Rackspace (RAX) is the self-termed "leading specialist in the hosting and cloud computing industry." The company's stock has soared over the past year, riding a wave of enthusiasm about the cloud. We conducted an in-depth analysis both of RAX's business model and its operating results, and we've arrived at some conclusions very different from those advanced by RAX bulls and by the Wall Street analysts covering the stock. We think RAX is a very attractive short right now.
Rackspace offers off-site storage solutions and IT services to companies ranging from small start-ups to large multinationals. The company's value proposition is that customers can save money by implementing RAX solutions rather than investing in their own servers and maintaining their own IT infrastructure. We take no issue with this perspective. RAX management likes to point out the considerable growth potential in the hosting and IT service industry. However, as euphoric investors and their sell-side analyst allies too often forget, providing value to customers in a growing industry does not necessarily mean that those providing the services will achieve strong profitability. This is especially true in a competitive, commoditized, and capital-intensive industry. We believe Rackspace operates in such an envinronment.
In a recent investor presentation, RAX claimed it has a "sustainable competitive advantage" on account of its "Fanatical Support." Fanatical Support is the company's trademarked term for its best-in-class customer support, a trait that the company believes makes it the IT service provider of choice for companies embracing the cloud. Rackspace says that its mission is to become "one of the world's great service companies."
In something of a contradiction, Rackspace seems to believe that competition is a formidable threat. From the company's Q1 2011 10-Q:
The market for hosting services continues to be highly competitive, and we face competition from existing competitors as well as new market entrants.
Either RAX has a sustainable competitive advantage or it doesn't. Which one is it?
The numbers tell the story. Companies with durable moats are able to achieve high rates of return on capital over many years. Notwithstanding quarterly fluctuations in ROC, the company's return is far lower than it was a few years ago. Here's a table showing RAX's ROC for the past five years (using the company's reported figures):
Return on Capital
The quarterly figures tell a similar story. Now, it's fair to expect ROC to decline for any business as it grows, but 9-11% returns on capital are not what one would expect of companies with sustainable competitive advantages. These figures are pretty pedestrian, and they're strong support for our belief that the industry is increasingly competitive and commoditized. Sure, there are certain differences between RAX and its competitors, but these differences aren't nearly substantial enough to give RAX pricing power.
As we said earlier, RAX wants to be "one of the world's great service companies." We think this strategy is flawed. Sure, Rackspace's customers appreciate the high level of service they get, but the numbers indicate that they're not willing to pay significantly more for Fanatical Support than for the less fanatical version they might get from a competitor. Importantly, providing Fanatical Support means that RAX will permanently have a higher cost structure than its competitors. It must hire more and better customer service employees than its competition. Furthermore, given the nature of Rackspace's business, ongoing customer service is only necessary if there is a problem. It seems to us that RAX customers would just as soon never have any interaction whatsoever with their dedicated service team after initial setup.
Another key fact that most people seem to miss about RAX is that the company's business is hugely capital intensive. Since RAX collects fees for renting space on its servers, it must buy new computing hardware if it wants to grow its business. This alone doesn't mean that Rackspace represents an attractive short, but it does mean that the company will have to make huge capital expenditures to grow its business at the rate Wall Street forecasts.
What makes RAX such an attractive short is that this indisputable fact is absent from all the research we've seen on the company. The consensus diluted EPS estimate for 2011 is just shy of 50 cents. The estimate rises to 90-95 cents in 2013. However, each research report we viewed does not show RAX capital expenditures rising meaningfully from 2011 levels. In other words, Wall Street analysts seem to believe that this capital intensive business can ramp its earnings growth without meaningfully increasing capital spending. This makes no sense. To quantify how absurd this projection is, RAX will have to earn 18-20% on its capital to meet both its EPS and cap ex consensus estimates in 2013. Conveniently, no one wants to stick their neck out by offering a coherent explanation for how RAX can achieve such high returns on capital in the future. Its ROC hasn't been higher than 12.5% in any quarter since 2007, and we don't see how this figure can grow given increasing competition and commoditization.
This leads us to our high-conviction short thesis: either Rackspace will have to invest much more in its infrastructure than is currently thought or its earnings will fall well short of analyst estimates down the road (or both). These outcomes will be bearish for RAX shares.
So what's a share of RAX worth right now? It's hard to claim that any capital intensive business operating in a competitive environment deserves a high multiple of earnings. It's rare to see such a business command a multiple north of 20x, unless, of course, it's riding a wave of irrational cloud euphoria. We think RAX will earn around 75 or 80 cents per share in 2013 if it spends about $1 billion in cap ex in 2012 and 2013 combined (the company has said it will spend around $300M this year). Its earnings will likely be lower than that if its capital spending is materially less than our forecast. Slap a 20x multiple on those earnings to get a valuation between $15 and $16 per share. We stress that we think 20x is too high, and these are future earnings estimates against which the company is likely to fall short. As such, a valuation lower than $15 is quite reasonable. Since the shares stand around $42 as of this writing, we think RAX is a juicy short opportunity.
The key risk to our forecast is that RAX could be an acquisition target. Rumors have swirled about the possibility for some time, and one of Rackspace's larger competitors, SAVVIS, was acquired recently for $3.2B, or about 11x estimated 2011 EBITDA. Currently, RAX trades at a $5.6B market cap, or about 18.5x its estimated 2011 EBITDA. Any acquirer would have to pay considerably more than to own RAX.
Now, companies make silly acquisitions all the time, but let's examine how absurd these valuations are. We're always skeptical when companies report EBITDA -- there's no reason to do so unless the E is unimpressive before the add-back of the BITDA -- but this metric is particularly ridiculous for capital intensive companies. Depreciation is a huge and very real expense for RAX, and it will become bigger and bigger as the company grows. There's no way around this. Sure, someone could buy RAX out and hurt our short position greatly. However, if this happens, you can be sure that we'll take a close look at the acquirer for our next short prospect.
If RAX remains independent, it could continue to trade higher. We have no idea when the swell of cloud irrationality will subside, but, when it does (if not sooner), RAX will trade much lower as its results fail to live up to expectations.