        $                6.6
Stock-based compensation                                         -                        (2.6 )
Capitalized salaries and other expenses                       (1.9 )                      (7.8 )
Total net decrease                           $                (0.7 )      $               (3.8 )

We believe that research and development expenses, in absolute dollar terms, will increase during the fourth quarter of 2011 as compared to the first nine months of 2011 because we expect to continue to hire additional development


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