Operator: Good afternoon, and welcome to the Akamai Technology Third Quarter 2023 Earnings Conference Call. [Operator Instructions] 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.

Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s third quarter 2023 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 7, 2023. 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 will 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, I’ll turn the call over to Tom.

Tom Leighton: Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai delivered excellent results in the third quarter with revenue, operating margin and earnings all exceeding the high end of our guidance range. Revenue grew to $965 million in Q3, up 9% year-over-year. Non-GAAP operating margin was 31%, and non-GAAP earnings per share was $1.63, up 29% year-over-year. Ed will cover the key factors that drove our bottom line performance in his portion of the call. I’ll now say a few words about each of our 3 main product areas, starting with security, our largest source of revenue. Security revenue grew 20% year-over-year in Q3. The acceleration in security growth was driven in part by especially strong demand for our market-leading Guardicor segmentation solution as enterprises confront the ever-present threats from malware and especially ransomware.

CISOs and corporate Boards everywhere have seen the recent headlines about devastating ransomware attacks, including at 2 casino hotels in Las Vegas, a major manufacturer of cleaning products in the U.S. and at a multinational provider of systems for smart buildings. One of them reportedly paid $15 million to get ransomware out of their systems. Another is reportedly spending $25 million to deal with the after effects and a third has reported more than $100 million in losses from the attack. Customers who purchased our segmentation solution last quarter include a major global services provider, one of the world’s most recognized entertainment brands and a leading bank in Switzerland that renewed their segmentation protection with a significant upgrade.

We also saw strong demand for our market-leading web app firewall solutions in Q3, where we continue to win against competitors who are challenged to provide the levels of reliability and performance required by major enterprises. Customers who switched to Akamai, including a nationwide retail chain in the U.S. and a leading global manufacturer based in India, also told us that our competitors simply can’t provide the level of support and professional services that they need and have come to depend on from Akamai. Customers also value being able to purchase an entire suite of integrated security products from Akamai, a provider who they trust to keep them safe against a wide variety of attacks. For example, we’re seeing very strong interest in our new API security solution that we announced last quarter.

This new product is in its very early days, but we’ve already integrated it with our market-leading web app firewall solution to make it even easier for customers to implement. At the Black Hat security conference last quarter, Akamai API Security was named one of the 20 hottest new cybersecurity tools by CRN, a major trade publication for channel resellers. And as with Guardicore, you don’t need to be a CDN customer to benefit from this new solution. Turning now to cloud computing. I’m pleased to say that we’re on track with our product development, infrastructure deployment and conversations with customers about use cases well suited for the Akamai connected cloud. Since our last call, we’ve gone live with 7 more core compute regions in Amsterdam, Jakarta, Los Angeles, Miami, Milan, Osaka and Sao Paulo.

In addition to the 6 that we opened earlier this year and the 11 that we acquired from Linode, this brings our total to 24 core compute regions to serve Akamai connected cloud customers. Of course, there are other cloud companies with a few dozen data centers. But Akamai is unique in having these data centers interconnected to the world’s most distributed edge platform with more than 4100 points of presence across 750 cities and 130 countries. As one trade pub block and files recently wrote, Akamai is focusing on a future where scale becomes more about the size of the network versus the size of its data centers, more effectively powering modern applications. We agree. Akamai’s massively distributed edge network, 25 years in the making and managed by Akamai’s team of experts around the world is a key differentiator in our strategy.

We believe that next-generation applications will need next-generation cloud infrastructure, and we intend to chart the course for the next decade of cloud computing when more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. As IDC put it in July, Akamai brings the simplicity, affordability and accessibility of its cloud computing services to larger commercial customers on an architecture built for the next decade, not the last. The Akamai Connected Cloud will put containers and VMs closer to end users and bring enterprise workloads to locations around the world that are otherwise difficult for organizations to reach. Customers are responding to Akamai’s unique offering, and we’ve already gained cloud computing business across multiple verticals in every major geography, including a European streaming media company, a digital advertising company in Japan, a large financial institution in Indonesia, and e-commerce platform in Korea, major carriers in EMEA and Central America and a television network in South America.

In addition to direct sales, we’re seeing good traction in our cloud computing partner ecosystem, where we’re acquiring new customers by selling with cloud service providers and managed service providers. We’ve also partnered successfully with independent software vendors and SaaS and PaaS providers. In fact, we recently signed one of the world’s best-known SaaS providers and our second largest cloud computing deal since we acquired Lanone [ph] Turning now to content delivery. I’m pleased to report that we saw an acceleration of traffic growth in Q3. In addition, we acquired enterprise customer contracts from StackPath and Lumen Technologies following their decisions to exit the CDN market. As Ed will talk about shortly, the financial terms of the acquisitions were very attractive for Akamai shareholders.

In addition to the delivery business that we acquired, we’re planning to introduce these customers to our full portfolio of security and cloud computing solutions to help them power and protect their businesses online. In summary, we are very pleased by our performance in Q3. Our expanded security portfolio is deepening our relationships with customers. Our cloud computing plans are executing on schedule, and we continue to invest in Akamai’s future growth while also enhancing our profitability. Now I’ll turn the call over to Ed for more on our Q3 results and our outlook for Q4 and the full year. Ed?

A close-up of a person using a laptop with cloud solutions in the background.

