UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission File number 0-27275

 

Akamai Technologies, Inc.
(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code:  (617) 444-3000

 

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, $.01 par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ  No o

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o  No þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

Large accelerated filer  þ     Accelerated Filer  o     Non-accelerated filer  o

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  þ  No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes o   No þ

 

The aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant was approximately $1,638 million based on the last reported sale price of the common stock on the Nasdaq National Market on June 30, 2005.

 

The number of shares outstanding of the registrant’s Common Stock, par value $0.01 per share, as of March 10, 2006: 154,012,668 shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission relative to the registrant’s 2006 Annual Meeting of Stockholders to be held on May 23, 2006 are incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III of this annual report on Form 10-K.

 

 

AKAMAI TECHNOLOGIES, INC.

 

ANNUAL REPORT ON FORM 10-K

 

For the Fiscal Year Ended December 31, 2005

 

TABLE OF CONTENTS

 

 

This report contains “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 based on information currently available to our management. Use of words such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “should,” “likely” or similar expressions, indicate a forward-looking statement. Certain of the information contained in this annual report on Form 10-K consists of forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements include, but are not limited to, those set forth under the heading “Risk Factors.”

 

Overview

 

Akamai provides services for accelerating and improving the delivery of content and applications over the Internet. Our solutions are designed to help businesses, government agencies and other enterprises enhance their revenue streams and reduce costs by maximizing the performance of their online businesses. By advancing the performance and reliability of their websites, our customers can improve visitor experiences and increase the effectiveness of Web-based campaigns and operations. Through the Akamai EdgePlatform, the technological platform of Akamai’s business solutions, our customers are able to utilize Akamai’s infrastructure and reduce expenses associated with internal infrastructure build-ups.

 

We began selling our content delivery services in 1999 under the trade name FreeFlow^®. Later that year, we added streaming media delivery services to our portfolio and introduced traffic management services that allow customers to monitor traffic patterns on their websites both on a continual basis and for specific events. In 2000, we began offering a software solution that identifies the geographic location and network origin from which end users access our customers’ websites, enabling content providers to customize content without compromising user privacy. In 2001, we commenced commercial sales of our EdgeSuite^® offering, a suite of services that allows for high-performance and dynamic delivery of web content. In 2003, we began offering on a commercial basis our EdgeComputing^® service, which enables Web-based delivery of applications, such as store/dealer locators, promotional contests, search functionalities and user registration, over our network. In 2004, we packaged a number of services and specialized features to tailor solutions to the needs of specific vertical market segments, such as media and entertainment, software downloads and online commerce. In particular, Akamai’s Media Delivery services are aimed at addressing the rapid increase in use of the Internet for delivery of music, sporting events and other types of audio and video entertainment. In 2005, we began commercial sales of our Web Application Accelerator service, which is designed to improve the performance of Web- and IP-based applications through a combination of dynamic caching, compression of large packets, routing and connection optimization. We also introduced two free, publicly-available information tools: the Akamai Net Usage Index for Retail, which measures Internet traffic to selected retail sites, and the Akamai Net Usage Index for News, which tracks online consumption of news at selected news sites and portals.

 

We were incorporated in Delaware in 1998 and have our corporate headquarters at 8 Cambridge Center, Cambridge, Massachusetts. Our Internet website address is www.akamai.com. We are not including the information contained on our website as part of, or incorporating it by reference into, this annual report on Form 10-K.

 

We are registered as a reporting company under the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act. Accordingly, we file or furnish with the Securities and Exchange Commission, or the Commission, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K as required by the Exchange Act and the rules and regulations of the Commission. We refer to these reports as Periodic Reports. The public may read and copy any Periodic Reports or other materials we file with the Commission at the Commission’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room is available by calling 1-800-SEC-0330. In addition, the Commission maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers, such as Akamai, that file electronically with the Commission. The address of this website is http://www.sec.gov.

We make available, free of charge, on or through our Internet website our periodic reports and amendments to those periodic reports as soon as reasonably practicable after we electronically file them with the Commission. The address of this website is www.akamai.com.

 

New Developments in 2005

 

On June 10, 2005, we acquired Speedera Networks, Inc., or Speedera, in a merger transaction. Speedera provided distributed content delivery services. This acquisition increased our customer base, added additional services to our suite of offerings and brought to our team talented employees in both the United States and India to augment our research and development and marketing groups. In the merger, we acquired all of the outstanding common and preferred stock, including vested and unvested stock options, of Speedera in exchange for approximately 10.6 million shares of Akamai common stock and options to purchase 1.7 million shares of Akamai common stock.

 

On April 1, 2005, Paul Sagan became our Chief Executive Officer, succeeding George Conrades who remains with Akamai as our Executive Chairman.

 

On September 7, 2005, we redeemed all of the $56.6 million in remaining principal amount of our 5.5% convertible subordinated notes due 2007 under the terms of the indenture governing notes. The redemption price was 101.571% of the principal amount of the notes plus accrued interest to September 7, 2005.

 

On November 3, 2005, we closed an underwritten public offering of 12 million shares of our common stock, which generated $202.1 million in net proceeds.

 

Meeting the Challenges of the Internet

 

The Internet has matured into a key tool for companies, public sector agencies and other entities to conduct business and reach the public. The Internet, however, is a complex system of networks that was not originally created to accommodate the volume or sophistication of today’s business communication demands. As a result, information is frequently delayed or lost on its way through the Internet due to many challenges, including:

 

 

In addition to the challenges inherent in the Internet, companies and other entities face internal technology challenges. Driven by competition, globalization and cost-containment strategies, companies need an agile Internet-facing infrastructure that cost-effectively meets real-time strategic and business objectives. For example, as public sector agencies migrate more and more of their processes from in-person, mail, or phone services to Internet-based applications, it has become essential that their websites be more reliable and that they deliver their content and applications more efficiently to their constituents. At the same time, budget limitations may preclude public sector agencies from developing their own infrastructure for Internet-facing applications. Enterprises of all types are confronted with the increasingly widespread use of broadband connectivity leading to more users requesting more varied types of rich content. As a result, there is greater stress on centralized infrastructures.

 

To address these challenges, Akamai has developed solutions that are designed to help companies and government agencies increase revenues and reduce costs by improving the performance, reliability and security of their Internet-facing operations.

 

Superior Performance.  Commercial enterprises invest in websites to attract customers, transact business and provide information about themselves. If, however, a company’s Internet site fails to provide visitors with a fast and dependable experience, they will likely abandon that site, potentially leading to lost revenues and damage to the enterprise’s reputation. Akamai’s EdgePlatform is designed to reduce or eliminate downtime and poor performance of a customer’s Website and applications. Through a combination of people, processes and technology, Akamai

offers solutions designed to achieve reliability, stability and predictability without the need for our customers to spend a lot of money to develop their own Internet-related infrastructure. Instead, we have a presence in hundreds of networks around the world so that content can be delivered from Akamai servers located closer to website visitors — from what we call, the “edge” of the Internet. We are thus able to reduce the impact of traffic congestion, bandwidth constraints and capacity limitations. At the same time, our customers have access to control features to enable them to provide content to end users that is current and customized for visitors accessing the site from different parts of the world.

 

Scalability.  We believe that scalability is one of the keys to reliability. Many Akamai customers experience seasonal or erratic demand for access to their websites. More generally, almost all websites experience demand peaks at different points during the day. In both instances, it can be difficult and expensive to plan for, and deploy solutions against, such peaks and valleys. Linking thousands of servers in hundreds of networks around the world, the Akamai EdgePlatform is designed with the robustness and flexibility to handle planned and unplanned traffic peaks without additional hardware investment and configuration on the part of our customers. As a result, we are able to provide an on demand solution to address our customers’ capacity needs in the face of unpredictable traffic spikes, which helps them avoid expensive investment in a centralized infrastructure.

 

Security.  Security may be the most significant challenge facing use of the Internet for business and government processes because security threats — in the form of attacks, viruses, worms and intrusions — can impact every measure of performance, including information security, speed, reliability and customer confidence. Unlike traditional security strategies that can impact performance negatively, Akamai’s EdgePlatform is designed to allow for proactive monitoring and rapid response to security incidents and anomalies. We rely on both built-in defense mechanisms and the ability to route traffic around potential security issues so performance is not compromised. Perhaps most significantly, our distributed network of thousands of servers is designed to eliminate a single point of failure and can reduce the impact of attacks.

 

Our Solutions

 

With the EdgePlatform as our backbone, we offer services and solutions for content and application delivery, application performance services, on demand managed services and business performance management services.

 

  The Akamai EdgePlatform

 

Akamai’s EdgePlatform is the foundation of our business solutions. We believe Akamai has deployed the world’s largest globally distributed computing platform, with thousands of servers located in hundreds of networks around the world. Leveraging this platform, we deliver our customers’ content and computing applications across a system of widely distributed networks of servers; the content and applications are then processed at the most efficient places within the network. Servers are deployed in networks ranging from large, backbone network providers to medium and small ISPs to cable modem and satellite providers to universities and other networks. We also have more than 500 peering relationships that provide us with direct paths to end user networks, reducing data loss, while also giving us more options for delivery during network congestion or failures.

 

To make this wide-reaching deployment effective, the EdgePlatform includes specialized technologies, such as advanced routing, load balancing, data collection and monitoring. Our intelligent routing software is designed to ensure that website visitors experience fast page loading, access to applications and content assembly wherever they are on the Internet, regardless of global or local traffic conditions. Dedicated professionals staff our Network Operations Control Center on a 24/7 basis to monitor and react to Internet traffic patterns and trends. We deploy frequent enhancements to our software globally to introduce new service offerings and to ensure that our network continues to run effectively. Technology updates are replicated across the system. Customers are also able to control the extent of their use of Akamai services to scale on demand, using as much or as little capacity of the global platform as they require, to support widely varying traffic and rapid e-business growth without expensive and complex infrastructure build-out.

  Content Delivery Services

 

Akamai’s EdgeSuite service and related content delivery offerings have represented the core of our business since our founding. Leveraging the EdgePlatform, our EdgeSuite service is designed to enable enterprises to improve the end-user experience, boost reliability and scalability and reduce the cost of Internet-related infrastructure. By providing the benefits of distributed performance to an enterprise’s entire website, we are able to provide our customers with a more efficient way to implement and maintain a global Internet presence. While site owners maintain a source copy of their content and applications, EdgeSuite provides global delivery, load balancing and storage of these content and applications, enabling businesses to focus valuable resources on strategic matters, rather than technical infrastructure issues.

