Don’t Believe The Takeover Hype, Rackspace Hosting Is A Juicy Short

Nov. 2 2010 - 2:56 pm | 1,364 views | 1 recommendation |

Red flags for RAX

Rackspace Hosting is one of the market’s?most dan-ger-ous stocks. (A copy of my?report on RAX is here.) ??RAX has mislead-ing earnings (account-ing prof-its are pos-i-tive and ris-ing while true, eco-nomic prof-its are neg-a-tive and falling) and very high expec-ta-tions embed-ded in the cur-rent valuation.

Here are some of the red flags as I see them:

1. Mis-lead-ing Earn-ings: RAX reported a $9 million increase in GAAP earn-ings while our model shows eco-nomic earn-ings declined by $13 million (a dif-fer-ence of $21mm or 3% of rev-enue).
2. Very Dan-ger-ous Val-u-a-tion: ?Stock price of $25.636 implies RAX must grow its NOPAT at 25% com-pounded annu-ally for 17 years.?Note that expectations are even higher with the takeover speculation that caused the stock price to jump Tuesday by 7% to above $27 at the time of this writing. ?The?company would have to grow NOPAT 25% compounded annually for 18 years to justify the $27 stock price.
3. Outstanding stock option liabilities of $205 million or 6.5% of current market value.
4. Off-balance sheet debt of $198 million or 37% of net assets.
5. Deferred tax liability of $31 million or 6% of net assets.
6. Asset write-offs of $4 million ?or 6% of net assets.

Over-all, the Risk/Reward of invest-ing in RAX’s stock is not appealing to me. ?There is lots of down-side risk while there is lit-tle upside reward given the already-rich expec-ta-tions embed-ded in the stock?price.

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The primary cause of the dif-fer-ence between Eco-nomic ver-sus Account-ing earn-ings is that RAX’s Invested Cap-i-tal grew faster than its net operating profit after taxes. Our report on RAX has detailed appendices for you to see how we perform all calculations. See Appen-dix 4 to learn how RAX’s net operating profit after taxes?rose last year while though slower than Net Income. See Appen-dix 5 for details on RAX’s Invested Cap-i-tal. Appen-dix 7 (in the return on invested cap-i-tal sec-tion) shows how a ris-ing net operating profit after taxes?Mar-gin but falling invested cap-i-tal turns result in a decrease in ROIC (from 6.5% to 5.72%) and eco-nomic profit/earnings, which fell by $13mm while Net Income rose by $9mm.

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