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Open a video on ESPN.com or Hulu and there's a good chance Akamai Technologies' (AKAM) software and servers are working behind the scenes. The company is the leader in the booming business of helping websites stream content. Researcher comScore (SCOR) estimates that people watched 35.7 billion online videos in June in the U.S., up from 19.5 billion a year earlier. Akamai and its competitors will have sales of about $600 million from online video this year, up 20 percent from 2009, estimates research firm Frost & Sullivan.
Akamai was the best-performing stock in the S&P 500 this year up to July 28, climbing 74 percent.
That's when investors did a U-turn, sending Akamai down by 13 percent over two days. The reason: Akamai said its second-quarter margin before interest, taxes, depreciation, and amortization had dropped 2 percentage points from a year earlier, to 46 percent, and could thin even more next quarter. (Akamai's stock has bounced back 11 percent since July 29, and is No. 2 on the S&P year to date.)
The narrower margin came from increased spending on equipment and new hires, and falling prices. Website owners typically pay Akamai based on the volume of digital content, measured in gigabytes, called up by users. The average price websites pay to stream video fell 40 percent to 45 percent in 2009 and is on track to decline another 25 percent this year, estimates Frost & Sullivan. The causes of the drop are Moore's Law—the number of transistors on a chip doubles every 18 months, making computers cheaper and more powerful over time—and competition. Once the only significant player in delivering online video, Akamai has faced increased pressure from newer entrants such as Level 3 Communications (LVLT) and Limelight Networks (LLNW), says Frost & Sullivan analyst Dan Rayburn. Delivering online video "is becoming much more of a commodity business," says Jim Louderback, CEO of video site Revision3, which uses Akamai competitor BitGravity to stream shows it produces over the Web.
Paul Sagan, Akamai's chief executive officer, says price wars don't mean commoditization. "I don't agree there is a fundamentally new pricing dynamic," he says. "Unit prices fall every year as volumes grow. If this were a mature, saturated business that would be a concern. We're at about 1 percent of the opportunity that has been tapped."
The most promising area of growth, Sagan says, may be high-definition video, which has just started arriving on PCs. About 7 percent of all videos watched on the Web are in high-definition, up from 3.5 percent last year, according to researcher IDC, and by 2014 one-third of all online video will be HD. Frost & Sullivan says Akamai charges a customer like Netflix about 5 cents for an HD movie, compared with about 3 cents for standard definition. "We're right on the cusp of rapid adoption" of HD, Sagan says.
During this year's World Cup, Akamai delivered live feeds of soccer matches to the websites of two dozen broadcasters worldwide, including ESPN and the BBC. Sagan says most viewers opted for high def. HD "is almost a requirement at this point in the sports field," says Eric Black, director of digital operations for NBC Sports.
"The majority of major broadcasters used us to deliver the World Cup in HD," says Sagan. "To me, that's not the definition of a commodity at all."
The bottom line: While demand for streaming video spikes, Akamai faces challenges as competition forces down prices. HD video may help its margins.