 

Customers of our EdgeSuite service also have access to advanced service features such as:

 

 

  Akamai Media Delivery

 

We believe that the demand for Internet access to media of all types—music, movies, games, streaming news and quotes and more—is growing rapidly; however, there are many challenges to successfully monetizing media assets online. In particular, media companies need cost-effective means to deliver large files to millions of users in different formats compatible with multiple end-user devices and platforms. The Akamai Media Delivery service is designed to provide a solution to many of the challenges of media delivery over the Internet by helping media industry clients bypass traditional server and bandwidth limitations to better handle peak traffic conditions and large file sizes. We support all major streaming formats, and the EdgePlatform provides capacity levels that individual enterprises cannot cost-effectively replicate on their own.

 

  Akamai Electronic Software Delivery

 

Internet traffic conditions and high loads can dramatically impact software download speed and reliability. Furthermore, surges in traffic from product launches or distribution of security updates can overwhelm traditional software delivery infrastructure, impacting Web site performance and causing users to be unable to download software. Our Electronic Software Delivery service is designed to leverage the Akamai EdgePlatform to provide capacity for large surges in traffic related to software launches and other distributions with a goal of improved customer experiences, increased use of electronic delivery and successful product launches.

 

  Application Performance Services

 

Application performance services are designed to improve the performance of highly dynamic content common on corporate extranets and wide area networks. Traditionally, this market has been addressed primarily by hardware and software products. We believe our managed service approach offers a more cost-effective and comprehensive solution in this area without requiring customers to make significant infrastructure investments. In addition to reducing infrastructure costs, our customers can offer more effective and reliable portal applications and other Web-based systems for communicating with their customers, employees and business partners.

In 2005, Akamai began commercial sales of our Web Application Accelerator service, which is designed to improve the performance of Web- and IP-based applications through a combination of dynamic caching, compression, routing and connection optimization. Customers are using this service to run applications such as online airline reservations systems, course planning tools, customer order processing and human resources applications. By tying such applications to the Akamai EdgePlatform, customers can enjoy improved performance through connection and route optimization techniques that avoid problem spots on the Internet or otherwise accelerate delivery of applications without having to undertake significant internal infrastructure build-out.

 

In addition, our Global Traffic Management solution is designed to provide application performance improvement for companies with mirrored websites that require traffic management for multiple application servers and databases. With Global Traffic Management, enterprises and organizations with a geographically distributed Web infrastructure can take advantage of real-time Internet performance information to distribute incoming requests to an optimal website.

 

  On Demand Managed Services

 

Akamai’s on demand managed services, including our EdgeComputing and on demand application offerings, enable enterprises to reduce the need for an internal infrastructure to handle unpredictable levels of Internet traffic. With access to the EdgePlatform, customers are able to rapidly launch and deploy new applications worldwide, with on demand availability and scalability on a cost-effective basis. For example, Akamai On Demand Events provides an on demand platform for running promotional websites — through Macromedia Flash^® promotions, site search, sweepstakes, polls, regional offers or other innovative applications that create a positive brand experience.

 

Akamai’s EdgeComputing service enables enterprises to deliver Java (J2EE) Web applications that scale on demand and are designed to perform faster and more reliably worldwide than a customer’s own internal information technology, or IT, infrastructure. At the same time, this reduces the demands on our customers’ IT infrastructures and simplifies their support requirements. By enabling Internet-based applications that improve promotion and sales, customer service, and vendor and partner management, our customers are better positioned to compete more effectively and reduce business costs.

 

  Business Performance Management Services

 

Akamai’s offerings in this area include our network data feeds and our Web analytics offering, which provide customers with real time data about the performance of their content and applications over the Internet and on the EdgePlatform. In addition, our business performance management services help customers better understand their Web operations through relevant, timely information with tools that measure all aspects of an application’s performance. For example, a customer could use website data feeds from Akamai’s customer portal to assist in managing costs and budget. The core of these offerings lies in our EdgeControl^SM tools, which provide comprehensive reporting and management capabilities.

 

EdgeControl tools can be integrated with existing enterprise management systems, allowing our customers to manage their distributed content and applications via a common interface. EdgeControl also provides integration with third party network management tools, including those offered by IBM, Hewlett-Packard and BMC Software. Having created one of the industry’s first examples of a commercially proven utility computing platform, Akamai now provides a global network of servers that can be utilized by a customer on demand, allowing our customers to manage usage, troubleshooting, monitoring and reporting, based on their individual business requirements.

 

  Custom Solutions

 

In addition to our core commercial services, we are able to leverage the expertise of our technology, networks and support personnel to provide custom solutions to both commercial and government customers. These solutions include replicating our core technologies to facilitate content delivery behind the firewall, combinations of our technology with that of other providers to create unique solutions for specific customers and support for mission-critical applications that rely on the Internet and intranets. Additionally, numerous federal government agencies look to Akamai for information about traffic conditions and activity on the Internet and tailored solutions to their content delivery needs.

Business Segments and Geographic Information

 

We operate in one business segment: providing services for accelerating delivery of content and applications over the Internet. For the years ended December 31, 2005, 2004 and 2003 , approximately 21%, 19% and 16%, respectively, of revenues was derived from our operations outside the United States, of which 16%, 14% and 13% of overall revenues, respectively, was derived from Europe. No single country outside of the United States accounted for 10% or more of our revenues in any of such years. Revenue from services accounted for 99%, 98% and 98% of our total revenues for the years ended December 31, 2005, 2004 and 2003, respectively. For more segment and geographic information, including revenue from customers, a measure of profit or loss and total assets, see our consolidated financial statements included in this annual report on Form 10-K, including Note 20 thereto.

 

Customers

 

Our customer base is centered on enterprises. As of December 31, 2005, our customers included many of the world’s leading corporations, including Airbus, Apple Computer, Inc., Best Buy.com, Inc. FedEx Corporation, L’Oreal, Microsoft Corporation, MTV Networks, Sony Ericsson Mobile Communications, Victoria’s Secret and XM Satellite Radio. We also actively sell to government agencies. As of December 31, 2005, our public sector customers included the Federal Emergency Management Agency, U.S. Centers for Disease Control and Prevention, the U.S. Department of Defense, U.S. Department of Labor, the U.S. Food and Drug Administration and the U.S. Geological Survey’s Earthquake Hazards Program. No customer accounted for 10% or more of total revenues for the year ended December 31, 2005. For the years ended December 31, 2004 and 2003, Microsoft Corporation accounted for 10% and 15% of total revenues, respectively. Less than 10% of our total revenues in each of 2003, 2004 and 2005 was derived from contracts or subcontracts terminable at the election of the federal government, and we do not expect such contracts to account for more than 10% of our total revenues in 2006.

 

Sales, Service and Marketing

 

Our sales and service professionals are located in 9 offices in the United States with additional locations in Europe and Asia. We market and sell our services and solutions domestically and internationally through our direct sales and services organization and through more than 40 active resellers including Electronic Data Systems Corporation, IBM, InterNap Network Services Corporation, MCI and Telefonica Group. In addition to entering into agreements with reseller partners, we have several other types of sales- and marketing-focused alliances, with entities such as system integrators, application service providers, sales agents and referral partners. By aligning with these companies, we are better able to market our services and encourage increased adoption of our technology throughout the industry.

 

Our sales and service organization includes employees in direct and channel sales, professional services, account management and technical consulting. As of December 31, 2005, we had approximately 286 employees in our sales and support organization, including 89 direct sales representatives whose performance is measured on the basis of achievement of quota objectives. Our ability to achieve revenue growth in the future will depend in large part on whether we successfully recruit, train and retain sufficient sales, technical and global services personnel, and how well we establish and maintain relationships with our strategic partners. We believe that the complexity of our services will continue to require a number of highly trained global sales and services personnel.

 

To support our sales efforts and promote the Akamai brand, we conduct comprehensive marketing programs. Our marketing strategies include an active public relations campaign, print advertisements, on-line advertisements, trade shows, strategic partnerships and on-going customer communication programs. As of December 31, 2005, we had 57 employees in our global marketing organization.

 

Research and Development

 

Our research and development personnel are continuously undertaking efforts to enhance and improve our existing services, strengthen our network and create new services in response to our customers’ needs and market demand. As of December 31, 2005, we had approximately 204 research and development engineers, many of whom hold advanced degrees in their field. Our research and development expenses were $18.1 million, $12.1 million and $13.0 million for the years ended December 31, 2005, 2004 and 2003, respectively. In addition, for each of the years

ended December 31, 2005, 2004 and 2003, we capitalized $8.5 million, $7.5 million and $7.5 million, respectively, net of impairments, of external consulting and payroll and payroll-related costs related to the development of internal-use software used to deliver our services and operate our network.

 

Competition

 

The market for our services is intensely competitive and characterized by rapidly changing technology, evolving industry standards and frequent new product and service installations. We expect competition for our services to increase both from existing competitors and new market entrants. We compete primarily on the basis of:

 

 

We compete primarily with companies offering products and services that address Internet performance problems, including companies that provide Internet content delivery and hosting services, streaming content delivery services and equipment-based solutions to Internet performance problems, such as load balancers and server switches. Some of these companies resell our services. In addition, potential customers may decide to purchase or develop their own hardware, software and other technology solutions rather than rely on an external managed services provider like Akamai.

 

Proprietary Rights and Licensing

 

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing on the proprietary rights of others. We rely on a combination of patent, trademark, trade secret and copyright laws and contractual restrictions to protect the proprietary aspects of our technology. We currently have numerous issued United States and foreign-country patents covering our content delivery technology, and we have numerous additional patent applications pending. Our issued patents extend to various dates between approximately 2015 and 2020. In October 1998, we entered into a license agreement with the Massachusetts Institute of Technology, or MIT, under which we were granted a royalty-free, worldwide right to use and sublicense the intellectual property rights of MIT under various patent applications and copyrights relating to Internet content delivery technology. Two of these patent applications have now been issued. These patents will expire in 2018. We seek to limit disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our source code.

 

Employees

 

As of December 31, 2005, we had a total of 784 full-time and part-time employees. Our future success will depend in part on our ability to attract, retain and motivate highly qualified technical and management personnel for whom competition is intense. Our employees are not represented by any collective bargaining unit. We believe our relations with our employees are good.

 

The following are certain of the important factors that could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this annual report on Form 10-K or presented elsewhere by management from time to time.

The markets in which we operate are highly competitive, and we may be unable to compete successfully against new entrants with innovative approaches and established companies with greater resources.

