I like to keep a close eye on the developments of the Information Technology Services industry. Over the past couple of days, Rackspace Hosting, Inc. (NYSE:RAX) has been widely discussed, as its stock took a strong beating -it fell more than 20% in two days. This drop was mainly set in motion by the news of the departure of the company's co-founder and CEO Lanham Napier. Despite the already analyzed consequences of this, I would like to take a look at a particular aspect of this company, which can tell us a lot about the risk implied in investing in this company in times of uncertainty: its on debt and liabilities.
I will look into Rackspace Hosting, Inc.'s total debt, total liabilities and debt ratios. In addition, I will examine what analyst and other top investors think about this company. This analysis is crucial to understanding the risks of investing in this company, and will allow us to appreciate how leveraged a company is, and what kind of returns to expect for a long-term investment. As the years 2008 and 2009 have taught us, leveraged companies with large amounts of debt can have a devastating impact over your investment. However, by taking a close look into the debt scheme of Rackspace Hosting, Inc., we will be able to elucidate if the company is likely to maintain its capital, and use it for future growth.
Total Debt to Total Assets Ratio
This metric is used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It results from adding short-term and long-term debt and then dividing this figure by the company's total assets. If the outcome is higher than 1, it means that a company´s total debt surpasses the value of its total assets. Au contraire, a debt ratio smaller than 1 indicates that a company's assets are worth more than its total debt. The total debt to total assets ratio (especially when complemented with other measures of financial health) can come in extremely handy when investors want to determine a company's level of risk.
Rackspace Hosting, Inc.'s total debt to total assets ratio has decreased over the past three years, from 0.16 to 0.09. This indicates that since 2010, the company has added more total asset value than total debt. This shows that management is committed to reducing debt. As this figure is currently well below 1x (0.09), Rackspace faces low financial risk, since it has more assets than total debt.
Debt ratio = Total Liabilities / Total Assets
The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged". A company with a high debt ratio -or that is "highly leveraged"- could be in danger if creditors start to demand repayment of debt.
Over the past three years, Rackspace Hosting, Inc.'s total liabilities to total assets ratio has experienced a decline, from 0.41 to 0.35, which is usually a good sign, in my view.
In addition, the fact that the 2013 TTM ratio is below the 0.50 mark, indicates that Rackspace has not financed most of its assets through debt. This is a good signal.
Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity
The debt-to-equity ratio is another leverage ratio that compares a company's total liabilities with its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligators have committed to the company versus what the shareholders have committed.
A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in the company reporting volatile earnings. In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, and therefore is considered a riskier investment.
Rackspace Hosting, Inc.'s debt-to-equity ratio has fallen over the past three years. In 2013, it acquired a value of 0.53, compared to 0.73 in 2011. This is an encouraging sign, as it shows that the company has ameliorated its balance sheet and risk profile.
As the company´s ratio for 2013 stands at 0.53, under 1x, the risk for the company is quite low. In addition, this figure implies that shareholders have invested less than suppliers, lenders, creditors and obligators.
Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity
(LT Debt = Long-Term Debt)
The capitalization ratio tells investors the extent to which the company is using its equity to support operations and growth. This ratio helps in the assessment of risk. Companies with a high capitalization ratio are considered to be risky: if they fail to repay their debt on time, jeopardy of insolvency gets high. Companies with an elevated capitalization ratio may also find it difficult to get more loans in the future.
Since 2011, Rackspace Hosting, Inc.'s capitalization ratio has decreased from 0.14 to 0.07, in 2013. This means that the firm's equity compared to its long-term debt has grown, and has served to the purpose of supporting operations and growth. Furthermore, a reduction in this ratio implies a lesser financial risk for the company and its investors.
Rackspace boasts strong fundamentals and looks very healthy, financially. This makes it a very safe investment. In addition, analysts estimate, in average, that the company will grow (its EPS) at an average rate of 18%-19% per year over the next five years. However, not every one of them is so sure about the company's ability to reach these projections. The lack of an economic moat makes it particularly susceptible to competition and new industry entrants. Not only can the company lose clients to its peers, but also increased competition (and low barriers to entry) will most likely drive Rackspace 's pricing power down considerably over the next few years. Actually, this phenomenon has already commenced, and the company last reported a shrinking gross margin.
On the other hand, increasing adoption of cloud solutions bodes well, not only for Rackspace , but also for the wider industry, and RAX is particularly well position to take advantage of this, and to increase its customer base. Furthermore, the company is using NASA technology for the development of OpenStack, an open-source platform that is poised to become a standard for cloud computing services. This could certainly provide an important revenue stream somewhere down the road.
Despite the steep descent in the stock price, Rackspace still trades at a substantial premium in relation to its peers. Valued at around 47 times the company's earnings, the stock triples its industry's average. However, I should also highlight that the stock trades closer to the lower end of its historic valuation than to the higher end.
Compared to a close competitor, Equinix Inc (NASDAQ:EQIX), Rackspace's valuation becomes even more attractive. EQIX trades at almost 110 times the company's earnings and boasts narrower returns on equity and capital, and net margin.
Despite the uncertainty surrounding Rackspace at the time, I like the way the company´s future looks. A strong financial standing makes it a safe bet, and a relatively low valuation provides plenty of room for upside.
It is important to check which hedge funds bought the stock in the last quarter and at what price they did so. I assume that if a prominent institutional investor put money into Rackspace Hosting, Inc., the stock will pass strict fundamental standards. In this line, both George Soros and Murray Stahi invested in the stock in the past quarter at an average price of $44.66.
Analysts also provide a good outlook for Rackspace Hosting, Inc.. Analysts at Yahoo! Finance expect Rackspace to retrieve EPS of $0.63 for FY 2013 and an EPS of $0.85 for FY 2014. Analysts at Bloomberg are estimating Rackspace Hosting, Inc.'s revenue to be at $1.78B million for FY 2013 and $2.07B million for FY 2014.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.