Ed McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered a strong and very profitable quarter in Q3. In my remarks today, I’ll cover our Q3 results and then provide some perspective on Q4, share some details on our recent customer contract acquisitions and closed with our increased full year 2023 guidance. First, let’s discuss revenue. Total revenue for the third quarter was $965 million, up 9% year-over-year as reported and in constant currency. In the third quarter, Security revenue was $456 million, growing 20% year-over-year as reported and 19% in constant currency. Security revenue growth was primarily driven by continued strength in our segmentation product, which is now over $100 million on an annualized run rate basis and up 97% year-over-year.

I’ll note that during the quarter, we had approximately $6 million of onetime segmentation license revenue. Adjusting for that onetime license revenue, total security growth for the third quarter would have been 18% year-over-year as reported and 17% in constant currency. And segmentation revenue growth would have been approximately 62% year-over-year and 60% in constant currency. In addition to strength and segmentation, we also saw very strong growth in our flagship Web Application Firewall or WAF product family. This growth was primarily driven by stronger-than-expected adoption of new security bundles offered to new and existing customers that we introduced this year. The new security bundles include additional security entitlements such as more security policies, additional security configurations and more advanced rate control policies.

Many existing customers are seeing greater value in these new bundles and as a result, are spending more with us. Moving to compute. Revenue was $130 million, growing 19% year-over-year as reported and in constant currency. On a combined basis, our securities and compute business product lines represented 61% of total revenue, growing 20% year-over-year and 19% in constant currency. Shifting to delivery. Revenue was $379 million, declining 4% year-over-year as reported and in constant currency. It’s worth noting that delivery was aided by approximately $4 million in revenue from the selected CDN customer contracts we acquired from StackPath. International revenue was $467 million, up 11% year-over-year and up 9% in constant currency. Foreign exchange fluctuations had a negative impact on revenue of $3 million on a sequential basis and a positive $7 million benefit on a year-over-year basis.

Moving now to company profitability. Non-GAAP net income was $251 million or $1.63 of earnings per diluted share, up 29% year-over-year and up 28% in constant currency. These especially strong EPS results exceeded the high end of our guidance range by $0.11. — were driven primarily by higher revenues and continued progress on the cost savings initiatives we outlined over the last few quarters. As an example, we continue to reduce our third-party cloud spend by migrating internal workloads to our connected cloud platform. In Q3, our third-party cloud spend declined 26% year-over-year. Moving to margins. Our cash gross margin was 73%. Included in our Q3 cost of goods sold was approximately $5 million of transition services agreement or TSA costs paid to StackPath.

With customer contract acquisitions, TSA payments are used to cover the seller’s customer-related network and support costs during the migration period. I’ll provide further detail on expected TSA costs going forward in the guidance section in a few moments. Adjusted EBITDA margin was 43%, and our non-GAAP operating margin was 31%, 2 points ahead of our guidance, driven by our revenue outperformance and continued focus on driving down costs across the business. Moving now to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $2.1 billion, which includes the proceeds from the convertible debt raise we did during the quarter. As a reminder, in August, we issued $1.65 billion of senior unsecured convertible debt that will mature on February 15, 2029.

The notes will bear interest at a rate of 1.125% per year payable semiannually. Finally, the net proceeds of approximately $1 billion from this offering have been invested in highly liquid marketable securities. These securities yield approximately 5.25% on a weighted average basis with maturities close to May 2025 as we intend to use these proceeds to pay off approximately $1.15 billion of convertible notes that mature in May 2025. We — for the third quarter, we spent roughly $113 million to repurchase approximately 1.1 million shares. We now have roughly $600 million remaining on our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buy back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself.

Before I cover Q4 guidance, I want to provide a quick reminder about our typical fourth quarter dynamics and add some color to our 2 recent transactions with StackPath and Lumen. As in prior year, seasonality plays a significant role in determining our financial performance for the fourth quarter. Typically, we see higher-than-normal traffic from large media customers and they pick up in seasonal online retail activity from our e-commerce customers. Both of these traffic patterns are difficult to predict. Q4 also tends to have higher operating expenses than in Q3, driven by higher sales commissions due to accelerator payments for sales reps who overachieved their annual quotas. As it relates to the transactions with StackPath and women’s, first, both transactions were acquisitions of selected CDN customer contracts, including over 200 net new customers to Akamai.

We did not acquire any other assets or liabilities at either company. Second, we expect the 2 transactions combined will add approximately $17 million to $20 million of revenue in Q4. Third, we expect to record approximately $13 million to $14 million of StackPath and lumen TSA costs in Q4. These costs will be recorded in our cost of goods sold and will have a negative impact of approximately 1 percentage point on gross margin, adjusted EBITDA margin and non-GAAP operating margin. Combined, the stack path of lumen TSAs will negatively impact our Q4 EPS by approximately $0.06 to $0.07. We do not expect to incur any material TSA costs in 2024. And finally, our expectations for these customer acquisitions remain the same as we disclosed previously for the full year 2024.

As a reminder, we expect the customer contracts acquired from StackPath to add approximately $20 million of revenue in 2024 and to be accretive to non-GAAP earnings per share by $0.03 to $0.05. And we expect the customer contracts acquired from women to add approximately $40 million to $50 million of revenue in 2024 and to be $0.08 to $0.12 accretive to non-GAAP EPS. With all that in mind, we are now projecting fourth quarter revenue in the range of $985 million to $1.005 billion or up 6% to 8% as reported and in constant currency over Q4 2022. We — at current spot rates, foreign exchange fluctuations are expected to have a negative $8 million impact on Q4 revenue compared to Q3 levels and a positive $2 million impact year-over-year. Taking into account the impact of the StackPath and Lumen TSAs for the fourth quarter, we expect cash gross margins of approximately 72%.