 

We compete in markets that are intensely competitive, highly fragmented and rapidly changing. We have experienced and expect to continue to experience increased competition. Many of our current competitors, as well as a number of our potential competitors, have longer operating histories, greater name recognition, broader customer relationships and industry alliances and substantially greater financial, technical and marketing resources than we do. Other competitors may attract customers by offering less-sophisticated versions of services than we provide at lower prices than those we charge. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Some of our current or potential competitors may bundle their offerings with other services, software or hardware in a manner that may discourage website owners from purchasing any service we offer. Increased competition could result in price and revenue reductions, loss of customers and loss of market share, which could materially and adversely affect our business, financial condition and results of operations.

 

In addition, potential customers may decide to purchase or develop their own hardware, software and other technology solutions rather than rely on an external provider like Akamai. As a result, our competitors include hardware manufacturers, software companies and other entities that offer Internet-related solutions that are not service-based competitors. It is an important component of our growth strategy to educate enterprises and government agencies about our services and convince them to entrust their content and applications to an external service provider, and Akamai in particular. If we are unsuccessful in such efforts, our business, financial condition and results of operations could suffer.

 

If we are unable to sell our services at acceptable prices relative to our costs, our business and financial results are likely to suffer.

 

Prices we have been charging for some of our services have declined in recent years. We expect that this decline may continue in the future as a result of, among other things, existing and new competition in the markets we serve. Consequently, our historical revenue rates may not be indicative of future revenues based on comparable traffic volumes. If we are unable to sell our services at acceptable prices relative to our costs or if we are unsuccessful with our strategy of selling additional services and features to our existing content delivery customers, our revenues and gross margins will decrease, and our business and financial results will suffer.

 

Failure to increase our revenues and keep our expenses consistent with revenues could prevent us from maintaining profitability at recent levels or at all.

 

The year ended December 31, 2004 was the first fiscal year during which we achieved profitability as measured in accordance with accounting principles generally accepted in the United States of America. We have large fixed expenses, and we expect to continue to incur significant bandwidth, sales and marketing, product development, administrative and other expenses. Therefore, we will need to generate higher revenues to maintain profitability at recent levels or at all. There are numerous factors that could, alone or in combination with other factors, impede our ability to increase revenues and/or moderate expenses, including:

 

 

 

Future changes in financial accounting standards may adversely affect our reported results of operations.

 

A change in accounting standards can have a significant effect on our reported results. New accounting pronouncements and interpretations of accounting pronouncements have occurred and may occur in the future. These new accounting pronouncements may adversely affect our reported financial results. For example, beginning in 2006, under Statement of Financial Accounting Standards No. 123R, or SFAS No. 123R, we will be required to account for our stock-based awards as a compensation expense and our net income and net income per share will be significantly reduced. Previously, we have recorded compensation expense only in connection with option grants that have an exercise price below fair market value. For option grants that have an exercise price at fair market value, we calculated compensation expense and disclosed their impact on net income (loss) and net income (loss) per share, as well as the impact of all stock-based compensation expense in a footnote to the consolidated financial statements. SFAS No. 123R requires us to adopt the new accounting provisions beginning in our first quarter of 2006, and will require us to expense stock-based awards, including shares issued under our employee stock purchase plan, stock options, restricted stock and stock appreciation rights, as compensation cost. As a result, our earnings per share is likely to be significantly lower even if our revenues increase.

 

If we are unable to develop new services and enhancements to existing services, and if we fail to predict and respond to emerging technological trends and customers’ changing needs, our operating results may suffer.

 

The market for our services is characterized by rapidly changing technology, evolving industry standards and new product and service introductions. Our operating results depend on our ability to develop and introduce new services into existing and emerging markets. The process of developing new technologies is complex and uncertain; we must commit significant resources to developing new services or enhancements to our existing services before knowing whether our investments will result in services the market will accept. Furthermore, we may not execute successfully our technology initiatives because of errors in planning or timing, technical hurdles that we fail to overcome in a timely fashion, misunderstandings about market demand or a lack of appropriate resources. Failures in execution or market acceptance of new services we introduce could result in competitors providing those solutions before we do and, consequently, loss of market share, revenues and earnings.

 

Any unplanned interruption in the functioning of our network or services could lead to significant costs and disruptions that could reduce our revenues and harm our business, financial results and reputation.

 

Our business is dependent on providing our customers with fast, efficient and reliable distribution of application and content delivery services over the Internet. For our core services, we currently provide a standard guarantee that our networks will deliver Internet content 24 hours a day, 7 days a week, 365 days a year. If we do not meet this standard, our customer does not pay for all or a part of its services on that day. Our network or services could be disrupted by numerous events, including natural disasters, failure or refusal of our third-party network providers to provide the necessary capacity, power losses, and intentional disruptions of our services, such as disruptions caused by software viruses or attacks by unauthorized users. Although we have taken steps to prevent such disruptions, there can be no assurance that attacks by unauthorized users will not be attempted in the future, that our enhanced security measures will be effective or that a successful attack would not be damaging. Any widespread interruption of the functioning our network or services would reduce our revenues and could harm our business, financial results and reputation.

 

As part of our business strategy, we have entered into and may enter into or seek to enter into business combinations and acquisitions that may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention.

 

In June 2005, we completed our acquisition of Speedera. We may seek to enter into additional business combinations or acquisitions in the future. Acquisitions are typically accompanied by a number of risks, including the difficulty of integrating the operations and personnel of the acquired companies, the potential disruption of our ongoing business, the potential distraction of management, expenses related to the acquisition and potential

unknown liabilities associated with acquired businesses. Any inability to integrate completed acquisitions in an efficient and timely manner could have an adverse impact on our results of operation. If we are not successful in completing acquisitions that we may pursue in the future, we may be required to reevaluate our business strategy, and we may incur substantial expenses and devote significant management time and resources without a productive result. In addition, with future acquisitions, we could use substantial portions of our available cash or, as in the Speedera acquisition, make dilutive issuances of securities. Future acquisitions or attempted acquisitions could also have an adverse effect on our ability to remain profitable.

 

Because our services are complex and are deployed in complex environments, they may have errors or defects that could seriously harm our business.

 

Our services are highly complex and are designed to be deployed in and across numerous large and complex networks. From time to time, we have needed to correct errors and defects in our software. In the future, there may be additional errors and defects in our software that may adversely affect our services. We may not have in place adequate quality assurance procedures to ensure that we detect errors in our software in a timely manner. If we are unable to efficiently fix errors or other problems that may be identified, or if there are unidentified errors that allow persons to improperly access our services, we could experience loss of revenues and market share, damage to our reputation, increased expenses and legal actions by our customers.

 

We may have insufficient transmission and server capacity, which could result in interruptions in our services and loss of revenues.

 

Our operations are dependent in part upon transmission capacity provided by third-party telecommunications network providers. In addition, our distributed network must be sufficiently robust to handle all of our customers’ traffic. We believe that we have access to adequate capacity to provide our services; however, there can be no assurance that we are adequately prepared for unexpected increases in bandwidth demands by our customers. In addition, the bandwidth we have contracted to purchase may become unavailable for a variety of reasons including due to payment disputes or network providers going out of business. Any failure of these network providers to provide the capacity we require, due to financial or other reasons, may result in a reduction in, or interruption of, service to our customers. If we do not have access to third-party transmission capacity, we could lose customers. If we are unable to obtain transmission capacity on terms commercially acceptable to us or at all, our business and financial results could suffer. We may not be able to deploy on a timely basis enough servers to meet the needs of our customer base or effectively manage the functioning of those servers. In addition, damage or destruction of, or other denial of access to, a facility where our servers are housed could result in a reduction in, or interruption of, service to our customers.

 

If the estimates we make, and the assumptions on which we rely, in preparing our financial statements prove inaccurate, our actual results may be adversely affected.

 

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments about, among other things, taxes, revenue recognition, capitalization of internal-use software, contingent obligations, doubtful accounts and restructuring charges. These estimates and judgments affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges accrued by us, such as those made in connection with our restructuring charges, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. If our estimates or the assumptions underlying them are not correct, we may need to accrue additional charges that could adversely affect our results of operations, which in turn could adversely affect our stock price.

 

If we are unable to retain our key employees and hire qualified sales and technical personnel, our ability to compete could be harmed.

 

Our future success depends upon the continued services of our executive officers and other key technology, sales, marketing and support personnel who have critical industry experience and relationships that they rely on in

implementing our business plan. There is increasing competition for talented individuals in the areas in which our primary offices are located. This affects both our ability to retain key employees and hire new ones. None of our officers or key employees is bound by an employment agreement for any specific term. The loss of the services of any of our key employees could delay the development and introduction of, and negatively impact our ability to sell, our services.

 

If our license agreement with MIT terminates, our business could be adversely affected.

 

We have licensed technology from MIT covered by various patents, patent applications and copyrights relating to Internet content delivery technology. Some of our core technology is based in part on the technology covered by these patents, patent applications and copyrights. Our license is effective for the life of the patents and patent applications; however, under limited circumstances, such as a cessation of our operations due to our insolvency or our material breach of the terms of the license agreement, MIT has the right to terminate our license. A termination of our license agreement with MIT could have a material adverse effect on our business.

 

We may need to defend our intellectual property and processes against patent or copyright infringement claims, which would cause us to incur substantial costs.

 

Other companies or individuals, including our competitors, may hold or obtain patents or other proprietary rights that would prevent, limit or interfere with our ability to make, use or sell our services or develop new services, which could make it more difficult for us to increase revenues and improve profitability. Companies holding Internet-related patents or other intellectual property rights are increasingly bringing suits alleging infringement of such rights. Any litigation or claims, whether or not valid, could result in substantial costs and diversion of resources and require us to do one or more of the following:

 

 

If we are forced to take any of these actions, our business may be seriously harmed. In the event of a successful claim of infringement against us and our failure or inability to obtain a license to the infringed technology, our business and operating results could be materially adversely affected.

 

Our business will be adversely affected if we are unable to protect our intellectual property rights from unauthorized use or infringement by third parties.

 

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We have brought numerous lawsuits against entities that we believe are infringing on our intellectual property rights. These legal protections afford only limited protection. Monitoring unauthorized use of our services is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Although we have licensed from other parties proprietary technology covered by patents, we cannot be certain that any such patents will not be challenged, invalidated or circumvented. Furthermore, we cannot be certain that any pending or future patent applications will be granted, that any future patent will not be challenged, invalidated or circumvented, or that rights granted under any patent that may be issued will provide competitive advantages to us.

 

We face risks associated with international operations that could harm our business.

 

We have operations in several foreign countries and may continue to expand our sales and support organizations internationally. Such expansion could require us to make significant expenditures. We are increasingly

subject to a number of risks associated with international business activities that may increase our costs, lengthen our sales cycle and require significant management attention. These risks include:

 

 

Any failure to meet our debt obligations would damage our business.

 

We have long-term debt. As of December 31, 2005, our total long-term debt was $200.0 million. If we are unable to remain profitable or if we use more cash than we generate in the future, our level of indebtedness could adversely affect our future operations by increasing our vulnerability to adverse changes in general economic and industry conditions and by limiting or prohibiting our ability to obtain additional financing for future capital expenditures, acquisitions and general corporate and other purposes. In addition, if we are unable to make interest or principal payments when due, we would be in default under the terms of our notes, which would result in all principal and interest becoming due and payable which, in turn, would seriously harm our business.

 

If we are required to seek additional funding, such funding may not be available on acceptable terms or at all.

 

If our revenues decrease or grow more slowly than we anticipate, if our operating expenses increase more than we expect or cannot be reduced in the event of lower revenues, or if we seek to acquire significant businesses or technologies, we may need to obtain funding from outside sources. If we are unable to obtain this funding, our business would be materially and adversely affected. In addition, even if we were to find outside funding sources, we might be required to issue securities with greater rights than the securities we have outstanding today. We might also be required to take other actions that could lessen the value of our common stock, including borrowing money on terms that are not favorable to us. In addition, we may not be able to raise any additional capital.

 

Internet-related and other laws could adversely affect our business.

 

Laws and regulations that apply to communications and commerce over the Internet are becoming more prevalent. In particular, the growth and development of the market for online commerce has prompted calls for more stringent tax, consumer protection and privacy laws, both in the United States and abroad, that may impose additional burdens on companies conducting business online or providing Internet-related services such as ours. This could negatively affect both our business directly as well as the businesses of our customers, which could reduce their demand for our services. Tax laws that might apply to our servers, which are located in many different jurisdictions, could require us to pay additional taxes that would adversely affect our continued profitability. We have recorded certain tax reserves to address potential exposures involving our sales and use and franchise tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different jurisdictions. Our reserves, however, may not be adequate to reflect our total actual liability. Internet-related laws remain largely unsettled, even in areas where there has been some legislative action. The adoption or modification of laws or regulations relating to the Internet or our operations, or interpretations of existing law, could adversely affect our business.

Provisions of our charter documents, our stockholder rights plan and Delaware law may have anti-takeover effects that could prevent a change in control even if the change in control would be beneficial to our stockholders.

 

Provisions of our amended and restated certificate of incorporation, amended and restated by-laws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. In addition, our Board of Directors has adopted a shareholder rights plan the provisions of which could make it more difficult for a potential acquirer of Akamai to consummate an acquisition transaction without the approval of our Board of Directors.

 

A class action lawsuit has been filed against us and an adverse resolution of such action could have a material adverse effect on our financial condition and results of operation in the period in which the lawsuit is resolved.

 

We are named as a defendant in a purported class action lawsuit filed in 2001 alleging that the underwriters of our initial public offering received undisclosed compensation in connection with our initial public offering of common stock in violation of the Securities Act and the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act. Any conclusion of these matters in a manner adverse to us could have a material adverse affect on our financial position and results of operations.

 

We may become involved in other litigation that may adversely affect us.

 

In the ordinary course of business, we may become involved in litigation, administrative proceedings and governmental proceedings. Such matters can be time-consuming, divert management’s attention and resources and cause us to incur significant expenses. Furthermore, there can be no assurance that the results of any of these actions will not have a material adverse effect on our business, results of operations or financial condition.

 

None.

 

Our headquarters are located in approximately 110,000 square feet of leased office space in Cambridge, Massachusetts. Of this space, we have subleased approximately 12,000 square feet to another company. Our primary west coast office is located in approximately 18,000 square feet of leased office space in San Mateo, California. We maintain offices in several other locations in the United States, including in or near each of Los Angeles, California; Atlanta, Georgia; Chicago, Illinois; New York, New York; Dallas, Texas; Reston, Virginia and Seattle, Washington. We also maintain offices in Europe and Asia in or near the following cities: Bangalore, India; Beijing, China; Munich, Germany; Paris, France; London, England; Tokyo, Japan; Singapore; Madrid, Spain; and Sydney, Australia. All of our facilities are leased. We believe our facilities are sufficient to meet our needs for the foreseeable future and, if needed, additional space will be available at a reasonable cost.

 

We are subject to legal proceedings, claims and litigation arising in the ordinary course of business. We do not expect the ultimate costs to resolve these matters to have a material adverse effect on our consolidated financial position, results of operations or cash flows. In addition to ordinary-course litigation, we are a party to the lawsuit described below.

 

Between July 2, 2001 and November 7, 2001, purported class action lawsuits seeking monetary damages were filed in the United States District Court for the Southern District of New York against us as well as against the underwriters of our October 28, 1999 initial public offering of common stock. The complaints were filed allegedly on behalf of persons who purchased our common stock during different time periods, all beginning on October 28, 1999 and ending on various dates. The complaints are similar and allege violations of the Securities Act of 1933 and the Exchange Act primarily based on the allegation that the underwriters received undisclosed compensation in

connection with our initial public offering. On April 19, 2002, a single consolidated amended complaint was filed, reiterating in one pleading the allegations contained in the previously filed separate actions. The consolidated amended complaint defines the alleged class period as October 28, 1999 through December 6, 2000. A Special Litigation Committee of Akamai’s Board of Directors authorized management to negotiate a settlement of the pending claims substantially consistent with a Memorandum of Understanding that was negotiated among class plaintiffs, all issuer defendants and their insurers. The parties negotiated a settlement that is subject to approval by the Court. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the bar order and, on August 31, 2005, the Court issued an order preliminarily approving the settlement. We believe that we have meritorious defenses to the claims made in the complaint and, if the settlement is not finalized and approved, we intend to contest the lawsuit vigorously. An adverse resolution of the action could have a material adverse effect on our financial condition and results of operations in the period in which the lawsuit is resolved. We are not presently able to estimate potential losses, if any, related to this lawsuit.

 

None.

 

Our common stock, par value $0.01 per share, trades under the symbol “AKAM” on The NASDAQ National Market. The following table sets forth, for the periods indicated, the high and low sale price per share of the common stock on The NASDAQ National Market:

 

 

As of March 1, 2006, there were 722 holders of record of our common stock.

 

We have never paid or declared any cash dividends on shares of our common stock or other securities and do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain all future earnings, if any, for use in the operation of our business. We did not repurchase any equity securities in 2005 nor did we sell any equity securities that were not registered under the Securities Act of 1933, as amended.

 

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this Annual Report on Form 10-K. The consolidated statement of operations data and balance sheet data for all periods presented is derived from audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K or in Annual Reports on

Form 10-K for prior years on file with the Securities and Exchange Commission. In 2002, the Company modified the presentation of the consolidated statement of operations to include in cost of revenues equity-related compensation expense, based on the functional role of the related employee, and depreciation and amortization on its network equipment.

 

We acquired several businesses in 2000 that we recorded under the purchase method of accounting. We allocated $3 billion of the cost of these acquisitions to goodwill and other intangible assets. As a result, loss from operations for the year ended December 31, 2001 includes $255.8 million for the amortization of goodwill and other intangible assets related to these acquisitions. In 2001, loss from operations includes a $1.9 billion impairment of goodwill. On January 1, 2002, in accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, “Goodwill and Other Intangible Assets,” we discontinued the amortization of goodwill and reclassified our assembled workforce of $1.0 million to goodwill. Loss from continuing operations for the years ended December 31, 2002 and 2001 includes restructuring charges of $45.8 million and $40.5 million, respectively, for actual and estimated termination and modification costs related to non-cancelable facility leases and employee severance.

 

Loss from continuing operations for the year ended December 31, 2003 includes a restructuring credit of $8.5 million for the reversal of previously accrued restructuring liabilities and loss on early extinguishment of debt of $2.1 million. Income from continuing operations for the years ended December 31, 2005 and 2004 includes a loss on early extinguishment of debt of $1.4 million and $6.8 million, respectively.

 

In 2005, we acquired a business accounted for under the purchase method of accounting. We allocated $139.5 million of the cost of this acquisition to goodwill and other intangible assets. Income from continuing operations for the year ended December 31, 2005 includes $5.1 million for the amortization of other intangible assets related to this acquisition.

 

In 2005, we released our United States and foreign deferred tax asset valuation allowance. Based upon our cumulative operating results and an assessment of our expected future results, we determined that is was more likely than not that our deferred tax assets will be realized. During 2005, the total valuation allowance release recorded as an income tax benefit in the statement of operations was $285.8 million.

 

Additionally, in 2005, we completed an equity offering of 12,000,000 shares of our common stock at a price of $16.855 per share for proceeds of $202.1 million, net of offering expenses. We also redeemed all $56.6 million in principal amount of our remaining outstanding 51/2 convertible subordinated notes for total cash payments of $58.1 million in 2005.

 

 

 

Overview

 

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 applicable for actual usage above the monthly minimum. Having a consistent and predictable base level of income 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 recurring revenue due to customer cancellations or terminations and build on that base by adding new customers and increasing the number of services, features and functions our 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 price, quality and the attractiveness of our services and technology. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and notes thereto which appear elsewhere in this Annual Report on Form 10-K. See “Risk Factors” elsewhere in this Annual Report on Form 10-K for a discussion of certain risks associated with our business.

 

Our improved financial results in 2005 as compared to 2004 and 2003 reflect our efforts to increase our monthly recurring revenues while reducing the expenses needed to support such growth. The following sets forth, as a percentage of revenues, consolidated statements of operations data for the years indicated:

 

 

We were profitable for fiscal years 2005 and 2004; however, we cannot guarantee continued profitability for any period in the future. 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:

 

 

 

Based on our analysis of these known trends and events, we expect to continue to generate net income on a quarterly basis during 2006; however, our future results will be affected by many factors identified below and in the section of this report entitled “Risk Factors,” including our ability to:

 

 

As a result, there is no assurance that we will achieve our expected financial objectives, including positive net income.