Q4 non-GAAP operating expenses are projected to be $305 million to $311 million. We expect Q4 adjusted EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense to be between $123 million to $125 million, and we expect a non-GAAP operating margin of approximately 29% for Q4. Moving on to CapEx. We expect to spend approximately $143 million to $153 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 15% of our projected total revenue for the fourth quarter. Additionally, our CapEx guidance includes the integration requirements to support the traffic for both CDN customer contract acquisitions. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS to be $1.57 to $1.62.

This EPS guidance assumes taxes of $50 million to $52 million based on an estimated quarterly non-GAAP tax rate of approximately 17%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.802billion to $3.22 billion, which is up 5% to 6% year-over-year as reported and 6% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $18 million impact on revenue in 2023 on a year-over-year basis. We are raising our security revenue growth expectations to approximately 15% for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a year of significant investment, we are estimating non-GAAP operating margin of approximately 29%.

With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $6.08 to $6.13. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17%, and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be 19% of total revenue. In closing, we are very pleased with how the business is performing in 2023 as we continue to invest for revenue growth and improve our profitability. With that, we now look forward to your questions. Operator?

Operator: [Operator Instructions] The first question is from James Fish of Piper Sandler. Please go ahead.

James Fish: Really nice quarter there. Understanding you’re selling Guardicore to the installed base primarily. But what are you seeing with selling outside of the installed base with security and compute and specifically within security. Is there a way to think about that drag along effect or how the Guardicore enterprise sales team are really dragging along the rest of the security or even compute portfolios into any net new customer wins. Really, the crux of the question is how is the sales process going outside of the CDN installed base?

Ed McGowan: Jim, this is Ed. I’ll start. Tom, you can jump in if there’s anything you want to add. So actually, it’s interesting, you started off by saying Guardicore is mostly to the installed base. Actually, we’ve done a really nice job of selling to new customers. One of the things that came over as part of the Guardicore acquisition is a pretty robust channel and pretty much every deal is done through the channel. As a matter of fact, I think we can do a better job of selling in the installed base and probably come up with some new incentives to incentivize the sales force to do that. So there’s a ton of room in the installed base because most of the growth in Guardicore has come from outside the installed base.

Tom Leighton: Yes. And I would just add to that, that there is good drag along with Guardicore and for example, Enterprise Application Access, one is considered north-south, the other East West, both are really important in terms of keeping malware out and identifying when it gets in and really blocking the spread. So it’s good that way, too.

James Fish: Helpful, guys. And just a follow-up, Tom, you had actually started to allude to it a little bit. But as we think about those lumen and Exacto [ph] contracts, I guess how much wallet share do you have in aggregate of these new customers? Or what’s the overall opportunity for those specific customers beyond just that CDN revenue that you bought?

Tom Leighton: Yes. Well, obviously, there’s a CDN revenue, which is what transfers, but we’re going to be looking to sell our security and compute solutions into those 200-plus new customers. And I think there’s some good opportunity there.

Operator: The next question is from Fatima Boolani of Citi.

Fatima Boolani: Good afternoon. Thank you for taking my question. Tom, maybe I’ll start with you. I want to have a broader conversation with regards to some of these contracts that you’ve been acquiring, it’s setting up to be a little bit of a pattern. So look, you’ve been doing delivery for the better part of 2 decades here. So I wanted to get your kind of longitudinal perspective on what you’re seeing in the marketplace and the market backdrop that’s sort of pointing more and more towards consolidation in the delivery here. And then ultimately, I wanted to get your perspective on how you think this is going to impact some of the pricing dynamics and ultimately, your pricing power in the delivery space. And then I have a follow-up for Ed, if I may.

Tom Leighton: Yes, I wouldn’t call it a pattern. It’s been a long time, really since we’ve acquired a competitor or a competitor contracts. This is a situation where 2 of the many CDNs out there decided to discontinue their operations. And they wanted — now they’re still remaining as companies, obviously, and they wanted to have their customers have the best possible experience as they exited the CDN space. And so they approached Akamai as the leader by far in CDN and made very compelling financial terms for the transaction. So it makes a lot of sense for our shareholders that we take on these customers. And also, it’s a good opportunity as we mentioned, to sell them security and compute. So really good for shareholders. It’s not something that we’re actively doing trying to go buy other CDMs. But every once in a while, there is an opportunity that is compelling for shareholders.

I don’t see any fundamental change in the marketplace the hyperscalers and a dozen – 2 dozen other companies are selling delivery services. So I don’t think there’ll be any fundamental change there or change with pricing. Separately from this, of course, you know that we talked about Akamai as being more conservative with pricing, as we talked about, we’re not taking some of the spiky traffic, if the pricing doesn’t make sense because we’ve been focusing more on the capital deployment into our compute offering, which we see enormous potential future growth for…

Fatima Boolani: Perfect. Thank you. Ed, I was hoping I could parse out some of your prepared remarks with respect to the third-party cloud spend that you’re effectively in-sourcing. I believe a couple of quarters ago, you may have ballpark that figure at about $100 million. So please correct me if that recollection is correct. And also just wanted to get a sense of how far down the path you are in this in-sourcing of third-party cloud spend on your Connected Cloud platform. Thank you.

Ed McGowan: Yes, sure. That’s a great recollection, thought me you’re correct. That’s about $100 million or actually north of $100 million. So we are still in the earlier innings of the journey. However, we’ve made a lot of progress, and the team is doing a great job. So we expect to see that the savings continue to ramp. I’m very happy to say that we’re slightly ahead of where we expected to be, and we have a lot of confidence that we’ll be able to drive the type of savings that we expect to throughout next year.