 

Application of Critical Accounting Policies and Estimates

 

Overview

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally

accepted in the United States of America. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, accounts receivable reserves, capitalized internal-use software costs, intangible assets and goodwill, income and other taxes, useful lives of property and equipment, restructuring accruals and contingent obligations. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. For a complete description of our significant accounting policies, see Note 2 to our consolidated financial statements included in this annual report on Form 10-K.

 

Definitions

 

We define our “critical accounting policies” as those accounting principles generally accepted in the United States of America that require us to make subjective estimates about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations as well as the specific manner in which we apply those principles. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time the accounting estimate is made and applied and require us to continually assess a range of potential outcomes.

 

Review of Critical Accounting Policies and Estimates

 

Revenue Recognition:

 

We recognize service revenues in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, “Revenue Recognition,” and the Financial Accounting Standards Board’s, or FASB, Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed and collectibility of the resulting receivable is reasonably assured.

 

At the inception of a customer contract for service, we make an estimate as to that customer’s ability to pay for the services provided. We base our estimate on a combination of factors, including the successful completion of a credit check or financial review, our payment history with the customer and other forms of payment assurance. Upon the completion of these steps, we recognize revenue monthly in accordance with our revenue recognition policy. If we subsequently determine that collection from the customer is not reasonably assured, we record an allowance for doubtful accounts and bad debt expense for all of that customer’s unpaid invoices and cease recognizing revenue for continued services provided until cash is received. Changes in our estimates and judgments about whether collection is reasonably assured would change the timing of revenue or amount of bad debt expense that we recognize.

 

We primarily derive income from the sale of services to customers executing contracts with terms of one year or longer. These contracts generally commit the customer to a minimum monthly level of usage and provide the rate at which the customer must pay for actual usage above the monthly minimum. For these services, we recognize the monthly minimum as revenue each month provided that an enforceable contract has been signed by both parties, the service has been delivered to the customer, the fee for the service is fixed or determinable and collection is reasonably assured. Should a customer’s usage of our service exceed the monthly minimum, we recognize revenue for such excess usage in the period of the usage. We typically charge the customer an installation fee when the services are first activated. The installation fees are recorded as deferred revenue and recognized as revenue ratably over the estimated life of the customer arrangement. We also derive income from services sold as discrete, non-recurring events or based solely on usage. For these services, we recognize revenue after an enforceable contract has been signed by both parties, the fee is fixed or determinable, the event or usage has occurred and collection is reasonably assured.

 

We periodically enter into multi-element service arrangements. When we enter into such arrangements, each element is accounted for separately over its respective service period, provided that there is objective evidence of fair value for the separate elements. For example, objective evidence of fair value would include the price charged for the element when sold separately. If the fair value of each element cannot be objectively determined, the total value of the arrangement is recognized ratably over the entire service period to the extent that all services have begun to be provided at the outset of the period. For most multi-element service arrangements to date, the fair value

of each element has not been objectively determinable. Therefore, all revenue under these arrangements has been recognized ratably over the related service period.

 

We also license software under perpetual and term license agreements. We apply the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modifications of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” As prescribed by this guidance, we apply the residual method of accounting. The residual method requires that the portion of the total arrangement fee attributable to undelivered elements, as indicated by vendor specific objective evidence of fair value, is deferred and subsequently recognized when delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, if all other revenue recognition criteria of SOP 97-2 are met.

 

We also sell our services through a reseller channel. Assuming all other revenue recognition criteria are met, we recognize revenue from reseller arrangements based on the reseller’s contracted non-refundable minimum purchase commitments over the term of the contract, plus amounts sold by the reseller to its customers in excess of the minimum commitments. These excess commitments are recognized as revenue in the period in which the service is provided.

 

We recognize revenue from fixed-fee arrangements and software arrangements that require significant customization or modification using the percentage-of-completion method in accordance with Accounting Research Bulletin, or ARB, No. 45, “Long-Term Construction-Type Contracts,” and with the applicable guidance provided by SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” We generally recognize revenue under these arrangements based on the percentage of cost incurred to date compared to the estimated total cost to complete the project. In certain customer arrangements, we recognize revenue based on the progress made towards achieving milestones under the contract. The impact of any change in estimate is recorded prospectively from the date of the change. At the outset of a fixed-fee arrangement, if we are not able to estimate the total cost-to-complete, nor able to measure progress towards the achievement of contract milestones, we account for the arrangement using the completed-contract method of accounting. Under this method, we recognize revenue when the contract is complete and there are no remaining costs or deliverables. In the event that the estimated total cost on a fixed-fee contract indicates a loss, we will record the loss immediately.

 

From time to time, we enter into contracts to sell our services or license our technology to unrelated companies at or about the same time we enter into contracts to purchase products or services from the same companies. If we conclude that these contracts were negotiated concurrently, we record as revenue only the net cash received from the vendor, unless both the fair values of our services delivered to the customer and of the vendor’s product or service we receive can be established objectively and realization of such value is believed to be probable.

 

We may from time to time resell licenses or services of third parties. We record revenue for these transactions when we have risk of loss related to the amounts purchased from the third party and we add value to the license or service, such as by providing maintenance or support for such license or service. If these conditions are present, we recognize revenue when all other revenue recognition criteria are satisfied.

 

Deferred revenue includes amounts billed to customers for which revenue has not been recognized. Deferred revenue primarily consists of the unearned portion of monthly billed service fees; deferred installation and activation set-up fees; amounts billed under extended payment terms; and maintenance and support fees charged under license arrangements.

 

Accounts Receivable and Related Reserves:

 

Trade accounts receivable are recorded at the invoiced amounts and do not bear interest. In addition to trade accounts receivable, our accounts receivable balance includes unbilled accounts that represent revenue recorded for customers that is typically billed within one month. We record reserves against our accounts receivable balance. These reserves consist of allowances for doubtful accounts, cash basis customers and service credits. Increases and decreases in the allowance for doubtful accounts are included as a component of general and administrative expenses. The reserve for cash basis customers increases as services are provided to customers where collection is no longer assured. The reserve decreases and revenue is recognized when and if cash payments are received. The

reserve for service credits increases as a result of specific service credits that are expected to be issued to customers during the ordinary course of business, as well as for billing disputes. These credits result in a reduction to revenues. Decreases to the reserve are the result of actual credits being issued to customers, causing a corresponding reduction in accounts receivable.

 

Estimates are used in determining these reserves and are based upon our review of outstanding balances on a customer-specific, account-by-account basis. The allowance for doubtful accounts is based upon a review of customer receivables from prior sales with collection issues where we no longer believe that the customer has the ability to pay for prior services provided. We perform on-going credit evaluations of our customers. If such an evaluation indicates that payment is no longer reasonably assured for current services provided, any future services provided to that customer will result in creation of a reserve until we receive consistent payments. In addition, we reserve a portion of revenues as a reserve for service credits. Reserves for service credits are measured based on an analysis of revenue credits to be issued after the month of billing and an estimate for future credits. These credits typically relate to management’s estimate of the resolution of customer disputes and billing adjustments. We do not have any off-balance sheet credit exposure related to our customers.

 

Impairment and Useful Lives of Long-Lived Assets:

 

We review our long-lived assets, such as fixed assets and intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events that would trigger an impairment review include a change in the use of the asset or forecasted negative cash flows related to the asset. When such a triggering event occurs, we compare the carrying amount of the long-lived asset to the undiscounted expected future cash flows related to the asset. If the carrying amount is greater than the sum of the undiscounted cash flows, we adjust the asset to its fair value through an impairment charge included in loss from operations. We determine fair value based upon a quoted market price or a discounted cash flow analysis. The estimates required to apply this accounting policy include forecasted usage of the long-lived assets and the useful lives of these assets and expected future cash flows. Changes in these estimates could materially impact results from operations.

 

Restructuring Liabilities Related to Facility Leases:

 

When we vacate a facility subject to a non-cancelable long-term lease, we record a restructuring liability for either the estimated costs to terminate the lease or the estimated costs that will continue to be incurred under the lease for its remaining term where there is no economic benefit to us. In the latter case, we measure the amount of the restructuring liability as the amount of contractual future lease payments reduced by an estimate of sublease income. To date, we have recorded a restructuring liability when our management approves and commits us to a plan to terminate a lease, the plan specifically identifies the actions to be taken, and the actions are scheduled to begin soon after management approves the plan. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” we record restructuring liabilities, discounted at the appropriate rate, for a facility lease only when we have both vacated the space and completed all actions needed to make the space readily available for sublease.

 

As of December 31, 2005, we had $2.3 million in accrued restructuring liabilities related to vacated facilities. In 2003, we were able to renegotiate two of our previously restructured facility leases to reduce rents payable under the leases to current market rates, resulting in a reversal of previously recorded restructuring liabilities of $9.6 million. We expect that approximately $1.4 million of the amount accrued as of December 31, 2005 will be paid within 12 months.

 

Loss Contingencies:

 

We define a loss contingency as a condition involving uncertainty as to a possible loss related to a previous event that will not be resolved until one or more future events occur or fail to occur. Our primary loss contingencies relate to pending or threatened litigation. We record a liability for a loss contingency when we believe that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. When we believe the

likelihood of a loss is less than probable and more than remote, we do not record a liability but we disclose material loss contingencies in the notes to the consolidated financial statements.

 

Tax Reserves:

 

Our provision for income taxes is comprised of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for the current year. The deferred income tax provision is calculated for the estimated future tax effects attributable to temporary differences and carryforwards using expected tax rates in effect in the years during which the differences are expected to reverse.

 

We currently have significant deferred tax assets resulting from net operating loss carryforwards, tax credit carryforwards and deductible temporary differences. Management weighs the positive and negative evidence to determine if it is more likely than not that some or all of the deferred tax assets will be realized. In the third quarter of 2005, management determined it was more likely than not that most of the deferred tax assets would be realized. This decision was based on our cumulative history of book earnings over a 12-quarter period and on projections of expected future taxable income. The tax assets estimated to be realized in future periods have been calculated by applying a blended federal and state tax rate of 39.65%, which is based upon the tax rates expected to be in effect in the periods during which the attributes are expected to be utilized. Changes in this blended rate in future periods could have a material effect on both the tax provision in the period of change as well as the net deferred tax asset carrying value.

 

We have recorded tax reserves to address potential exposures involving our sales and use and franchise tax positions. These potential exposures result from the varying application of statutes, rules, regulations and interpretations by different jurisdictions. Our determination of the amount of these tax reserves involves assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the cost of the ultimate resolution of these matters may be greater or less than the amount that we estimated.