Fatima Boolani: Thank you.

Operator: The next question is from Magellan Brooks [ph] of Bank of America. Please go ahead.

Q – Unidentified Analyst: Thanks for taking my question. Just want to dive into security a bit and see are the trends differing between international and domestic in terms of what products are getting better versus not? And then one follow-up question after that. Thanks.

Tom Leighton: I don’t think there’s a fundamental difference. The attacks are global in nature and the same attacks we see here domestically. We see in pretty much all of the major geos. And yes, you do see a little bit more attacks where there’s hotspots wars taking place or political tensions, there’ll be more attacks, but the nature of the attacks is similar. You got a denial of service attacks, you got ransomware. You’ve got application layer attacks, more recently, AI attacks. So — and that happens everywhere because there’s no reason it should be in one geography versus another.

Q – Unidentified Analyst: Got it. And then for the Connected Cloud and just the compute segment as well, you guys talked about a lot of really nice international deals, but also just wanted to get a pulse on what’s happening domestically and appetite for the products here.

Tom Leighton: Again, I think that is universal as well. We’ll have special advantages in locations where the hyperscalers aren’t. But that kind of compute capability can be accessed by customers anywhere. Big U.S. companies care a lot about being able to give really good performance for their users all around the world. So again, I think that’s — there’s not a fundamental difference between the U.S. or other regions. We have gotten off to a really good start, and I would say APJ, but it’s across the board. We’re deep in conversations with major enterprises across all the major geos.

Q – Unidentified Analyst: Got it. Congrats.

Operator: The next question is from Ray McDonough of Guggenheim Securities. Please go ahead.

Ray McDonough: Thanks for taking the questions. And Ed, I appreciate the color on the additional bundles of security and the additional services you added to those bundles. And then in our conversations, we did pick up a decent price up with when those services are added. So can you help us understand what sort of pricing uplift, if any, there might be there? And what the penetration rate is in your installed base currently of those services and what the opportunity is going forward?

Ed McGowan: Yes. So I’ll start and then Tom, if there’s anything you want to add. So this is a pretty targeted program that we identified customers in selected verticals primarily in commerce, manufacturing, health care, pharma, financial services, what we traditionally call sort of our legacy web customers. And as we have talked about, included a lot more services and functionality into the bundles. And upon renewal, we’re able to upsell. And we’re about — this is probably 2,000 to 3,000 customers that fit into this sort of targeted group. We’re probably about halfway through in terms of the customers that come up for renewal. If you remember, our customer — average customer contract length is about 18 months. So this probably runs about 18 months to 2 years kind of a program, but we’re very happy with what we’re seeing with the average uplift on the average sale price.

Ray McDonough: Great. And then maybe if I could, just on compute. Now that the majority of those core data centers are online. Can you talk about how much of the contracted space you filled out and what sort of utilization you’re hoping to achieve as you enter 2024? I know you’re not going to provide any sort of guidance here, but any sort of guidepost in terms of the actual capacity that will be online in ’24 and what the compute pipeline looks like heading into next year to fill that capacity, it would be helpful just to understand kind of the capital needs of that business as we think about ’24.

Ed McGowan: Yes. In terms of the capital, we pretty much now done the major buildout. And of course, we’re big consumers of that ourselves as we move our own applications in-house to Akamai Connected Cloud. And we’ve also got plenty of room to take on major enterprise business. So I don’t think you’ll see a lot of CapEx associated with the big core data centers until we start generating a lot more revenue from that. And then we would build out further. There’ll probably be another couple that we do. What you will see is a relatively smaller amount of CapEx as we do build out into our existing Edge pops. And our goal is to start equipping them with compute so that you can run containers, VMs, Kubernetes and many more cities around the world.

And so that — and more cities than you can do that with, for example, the hyperscalers. And so that will be taking place over the course of the next year, but it’s not a large amount of CapEx, so much smaller than what you saw this year. And then going from there, it will depend on how fast the revenue grows. So it will be a good news story if we’re back next year saying that, okay, great, we fill that up, and now we’re going to be building out some more. So it’s a much better situation than we were in this year where there was a lot of build out getting ready and no revenue yet.

Operator: The next question is from Frank Louthan from Raymond James.

Frank Louthan: Great. Thank you. Can you give us some color on sort of the nature of the compute deals that you’re getting now versus maybe 6 to 12 months ago? And then what have you learned by putting some of your own enterprise-level workloads on the compute platform that you’ve maybe been able to utilize as you sell to customers? And how has that process benefited the product?

Tom Leighton: Yes. Good question. I would say you start going back 6-plus months ago, there really wasn’t a lot of compute deals at that time because the Linode infrastructure really wasn’t ready for it. There was some early experimentation. Now we’re in a position where we really can take on mission-critical applications from big enterprises. We’re starting to do that. Some are starting to grow very nicely. In terms of the learnings, we’ve learned a lot. I would say on the good news side, we’re saving a lot of money. And we’re going to help our customers save a lot of money. We’re also seeing really good performance and better in many cases than we can get with the hyperscalers. And as we go forward, we’ll get — we, of course, have better scalability in terms of faster scalability.