 

Accounting for Stock Options

 

Historically, through December 31, 2005, we recognized stock option costs pursuant to Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. We have disclosed the impact of expensing stock options pursuant to SFAS No. 123, “Accounting for Stock-Based Compensation,” in the notes to our consolidated financial statements. Effective in 2006, we will adopt the provisions of SFAS No. 123R, “Share-Based Payment.” Both SFAS No. 123 and 123R require management to make assumptions to determine the fair value of stock options, including the expected life of the stock options and the volatility of the underlying common stock. Changes to the assumptions may have a significant impact on the fair value of the stock options, which could have a material impact on our financial statements. Additionally, in our pro forma disclosure, we incorporate a forfeiture estimate as we recognize equity expense. Should our actual forfeitures differ from our estimates, this could have a material impact on our consolidated financial statements.

 

Capitalized Internal-Use Software Costs:

 

We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of internal-use software projects. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus qualifying the work incurred for capitalization. Once the project is complete, we estimate the useful life of the internal-use software, and we periodically assess whether the software is impaired. Changes in our estimates related to internal-use software would increase or decrease operating expenses or amortization recorded during the period.

 

Results of Operations

 

Revenues.  Total revenues increased 35%, or $73.1 million, to $283.1 million for the year ended December 31, 2005 as compared to $210.0 million for the year ended December 31, 2004. Total revenues increased 30%, or $48.8 million, to $210.0 million for the year ended December 31, 2004 as compared to $161.3 million for the year ended December 31, 2003. The increase in total revenues for 2005 as compared to 2004 was attributable to an

increase in service revenue of $74.7 million, partially offset by a reduction in software and software-related revenue of $1.6 million. The increase in total revenues for 2004 as compared to 2003 was attributable to an increase in service revenue of $49.4 million, partially offset by a reduction in software and software-related revenue of $477,000 and related party revenue of $137,000.

 

Service revenue, which consists of revenue from our content and application delivery services, increased 36%, or $74.7 million, to $281.5 million for the year ended December 31, 2005 as compared to $206.8 million for the year ended December 31, 2004. Service revenue was $157.4 million for the year ended December 31, 2003. The increases in service revenue were primarily attributable to increases in the number of customers under recurring revenue contracts, as well as increases in traffic and additional services sold to new and existing customers and increases in the average revenue per customer. These increases are attributable to greater market acceptance of our services among new customers and improvements in our ability to sell additional features to our existing customers. Also contributing to the increases in service revenue were revenues generated from the acquisition of Speedera on June 10, 2005. As of December 31, 2005, we had 1,910 customers under recurring revenue contracts as compared to 1,310 as of December 31, 2004, and 1,126 as of December 31, 2003.

 

For 2005 and 2004, 21% and 19%, respectively, of our total revenues was derived from our operations located outside of the United States, of which 16% and 14% of overall revenues, respectively, was derived from operations in Europe. For 2003, 16% of our total revenues was derived from our operations located outside of the United States, of which 13% of overall revenues was derived from operations in Europe. No single country accounted for 10% or more of revenues derived outside of the United States during these periods. Resellers accounted for 24% of revenues in 2005, 27% in 2004 and 25% in 2003. For 2005, no single customer accounted for 10% or more of total revenues. For 2004 and 2003, Microsoft Corporation accounted for 10% and 15%, respectively, of total revenues.

 

Software and software-related revenue decreased 49%, or $1.6 million, to $1.6 million for the year ended December 31, 2005 as compared to $3.3 million for the year ended December 31, 2004. Software and software-related revenue was $3.7 million for the year ended December 31, 2003. Software and software-related revenue includes sales of customized software projects and technology licensing. The decreases in software and software-related revenue over the periods presented reflect a reduction in the number of customized software projects that we undertook for customers and a decrease in the number of software licenses executed with customers. We do not expect software and software-related revenue to increase as a percentage of revenues in 2006.

 

We had no revenue from related parties during 2005 and 2004. Service and software revenue from related parties was $137,000 for the year ended December 31, 2003. Related party revenue in 2003 represented revenue from Akamai Australia, a joint venture with ES Group Ventures Pty Ltd, relating to resale commitments. In June 2003, this joint venture was terminated. We do not expect to have any revenue from related parties in 2006.

 

Cost of Revenues.  Cost of revenues includes fees paid to network providers for bandwidth and co-location of our network equipment. Cost of revenues also includes payroll and related costs and equity-related compensation for network operations personnel, cost of software licenses, depreciation of network equipment used to deliver our services and amortization of internal-use software.

 

Cost of revenues increased 21%, or $9.5 million, to $55.7 million for the year ended December 31, 2005 as compared to $46.2 million for the year ended December 31, 2004. Cost of revenues decreased 24%, or $14.7 million, to $46.2 million for the year ended December 31, 2004 compared to $60.8 million for the year ended December 31, 2003. The increase in cost of revenues for 2005 as compared to 2004 was primarily due to an increase in aggregate bandwidth costs due to higher traffic levels and an increase in depreciation expense of network equipment as we continue to invest in our infrastructure, partially offset by reduced bandwidth costs per unit. The total cost of revenues decreased in 2004 as compared to 2003 as a result of a decline in depreciation expense of network equipment as the impact of our network assets becoming fully depreciated exceeded the depreciation from the investments we made in our network infrastructure. The decline in deprecation expense in 2004 was partially offset by an increase in total bandwidth costs due to an increase in the amount of traffic delivered.

 

Cost of revenues during 2005, 2004 and 2003 also included credits of $1.2 million, $1.0 million and $3.0 million, respectively, as a result of settlements and renegotiations entered into in connection with billing

disputes related to bandwidth contracts. Credits of this nature may occur in the future; however, the timing and amount of future credits, if any, will vary.

 

Cost of revenues is comprised of the following (in millions):

 

 

We have long-term purchase commitments for bandwidth usage and co-location with various networks and Internet service providers. For the years ending December 31, 2006, 2007 and 2008, the minimum commitments related to bandwidth usage and co-location services are approximately $6.0 million, $1.1 million and $409,000, respectively.

 

We believe cost of revenues will increase in 2006. We expect to deliver more traffic on our network, which would result in higher expenses associated with the increased traffic; however, such costs are likely to be partially offset by lower bandwidth costs per unit. Additionally, we expect increases in depreciation expense related to our network equipment and amortization of internal-use software development costs, as well as an increase in payroll and payroll-related costs, as we continue to make investments in our network to service our expanding customer base. Additionally, with the impact of implementing SFAS No. 123R for the expensing of employee stock awards at fair value beginning in the first quarter of 2006, we expect significant increases in cost of revenues attributable to equity-related compensation expense.

 

Research and Development.  Research and development expenses consist primarily of payroll and related costs and equity-related compensation 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 software development costs requiring capitalization. During the years ended December 31, 2005, 2004 and 2003, we capitalized software development costs of $8.5 million, $7.5 million and $7.5 million, respectively, consisting of external consulting and payroll and payroll-related costs related to the development of internal-use software used to deliver our services and operate our network. These capitalized internal-use software costs are amortized to cost of revenues over their estimated useful lives of two years.

 

Research and development expenses increased 49%, or $5.9 million, to $18.1 million for the year ended December 31, 2005 as compared to $12.1 million for the year ended December 31, 2004. Research and development expenses decreased 6%, or $839,000, to $12.1 million for the year ended December 31, 2004 as compared to $13.0 million for the year ended December 31, 2003. The increase in 2005 as compared to 2004 was primarily due to an increase in payroll and related costs due to an increase in headcount. The decrease in 2004 as compared to 2003 was primarily due to decreases in payroll and related costs, including equity-related compensation, as a reflection of the impact of workforce reductions in prior years and a reduction in equity compensation as stock awards became fully vested. The following table quantifies the net changes in research and development expenses over periods presented (in millions):

 

We believe that research and development expenses will increase in 2006, as we continue to increase hiring of development personnel and make investments in our core technology and refinements to our other service offerings. Additionally, with the impact of implementing SFAS No. 123R for the expensing of employee stock awards at fair value beginning in the first quarter of 2006, we expect significant increases in research and development expense attributable to equity-related compensation expense.

 

Sales and Marketing.  Sales and marketing expenses consist primarily of payroll and related costs, equity-related compensation and commissions for personnel engaged in marketing, sales and service support functions, as well as advertising and promotional expenses.

 

Sales and marketing expenses increased 40%, or $22.2 million, to $77.9 million for the year ended December 31, 2005 as compared to $55.7 million for the year ended December 31, 2004. Sales and marketing expenses increased 17%, or $8.1 million, to $55.7 million for the year ended December 31, 2004 as compared to $47.6 million for the year ended December 31, 2003. The increase in sales and marketing expenses during these periods was primarily due to higher payroll and related costs, particularly commissions, for sales and marketing personnel due to revenue growth. Additionally, marketing and related costs increased in 2005 due to higher advertising and promotional costs as compared to 2004. The following table quantifies the net increase in sales and marketing expenses for the periods presented (in millions):

 

 

We believe that sales and marketing expenses will continue to increase in 2006 due to an expected increase in commissions on higher forecasted sales, the expected increase in hiring of sales and marketing personnel and additional expected increases in marketing costs such as advertising. Additionally, with the impact of implementing SFAS No. 123R for the expensing of employee stock awards at fair value beginning in the first quarter of 2006, we expect significant increases in sales and marketing expenses attributable to equity-related compensation expense.

 

General and Administrative.  General and administrative expenses consist primarily of the following components:

 

 

General and administrative expenses increased 13%, or $6.0 million, to $53.0 million for the year ended December 31, 2005 as compared to $47.1 million for the year ended December 31, 2004. General and administrative expenses decreased 18%, or $10.2 million, to $47.1 million for the year ended December 31, 2004 as compared to $57.3 million for the year ended December 31, 2003. The increase in general and administrative expenses during 2005 was primarily due to an increase in payroll and related costs as a result of headcount growth, as well as an increase in the provision for doubtful accounts. This increase was offset by a reduction in legal and consulting costs associated with the dismissal of the lawsuits between Akamai and Speedera as a result of our

acquisition of Speedera. The decrease in general and administrative expenses during 2004 was primarily due to a reduction in depreciation expense as a result of assets becoming fully depreciated, a reduction in payroll and related costs, including equity compensation, as a result of equity awards becoming fully vested and reduced rent expense due to lease restructurings in prior years. During 2005 and 2004, consulting and advisory services increased significantly compared to those in 2003 as a result of the costs associated with the evaluation of our internal controls in order to allow management to report on, and our independent auditors to attest to, our internal control over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. The following table quantifies the net change in general and administrative expenses for the periods presented (in millions):

 

 

During the years ended December 31, 2005 and 2004, we capitalized software development costs of $718,000 and $236,000, respectively, consisting of external consulting fees and payroll and payroll-related costs associated with the development of internally-used software applications. Once the projects are completed, such costs will be amortized and included in general and administrative expenses.

 

We expect general and administrative expenses to increase in 2006 due to increased payroll and related costs attributable to increased hiring, an increase in non-income tax expense and an increase in rent and facilities costs as we expanded our leasing of office space in 2005. These increases will be offset by an expected reduction in legal costs. Additionally, with the impact of implementing SFAS No. 123R for the expensing of employee stock awards at fair value beginning in the first quarter of 2006, we expect significant increases in general and administrative expenses attributable to equity-related compensation expense.

 

Amortization of Other Intangible Assets.  Amortization of other intangible assets consists of the amortization of intangible assets acquired in business combinations and amortization of acquired license rights. Amortization of other intangible assets increased to $5.1 million for the year ended December 31, 2005 as compared to $48,000 for the year ended December 31, 2004. Amortization of other intangible assets for the year ended December 31, 2003 was $2.2 million. The increase in amortization of other intangible assets in 2005 was due to the amortization of intangible assets from the acquisition of Speedera in June 2005. Intangible assets acquired in prior acquisitions were fully amortized in the first quarter of 2003; consequently, there was no corresponding amortization of such assets in 2004. We expect to amortize approximately $8.4 million, $7.4 million, $6.1 million, $4.8 million and $4.1 million for fiscal years 2006, 2007, 2008, 2009 and 2010, respectively, in connection with the Speedera acquisition.

 

Restructuring (Benefits) Charges.  We did not record any restructuring charges or benefits during 2005 or 2004. During the year ended December 31, 2003, we recorded net restructuring benefits of $8.5 million as a result of amendments to certain real estate leases. During the year ended December 31, 2003, we amended or terminated three long-term leases in connection with which we paid our lessors a total of $16.1 million in cash and restricted cash. As a result of these amendments to, or terminations of, long-term leases, we reversed $9.6 million of previously recorded restructuring liabilities, offset by a restructuring charge of $1.1 million for costs relating to the restructuring of a facility located in Europe. The reversals represent the difference between the previously estimated restructuring liabilities and the amounts payable under negotiated agreements for certain leased properties with the landlords thereof. We estimate the amount of restructuring liabilities associated with real estate leases based on the most recent available market data and discussions with our lessors and real estate advisors.

We do not anticipate significant restructuring charges in the future; however, we will continue to pursue modifications or settlements on our long-term leases if we believe it to be in our best interest.

 

Interest Income.  Interest income includes interest earned on invested cash balances and marketable securities. Interest income increased 98%, or $2.1 million, to $4.3 million for the year ended December 31, 2005 as compared to $2.2 million for the year ended December 31, 2004. Interest income increased 66%, or $856,000, to $2.2 million for the year ended December 31, 2004 as compared to $1.3 million for the year ended December 31, 2003. The increase in interest income in 2005 and 2004 as compared to previous years was due to an increase in our invested marketable securities period over period as we generated more cash from operations and invested the proceeds from the issuance of our 1% convertible senior notes. In 2004 and 2005, we also experienced an increase in interest rates earned on our investments. In November 2005, we received proceeds of $202.1 million from our public equity offering of 12.0 million shares of our common stock; accordingly, we expect interest income to increase in 2006.

 

Interest Expense.  Interest expense includes interest paid on our debt obligations as well as amortization of deferred financing costs. Interest expense decreased 48%, or $4.9 million, to $5.3 million for the year ended December 31, 2005 compared to $10.2 million for the year ended December 31, 2004. Interest expense decreased 44%, or $8.1 million, to $10.2 million for the year ended December 31, 2004 as compared to $18.3 million for the year ended December 31, 2003. The decrease during each of these periods was due to lower interest expense as a result of redemptions and repurchases of our 51/2% convertible subordinated notes at various times between December 2003 and September 2005, offset by interest payable on our 1% convertible senior notes issued in December 2003 and January 2004. During 2005 and 2004, we redeemed or repurchased $56.6 million and $169.4 million, respectively, in aggregate principal amount of our 51/2% convertible subordinated notes. As a result of these transactions, we believe that interest expense on our debt obligations, including deferred financing amortization, will not exceed $3.1 million in 2006.

 

Other (Expense) Income, net.  Other net expense represents foreign exchange gains and losses incurred during the periods presented, as well as gains and losses on legal settlements. Other net expense increased 148%, or $1.6 million, to $507,000 for the year ended December 31, 2005 as compared to other net income of $1.1 million for the year ended December 31, 2004. Other net income increased to $1.1 million for the year ended December 31, 2004 as compared to other net expense of $44,000 for the year ended December 31, 2003. Other net expense for the year ended December 31, 2005 represented $1.5 million of foreign exchange losses, offset by $1.0 million of net gains on legal settlements. Other net income of $1.1 million for the year ended December 31, 2004 represented approximately $518,000 of gains on legal settlements and $543,000 of foreign exchange gains. For the year ended December 31, 2003, other net expense of $44,000 consisted of foreign exchange losses. Other net (expense) income may fluctuate in the future based upon the movement in foreign exchange rates.

 

(Loss) Gain on Investments, net.  During the years ended December 31, 2005 and 2004, we recorded a net loss on investments of $27,000 and $69,000, respectively, on the sale of marketable securities. During 2003, we recorded a net gain of $1.6 million, of which $1.7 million related to the sale of equity investments in publicly-traded companies, offset by losses of $55,000 on investments in privately-held companies and sales of marketable securities. We do not expect significant gains or losses on investments in 2006, as we no longer hold any substantial investments in publicly or privately-held companies.

 

Loss on Early Extinguishment of Debt.  Loss on early extinguishment of debt decreased to $1.4 million for the year ended December 31, 2005 as compared to $6.8 million for the year ended December 31, 2004. Loss on early extinguishment of debt increased to $6.8 million for the year ended December 31, 2004 as compared to $2.1 million for the year ended December 31, 2003. The decrease in loss on early extinguishment of debt in 2005 is due to costs incurred in connection with our redemption of $56.6 million in principal amount of our 51/2% convertible subordinated notes during 2005. This loss of $1.4 million consists of $889,000 in premiums above par value paid to redeem such notes and $481,000 of deferred financing costs associated with redeeming the notes prior to their maturity. During 2004 and 2003, we repurchased $169.4 million and $74.0 million, respectively, in principal amount of our 51/2% convertible subordinated notes which resulted in a loss on early extinguishment of debt of $6.8 million and $2.1 million, respectively.

(Benefit) Provision for Income Taxes.  Benefit for income taxes increased to $257.6 million for the year ended December 31, 2005 as compared to a provision for income taxes of $772,000 during the year ended December 31, 2004. Provision for income taxes increased 23%, or $143,000, to $772,000 for the year ended December 31, 2004 as compared to $629,000 for the year ended December 31, 2003. During 2005, in connection with the release of our deferred tax asset valuation allowance, we recorded an income tax benefit of $285.8 million. The provision for income taxes for each of 2004 and 2003 was primarily related to our alternative minimum tax payment obligations and income earned in foreign jurisdictions where we were profitable.

 

As of June 30, 2005, our United States and foreign net operating losses, or NOLs, and other deferred tax assets were fully offset by a valuation allowance primarily because at the time, pursuant to SFAS No. 109, “Accounting for Income Taxes,” we did not have sufficient history of taxable income to conclude that it was more likely than not that we would be able to realize the tax benefits of those deferred tax assets. Based upon our cumulative history of earnings over a 12-quarter period and an assessment of our expected future results of operations, during the third quarter of 2005, we determined that it is more likely than not that we would be able to realize a substantial portion of our United States and foreign NOL carryforward tax assets prior to their expiration and other deferred tax assets. As a result, during the third quarter of 2005, we released a total of $321.8 million of our United States and foreign deferred tax asset valuation allowance. Of the $321.8 million, $258.1 million of the valuation release was recorded as an income tax benefit in our statement of operations, $61.0 million of the valuation release was attributable to stock option exercises, which was recorded as an increase in additional paid-in capital on the balance sheet, and approximately $2.7 million of the valuation release was recorded as a reduction to acquired goodwill and intangible assets.

 

As of September 30, 2005, we had a remaining valuation allowance of $35.6 million. During the fourth quarter of 2005, the Company released the remainder of the valuation allowance, except for $6.9 million that we will maintain because the realization of certain deferred tax assets does not meet the “more likely than not” criterion under SFAS No. 109. This portion of the valuation allowance primarily relates to certain state NOLs with a five-year carryover period that, as of December 31, 2005, we expect will expire unused. The fourth-quarter valuation allowance release is consistent with the requirement under APB No. 28 “Interim Financial Reporting,” that we use an annualized effective tax rate for each interim period during the year, including current year interim periods, after a valuation allowance release has occurred. The total valuation allowance release recorded as an income tax benefit in our consolidated statement of operations for 2005 was $285.8 million.

 

Our effective tax rate for the year ended December 31, 2005 remained relatively low before considering the deferred tax valuation allowance release as discussed above; however, our annualized effective tax rate in future periods after 2005 is expected to significantly increase. We expect that our consolidated annualized effective tax rate in 2006 will be approximately 40%.

 

Because of the availability of the NOLs discussed above, a significant portion of our future provision for income taxes is expected to be a non-cash expense; consequently, the amount of cash paid with respect to income taxes is expected to be a relatively small portion of the total annualized tax expense during periods in which the NOLs are utilized. In determining our net deferred tax assets and valuation allowances, and projections of our future provision for income taxes, annualized effective tax rates, and cash paid for income taxes, management is required to make judgments and estimates about domestic and foreign profitability, the timing and extent of the utilization of NOL carryforwards, applicable tax rates, transfer pricing methodologies and tax planning strategies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from our projections.

 

We have recorded certain tax reserves to address potential exposures involving our sales and use and franchise tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different jurisdictions. Our estimate of the value of these tax reserves reflects assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the ultimate resolution of these matters may be greater or less than the amount that we have estimated.

Liquidity and Capital Resources

 

To date, we have financed our operations primarily through the following transactions:

 

 

As of December 31, 2005, cash, cash equivalents and marketable securities totaled $314.1 million, of which $4.5 million is subject to restrictions limiting our ability to withdraw or otherwise use such cash, cash equivalents and marketable securities. See “Letters of Credit” below.