And for Akamai, that’s really important because we have a lot of customers that have flash crowds, peak events and so forth, Hard to predict how big they’ll be. And with our deployed platform, we’re really good at that, of course, with security and with delivery. And now we’re applying those capabilities to compute so that we can spin up more compute instances in a faster, more responsive way. So we’re very happy consumers of our own cloud. Now on the other side, we’ve learned that it’s not just flip a switch. And you just don’t flip a switch and suddenly you’re off the hyperscaler and you’re on to Akamai. And of course, that’s true when you move from any cloud environment into another one, it does take some effort to do it, but it is well, well worth it.

And we’re so a great reference, and we can now help our customers and our partners. We’re working with many partners in cloud so that they can take their customers and get them on to Akamai Connected Cloud.

Operator: Next question is from Tim Horan of Oppenheimer.

Tim Horan: Staying on that point, can you maybe just talk about the backlog and customer interest at this point? Just any update, it sounds like it’s going well. Also, where are you kind of all the value-added services and tools? And I just — maybe just a complete cloud portfolio at this point? And then lastly, could you just remind us what the margins of this business will look like longer term? And I guess we do get asked a lot like why can you sell this cheaper than the cloud providers, I guess, at the end of the day? And will that impact your margins?

Tom Leighton: Okay. A lot of components there. I’ll start with some of them and then probably Ed will fill in with some. Yes, we’re in a lot of really good conversations, as you can imagine, because the world’s major media companies, gaming companies, commerce companies all use Akamai. They had for many, many years. They trust us for scale, reliability, performance, they trust us with security. They trust us not to compete with them. And as they see what we’re building in terms of compute, they like the idea of getting better performance, more distributed compute capabilities. And some of those folks really like the idea of a much lower price point. And as an extra benefit, especially if you’re in media or commerce, it’s getting to be a bigger problem that they’re cutting such giant checks to their leading competitor and sharing all the crown jewels of their data with their leading competitor.

So they’re taking the Akamai solution with great interest, I would say. Now in terms of being cheaper, Akamai has been for a long time, the world’s most distributed platform. We run one of the world’s largest backbones. We have worked for many, many years to be incredibly efficient in terms of moving data around and doing the delivery. And that gives us a real advantage of being able to do this now for compute in a very cost-effective way. Now that said, I am sure that the hyperscalers pay a little bit less for their hardware than we do, probably not a lot less, maybe a little less. But when it comes to everything else, I think Akamai is in an excellent position. And what we’re seeing in the marketplace is that they’ll get their best offer from the hyperscalers, and we can be a lot lower than that and be very profitable at doing it.

And the good news, I think, for Akamai is that here you’ve got a $10-plus billion market growing at 20% a year. And we’re a tiny guy there compared to the hyperscalers. So we can operate at a level that is not threatening to them in any way. They got to worry about each other. And there’s plenty of room for us to take on a lot of revenue at lower price points and very good margins for Akamai. Now in terms of the marketplace, that’s an area, obviously, with the hyperscalers are way ahead some of those folks, every application ever made is available in the marketplace. — as a managed service, we are growing our marketplace. We are growing the tools that are available on Akamai Connected Cloud. And the first applications that we’re targeting are applications that are more easily able to be cloud agnostic, that are not locked in, that aren’t using 20 other applications in the marketplace.

And so that we are much easier to port onto Akamai Connected Cloud. And so there are some applications that won’t be able to report in the near term. But we don’t need all those applications. All we need is to get going as a tiny share of that market. And we’ve identified just, for example, in the media vertical alone, there’s a lot of applications that are amenable to moving to our platform. And of course, a lot of our partners in our marketplace to begin with our media-related companies, for that reason because they’re also threatened by the hyperscalers, and they’re very excited about having media applications beyond Akamai. Ed, do you want to add anything there?

Ed McGowan: Yes. Just a couple of things. Yes, Tom talked a little bit about the leverage we have with the backbone, but we also have a lot of other leverage in the company with our go-to-market, where the focus is going to be initially with our installed base. As Tom talked about in media to start, there’s a tremendous amount. We pretty much work with every major brands. So there’s a lot of leverage from that perspective. Also the people that build and deploy the network are the same people who are building and deploying our CDN network. — and we’re getting leverage with our co-location vendors and things like that. So we — I’ve seen some pretty large proposals go out that get us margins that are pretty similar to the company margins in terms of gross margins that are somewhere between security and delivery and operating margins that potentially could be even greater as we get scale to the bottom line.

So there’s an enormous amount of margins. If you think of the math that we’re doing with how much we’re saving, the amount of capital that we’re deploying and the cost, we’re going to be saving a tremendous amount of money on moving our own applications, and we’ll be able to offer some of that to our customers as well.

Operator: The next question is from Alex Henderson of Needham & Company.

Alex Henderson: Great. I’m rather than astounded that we haven’t heard the word AI, so far in this conference call, at least I don’t think we have. So can you talk a little bit about the impact of AI in terms of your opportunity to bring it to compute? Is it something that you think you can bring to the edge piece? Or is to run on your security — our CDN Edge. And alternatively, is at a risk in the sense that InferenceI is going to be distributed, but a lot of the compute process might be more centralized in that context, diminish the willingness of people to move applications to your compute. So how do I think about the – the infant AI opportunity and the risk of customers being more challenges in moving.

Tom Leighton: Okay. Great question. In fact, there’s a lot of components to this one, too. At a high level, there’s a lot of potential opportunity, I would say. But let me step back just a minute. Akamai has been using AI and machine learning in our products for a long, long time. Obviously, useful for anomaly detection, bot detection, when an entity is accessing their bank account with the right credentials. Is it the right person or not detecting that malware has infected an application inside an enterprise. Lots of ways that we’ve been using AI and machine learning. Now with Gen AI, I think it helps some, but it really helps the attack. It’s much easier now to morph malware into a lot of different forms, makes it harder to detect.

Our teams have created some very nasty bots very quickly using Gen AI. And I think we’re already seeing more penetration as a result of Gen AI. That’s one area where really it is being actively used today. Now on that side of the house, the implications are — there’s more risk in terms of cybersecurity for enterprises. They’re going to get penetrated more. And so you really have to double down on your defense and depth. I think it makes products like [indiscernible] segmentation even more critical because you’re going to get penetrated, the key is to identify it quickly and proactively block the spread. And that — I think when you look at our growth rate there, very, very hot with a market-leading solution. Now you also asked about what about compute and the impact of Gen AI there?

I do think over time, it will suck up a lot more compute. And that’s good for vendors selling compute, like Akamai sales compute. And you’re right, there’s a difference between the generation of the model, which is — if they’re large models, very heavy, and that will be done in core compute and storage data centers. inference engines can run at the edge and will make sense to run at the edge for many applications. And we already have several partners that are porting their AI models on to Akamai for inference engines — and so — and I expect that they will be selling that in our marketplace to other companies. And so in fact, we’re already in a sense, using AI as we put our internal applications on to Akamai Connected Cloud. So I think you will see, over time, a lot of revenue generated there because of all the uses that I think will come about through AI.

Now you ask about risk. I think you will need — you do the model generation in the big data centers. That’s not a risk for Akamai because we’ve got 2 dozen of those today. So that’s — it’s just to be done in a different place. It won’t be done at the edge. But inference engines, yes, a lot of that work will be done at the edge, and we’re in a great place there because other companies don’t have an edge, anything like Akamai..

Operator: Next question is from Abdul Khan of Evercore.

Q – Unidentified Analyst: This is Dua speaking for Abdul. And I just wanted to ask for you broadly on the enterprise spend environment. And I know we’ve previously we’ve noted elongating sales cycles. And I was just generally curious whether there’s any change there. And if you had to characterize it, is enterprise IT spend incrementally worse or better or about the same versus, let’s say, 90 days ago?

Tom Leighton: Yes. Good question. I would say, I think there’s a lot of companies that are being cautious. We have seen a slight uptick in bankruptcies as you typically would see in cycle like this. But we’re not seeing a significant impact certainly in our security business. If anything, we’ve seen better-than-expected results there. So I think security is not as impacted, at least at the moment. Obviously, there’s a lot of speculation out there that we’re heading towards a recession and things can change pretty quickly. But so far, we fared very well. And also, if you think about our messaging around compute, one of the biggest challenges a lot of companies have is the runaway cost of compute, and we offer a very compelling option for people to look to save money and increase their performance by moving to us. So I think that will play into our favor in an environment like this.

Operator: Next question is from Mark Murphy of JPMorgan.

Mark Murphy: Ed, how noticeable or how sudden is the increase that you’re seeing and the sophistication of all these mallware and ransomware attacks. The part of why I was asking is we noticed that you’re launching some scrubbing centers in Canada. And I’m wondering if that’s driving CapEx a little higher to help make sure that you’re able to address all these attacks. And then I have a quick follow-up.

Tom Leighton: Yes, let me just start on the product side, and then Ed will pick up your questions. So ransomware isn’t related to scrubbing centers. scrubbing centers are just restricting the flow of packets and screening out or scrubbing out the packets that are trying to flood any particular resource. And that’s nothing really per se to do with malware and ransomware to filter that out, you need application layer defenses where the scrubbing centers are routing layer defenses. And putting the scrubbing centers in Canada, and we’re actually putting scrubbing centers in many more cities around the world and greatly increasing our capacity so that with local customers there, we can do the scrubbing for them locally. And that gives them better performance while we’re giving them the defense against the volumetric attacks.

For ransomware, you need Gardicor for malware, you need app and API security. And those are different products where they’re done at our edge network in the 4,000 POPs, EdgePops we have around the world. And then, Ed, do you want to pick up the other part of that?

Tom Leighton: Yes, sure. Usually, the — as Tom mentioned, the building of the scrubbing center generally will follow where we see significant demand from customers. And one of the other reasons security is up a bit this year as we have seen an increase in some of these volumetric attacks in the health care sector, a little bit in the financial sector as well. So this is pretty ordinary course for us. So in terms of like the CapEx needs or builds going forward, I’d say this is just ordinary course — there’s really nothing unusual to call out there, but we have seen a bit of a pickup in DDoS, in particular, tends to be a bit more episodic as you see big headline grabbing attacks. We do tend to see a pickup in business. And oftentimes, that will include a scrubbing center build. But they’re pretty well informed with where we’re seeing increased demand.

Mark Murphy: Okay. Understood. And then, Ed, just as a follow-up, did you mention what was the total consideration paid for the acquired contracts from StackPath in Lumin? I’m wondering, I believe those are expected to contribute something like $60 million to $70 million next year in aggregate. Is that — are you taking — like are you assuming a similar ongoing run rate that those contracts had with the prior providers and extrapolating that into next year? Or are you contemplating into that any kind of expansion, contraction, right, or pricing that up or pricing that lower?