 

Cash provided by operating activities increased $31.6 million to $82.8 million for the year ended December 31, 2005 compared to $51.2 million for the year ended December 31, 2004. Cash provided by operating activities increased $69.2 million to $51.2 million for the year ended December 31, 2004 compared to cash used in operating activities of $18.0 million for the year ended December 31, 2003. The increase in cash provided by operating activities for each of 2005 and 2004 as compared to previous years was primarily due to increased service revenue and increases in deferred revenue. We expect that cash provided by operating activities will continue to increase as a result of an upward trend in cash collections related to higher revenues, partially offset by an expected increase in operating expenses that require cash outlays such as salaries in connection with expected increases in headcount. The timing and amount of future working capital changes and our ability to manage our days sales outstanding will also affect the future amount of cash used in or provided by operating activities.

 

Cash used in investing activities was $183.8 million for the year ended December 31, 2005, compared to cash provided by investing activities of $9.1 million for the year ended December 31, 2004. Cash used in investing activities was $33.1 million for the year ended December 31, 2003. Cash used in investing activities for 2005 reflects net purchases of marketable securities of $149.5 million primarily related to the cash received from our equity financing in November 2005. Additionally, cash used in investing activities for 2005 includes capital expenditures of $36.2 million, consisting of the capitalization of the purchase of network infrastructure equipment and internal-use software development costs related to our current and future service offerings. These investments were offset by $1.7 million of cash acquired through the Speedera acquisition and a decrease of $202,000 in restricted investments previously held for security deposits. Cash provided by investing activities for 2004 reflects proceeds from net sales and maturities of investments of $24.1 million, offset by capital expenditures of $20.1 million. During 2004, cash provided by investing activities also included a decrease of $5.0 million in restricted cash to reflect our repurchase of $5.0 million in principal amount of our 51/2% convertible subordinated notes in early 2004 and a decrease of $96,000 in restricted investments previously held for security deposits. Cash used in investing activities for 2003 reflects net purchases of investments of $19.3 million, an increase in restricted cash to reflect a commitment to repurchase $5.0 million in principal amount of our 51/2% convertible subordinated notes in early 2004 and capital expenditures of $8.9 million. For 2006, we expect total capital expenditures, a component of cash used in investing activities, to be approximately the same percentage of revenues as 2005.

 

Cash provided by financing activities was $159.1 million for the year ended December 31, 2005, compared to cash used in financing activities of approximately $131.9 million for the year ended December 31, 2004. Cash provided by financing activities was $105.2 million for the year ended December 31, 2003. Cash provided by financing activities in 2005 reflects net proceeds from our November 2005 equity offering of $202.1 million and

proceeds from issuances of common stock under our equity compensation plans of $14.5 million, offset by payments made to redeem $56.6 million in principal amount of our outstanding 51/2% convertible subordinated notes and payments on capital lease obligations of $818,000. Cash used in financing activities in 2004 reflects payments for the repurchase of approximately $169.4 million in principal amount of our 51/2% convertible subordinated notes and payments on our capital leases of $543,000, offset by net proceeds received from the issuance of our 1% convertible senior notes of $24.3 million and proceeds from issuances of common stock under our equity compensation plans of $13.8 million. Cash provided by financing activities in 2003 reflects net proceeds from the issuance of our 1% convertible senior notes of $169.8 million, proceeds from issuances of common stock under our equity compensation plans of $8.6 million, settlement of notes receivable for stock of $2.3 million, offset by payments for the repurchase of $74.0 million in principal amount of our 51/2% convertible subordinated notes and payments on our capital leases of $1.4 million.

 

Changes in cash, cash equivalents and marketable securities are dependent upon changes in working capital items such as deferred revenue, accounts payable, accounts receivable and various accrued expenses, as well as changes in our capital and financial structure, including debt repurchases and issuances, stock option exercises, sales of equity investments and similar events.

 

The following table represents the net inflows and outflows of cash, cash equivalents and marketable securities for the periods presented (in millions):

 

 

We believe, based on our current business plan, that our current cash, cash equivalents and marketable securities of $314.1 million and forecasted cash flows from operations will be sufficient to meet our cash needs for working capital and capital expenditures and restructuring expenses for at least the next 24 months. If the assumptions underlying our business plan regarding future revenue and expenses change or if unexpected opportunities or needs arise, we may seek to raise additional cash by selling equity or debt securities. If additional funds are raised through the issuance of equity or debt securities, these securities could have rights, preferences and privileges senior to those accruing to holders of common stock, and the terms of such debt could impose restrictions on our operations. The sale of additional equity or convertible debt securities would also result in additional dilution to our stockholders. See “Risk Factors” elsewhere in this Annual Report on Form 10-K for further discussion of potential dilution.

Contractual Obligations, Contingent Liabilities and Commercial Commitments

 

The following table presents our contractual obligations and commercial commitments as of December 31, 2005 over the next five years and thereafter (in millions):

 

 

Letters of Credit

 

As of December 31, 2005, we had outstanding $4.5 million in irrevocable letters of credit issued by us in favor of third-party beneficiaries, primarily related to long-term facility leases. The letters of credit are collateralized by restricted marketable securities, of which $3.8 million are classified as long-term marketable securities and $730,000 are classified as short-term marketable securities on our consolidated balance sheet dated as of December 31, 2005. The restrictions on these marketable securities lapse as we fulfill our obligations or as such obligations expire under the terms of the letters of credit. These restrictions are expected to lapse through May 2011.

 

Off-Balance Sheet Arrangements

 

We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, joint venture partners and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. These indemnification obligations are considered off-balance sheet arrangements in accordance with FASB Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements. See Note 11 to our consolidated financial statements included in this annual report on Form 10-K for further discussion of these indemnification agreements.

 

The conversion features of our 1% convertible senior notes are equity-linked derivatives. As such, we recognize these instruments as off-balance sheet arrangements. The conversion features associated with these notes would be accounted for as derivative instruments, except that they are indexed to our common stock and classified in stockholder’s equity. Therefore, these instruments meet the scope exception of paragraph 11(a) of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and are accordingly not accounted for as derivatives for purposes of SFAS No. 133. See Note 12 to our consolidated financial statements for more information.

 

Litigation

 

We are party to litigation which we consider routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our business, results of operations or financial condition. See “Legal Proceedings” elsewhere in this annual report on Form 10-K for further discussion on litigation.

Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” Effective on January 1, 2006, we adopted the provisions of SFAS No. 123R, which requires all share-based payments to employees, including grants of stock options, to be recognized in the income statement based on their fair values as of the date of grant. The adoption of this statement will result in the expensing of the fair value of stock options granted to employees. Prior to the adoption of SFAS 123R, we disclosed the impact of expensing the fair value of stock options only in the notes to the financial statements, which is no longer permitted. See Equity-Related Compensation in Note 2 to our consolidated financial statements.

 

SFAS No. 123R applies to new equity awards and to equity awards modified, repurchased, or canceled after the effective date of adoption. Additionally, compensation costs for the portion of awards for which the requisite service has not been rendered that are outstanding as of the effective date of adoption shall be recognized as the requisite service is rendered. The compensation cost for that portion of such awards shall be based on the grant-date fair value of those awards as calculated from the pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before the effective date of this statement are precluded. The compensation cost for those earlier awards shall be attributed to periods beginning on or after the effective date of our adoption of SFAS 123R using the attribution method that was used under SFAS No. 123, which was the straight-line method. Any unearned or deferred compensation related to those earlier awards shall be written off against the appropriate equity accounts. Additionally, common stock purchased pursuant to stock options granted under our employee stock purchase plan will be expensed based upon the fair market value of the stock option.

 

We adopted SFAS No. 123R on a modified prospective basis beginning January 1, 2006. Accordingly, the results of operations for future periods will not be comparable to our historical results of operations. The adoption of SFAS No. 123R will have a material impact on our results of operations, increasing cost of revenues, research and development, sales and marketing and general and administrative expenses. We currently estimate that adoption of the statement will reduce diluted earnings per share by approximately $0.14 in 2006; however, the amount may change based upon the number and value of additional stock option grants and forfeiture rates. We have utilized the Black-Scholes option pricing model to determine the value of our stock options. For more information on the impact of expensing stock options for the three years ended December 31, 2005, 2004 and 2003, see Equity-Related Compensation in Note 2 to our consolidated financial statements.

 

SFAS No. 123R also changes the reporting of tax-related amounts within the statement of cash flows. The gross amount of any windfall tax benefits resulting from stock-based compensation will be reported as cash flows from financing activities. Under the indirect method of presentation of the statement of cash flows, any shortfalls resulting from the write-off of deferred tax assets will be reported in net income and classified within the change of deferred income taxes in the operating section of the statement of cash flows.

 

Our exposure to market risk for changes in interest rates relates primarily to our debt and investment portfolio. In our investment portfolio we do not use derivative financial instruments. We place our investments with high quality issuers and, by policy, limit the amount of risk by investing primarily in money market funds, United States Treasury obligations, high-quality corporate and municipal obligations and certificates of deposit.

 

Our 1% convertible senior notes are subject to changes in market value. Under certain conditions, the holders of our 1% convertible senior notes may require us to redeem the notes on or after December 15, 2010. In December 2005, one of the conversion terms for the holders to redeem the 1% convertible senior notes was met; however, no notes have been converted as of March 15, 2006. As of December 31, 2005, the aggregate outstanding principal amount and the fair value of the 1% convertible senior notes were $200.0 million and $274.5 million, respectively.

 

We have operations in Europe and Asia. As a result, we are exposed to fluctuations in foreign exchange rates. Additionally, we may continue to expand our operations globally and sell to customers in foreign locations, which may increase our exposure to foreign exchange fluctuations. We do not have any foreign hedge contracts.

 

Index to Consolidated Financial Statements and Schedule

 

 

To the Board of Directors and Stockholders of Akamai Technologies, Inc.:

 

We have completed integrated audits of Akamai Technologies, Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements and financial statement schedule

 

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Akamai Technologies, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing on page 71 of this Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

/s/  PricewaterhouseCoopers LLP

 

Boston, Massachusetts

March 16, 2006

AKAMAI TECHNOLOGIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of the consolidated financial statements.

AKAMAI TECHNOLOGIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

The accompanying notes are an integral part of the consolidated financial statements.

AKAMAI TECHNOLOGIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

AKAMAI TECHNOLOGIES, INC.

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

For the Years Ended December 31, 2005, 2004 and 2003