Tom Leighton: Sure. Let me start — I’ll take it in different pieces here. So in terms of anticipating any upsell or anything like that with the 200-plus customers, I haven’t factored anything in for that. So that would be upside to the extent that we can do that. Remember, we purchased selected contracts. There are certain contracts that we did not take. There’s, for example, adult content and some of the small medium business customer contracts we didn’t take. So that’s not included. So if you’re looking at other numbers that you may have heard about these companies are private, I’d just caution anybody with private company numbers and other is accurate. We just looked at the contracts that we’re acquiring, what we think will — how many will onboard, what will happen with pricing, how much traffic we’ll keep some of these customers are splitters, so we anticipate some of that traffic may go away.

But we’ve tried to factor all that in. So what we’re trying to do effectively is look at the other side of the integration in terms of the contracts that we acquired, what is that run rate of business that we acquired taking into consideration the best we can, volume and pricing dynamics. In terms of consideration, we’ll file our 10-Q tomorrow, and you’ll see that for STACK PAT, that contract has got an upfront fee of about $35 million, and there’s a small earnout. Also with the TSA agreement, a little wonky accounting here for you, but you have to fair value the TSA and to the extent that there’s excess cost there that goes to the purchase price. So when you see the final 10-K once it’s filed and the cash flow, the numbers may be slightly higher.

On the lumen, it’s about $75 million. There is no earnout there. Same comments on the TSA. There is a fair value analysis you do in purchase accounting. So that might be slightly higher. But that’s the extent of the agreements.

Operator: The next question is from Rishi Jaluria of RBC.

Rishi Jaluria: One wanted to follow up on 2 earlier questions that were asked, one on AI and then one on the contracts. Thinking specifically around AI, Tom, I appreciate your answer earlier. If we think about the opportunity to do inferencing at the edge, especially for cases like connecting devices or med tech or financial services now that people are increasingly worried about data and data residency. Can you speak to a little bit of your opportunity for that? And maybe alongside that, what investments do you need to make both in the software stack as well as in hardware infrastructure, be it GPUs or anything else to really capitalize and get your fair share of that opportunity? And then I’ve got a quick follow-up.

Tom Leighton: Great. Yes, the data residency, data sovereignty issues are increasingly important, as I imagine you know, — and that’s where Akamai has a great opportunity because we’re in 130 different countries with our infrastructure. And as we move compute into our edge pops, that enables us to do the work locally, keep the data local, which is an exciting opportunity for us. And I think in the not-too-distant future, we’ll be in locations and countries that even the hyperscalers aren’t there. Now in terms of the work on the software stack to be able to do that, that is ongoing work now. We are actually already in beta with a few customers — so we’re pretty far along. And then next year, as I mentioned, there’ll be relatively small amount of CapEx as we do build out in a nontrivial number of our edge pops to be able to support compute.

Now today, at the edge, I don’t — we support GPUs today, but that would be more in the core data centers. I think for the inference engines, we’re running that just fine on CPUs. And so as we look at the edge, where you’d be running the inference engines, I don’t, I think, run on CPUs and be much more cost-effective than trying to buy GPUs or custom hardware there. I think where you might see that as more if you’re working with large-scale model development. And then that would be in the core data centers. That wouldn’t be at the edge. The edge is where you want to do the inferencing. And that’s — it seems like that’s going to be working very well on our edge platform with CPUs.

Rishi Jaluria: Got it. That’s really helpful. And then just in terms of the StackPath and Lumen contracts, again, I appreciate the color in terms of your set of assumptions. Can you walk us through what you can do on your part to ensure those customers, whether they’re net new or existing Akamai customers that maybe we’re trying to use a multi-CDN approach, what you can do to get those customers to stay and to not turn off on to other competitors or even just kind of figure out how to reduce the peaty.

Tom Leighton: Yes. Good question. I think first is the approach that we took, right? We got an inbound request from these 2 companies, and some of them are customers we know and have had a long relationship with. And providing an orderly transition is step 1 in the relationship, right? So now you get a warm relationship and introduction to it’s a new customer, and certainly, for the customers that we have. They obviously know us — and you get — instead of having a jump ball in the open market, you have a chance to sit down with the customer and understand what their needs are, understand what’s going on with their contracts, length of contracts, pricing, et cetera. And you could just set up a relationship and just go through a normal sales cycle effectively.

I think we’ve got a pretty good track record, and I’m certainly understanding the customers. And if I think about sort of the weighted average of where the revenue is, we’ve obviously gone and talked to a lot of those customers. We obviously have had a long-term relationship with a lot of these folks. So I think we have a fairly high degree of confidence in the numbers that we’ve put out. Obviously, things can change. But based on our experience with a lot of these folks and with some of these new folks that we have not worked with us in the past, we have an awful lot of other services to offer that they didn’t have before. And especially with security being such a big topic these days. We’re hearing from some of these customers that they’re glad that they have a relationship with us now.

Operator: The next question is from Ruby Kessinger of D.A. Davidson.

Ruby Kessinger: Ed, I just want to quantify the TSA impact. It seems to be about 1.5 points impact cash gross margins in Q4. Is that accurate? And just to be clear, it sounds like that, that TSA ends at year-end? Or when exactly does that TSA add?

Tom Leighton: Yes. So there might be just a tiny bit that goes into Q1 just depending on how the migration goes. Hopefully, we can be done with it by the next couple of months. Yes, it’s just under 1.5 points. I rounded down to a point, but you’re right. If you just take the amount divided by the revenue, it’s about 1.3%, 1.4%.

Ruby Kessinger: Okay. Got it. And then if I just look at your delivery guidance, which, I guess, is implied by your compute security revenue guidance, and then I back out the expected $17 million to $20 million of revenue from Lumin and StackPath in Q4, it implies delivery revenue flat to down in Q4 versus Q3. So is any extra conservatism in the Q4 delivery guide just based on what you’re seeing from traffic trends or any pricing pressure to call out? Or why not — why aren’t we seeing a typical seasonal Q4 uplift in delivery revenue ex those acquisitions.

Tom Leighton: Yes. That’s a good question. First of all, there’s $4 million of delivery in the Q4 number so that you have to look at the net delta between the 2. Also, there’s about an $8 million headwind from FX. So there is some implied growth in the delivery number. As I talked about there’s a high degree of uncertainty in Q4 as it relates to traffic, right? You’ve got — typically, we see a big seasonality in terms of retail and the media side of the business. Retail as we’ve gone to 0 overage is less impactful. We do still see some bursting. I think we’re being probably a bit more cautious, especially on the commerce side of the equation for now. But there is some implied growth in there as you factor in those other 2 items I just mentioned.

Ruby Kessinger: Okay. That’s helpful.

Operator: The next question is from William Power of Baird.

Q – Unidentified Analyst: This is Yan Simoes on for Will. So first of all, just looking at delivery, how are you thinking about Q4 delivery trends this year versus normal seasonality given all the questions around the consumer and media activity in general? Any color there would be great.

Tom Leighton: Yes. As I just mentioned on the last question that we’re probably a bit more cautious in terms of our outlook certainly with retail. I mentioned earlier in an earlier question that we’ve seen an uptick in bankruptcies. We do have a lot of customers that are on the 0 overage for commerce. So we’re going into disease. We haven’t seen it yet. It usually starts right after Thanksgiving. We’re just being a bit more cautious. And in terms of the media cycle, — we did see a little bit of gaming activity. Gaming has been light for the last 1.5 years. A couple of years ago, we saw a big console refresh cycle. We don’t — not expected to see that. So I’d say we’re going into this quarter, probably a bit more cautious than we normally have in Q4 and certainly what we’ve seen in the past.

Operator: The next question is from Michael Elias of TD Cowen.

Michael Elias: First, earlier you talked about portability, particularly for cloud-agnostic workloads. I guess my question for you is, as you think about moving and garnering more share here, what are the steps that you could do to pretty much increase the ease of portability of workloads? And as part of that, through your data center deployments, do you have essentially direct cross connect into the cloud on ramps of the major cloud providers to essentially help facilitate the movement of workloads to your platform? And then I have a quick follow-up.

Tom Leighton: Yes. Great question. I think partners are really helpful there because they do a lot of the work in the first place to get into the third-party cloud provider. And today, some of them move between third-party cloud providers. And so there is a natural partner ecosystem that can be helpful porting that to Akamai. And I think they’re finding that the terms are even more favorable for them as well as for the partners. Also, as we grow the ecosystem of third-party capabilities, which with our qualified compute partner program we’re doing early focus on media there, which is our initial focus in terms of applications to move to Akamai. And yes, what it depends on the data center and the third-party cloud provider, but we do have direct connections in many cases.

And of course, we operate, as I mentioned, one of the world’s largest backbones and in a position to also make direct connections to major enterprises, which can help quite a bit. And then just as a quick follow-up. Just curious if you could talk a little bit about the M&A environment that you’re seeing. I know you have that your security growth guidance that you gave at your Analyst Day, which includes some M&A. Just curious, any thoughts around the M&A environment, particularly for security? And maybe as part of that, just comments on valuation. Yes, valuations in the companies that we’re most interested in are still extremely high. And you see some of the recent acquisitions that have been done at very high revenue multiples. So not a lot of change yet.

Probably at the fringes, it’s getting harder. But for companies that we have an interest in, I’d not say it’s made a lot of improvement yet. That may change with time. We just have to see. It’s something we keep a close eye on. Of course, we’re always looking, but we’re very disciplined buyers. So it really has to make very good sense for our customers and for our shareholders. Operator, we have time for one more, please.

Operator: The last question is from Jeff Van Rhee of Craig Hallum.

Jeff Van Rhee: Just one quick one on compute, Kind of getting to the inflection or the acceleration in growth. I have a couple of questions. Just on sales cycles there, refractory, what is the typical sales cycle for a compute deal? And then secondly, with the bulk of the build-out done, and it sounds like functionality isn’t the limiter, then it’s really just getting to maturity of these sales cycles. The sales force has trained the functionalities there, the infrastructure is there. So it looks like Q4 builds in organic growth roughly similar to Q3. So just trying to get a sense of timing of acceleration there.

Tom Leighton: Yes. Good question. There is the sales cycle. But when you close the deal, then there’s the effort to actually port it and then the time to grow it. And so it’s not like maybe one of a normal service or sell delivery were very quick to to port the business and turn it up. It can — that can happen in a period of days to weeks. Here, probably it’s more months to actually get the app corded. And then all the traffic or all the compute won’t move over all at once. You wouldn’t be growing it over time. So it will — this is something you’ll see, I think, throughout next year as we close customers and then we grow their revenue. And the early signings we did this year, that’s exactly what we’re seeing, initially very small amounts of revenue, relatively speaking, and then grows over time.

Jeff Van Rhee: Okay. Well, thank you, everyone. In closing, we will be presenting at a number of investor conferences and events throughout the rest of the year. Details of these can be found in the Investor Relations section of Rockmy.con. Again, thank you for joining us, and all of us here at Akamai wish you and yours a wonderful rest of the year. Have a nice evening.

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.+

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Q3 2023

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