Rackspace: A Poor Business Model That's Severely Overvalued

| About: Rackspace Hosting, (RAX)

Rackspace (NYSE:RAX) is a flawed business model. It is a matching problem. RAX buys tech hardware that it owns as a long term investment and then rents it out in contracts of 1 to 2 years. This is a mismatch and the company will suffer from this flawed strategy. The valuation is also sky high. Maintaining the company’s growth rate will require unjustifiable capital outlays. This will cause the balance sheet to deteriorate, and the stock to fall.

Rackspace offers customers outsourced information technology or (IT). It offers customers the value proposition of buying their IT hardware and renting it back to them. RAX claims to add value with software and optimization. There may be some marginal benefit to these services but in reality the customers are talking to RAX because it is a way for them to reduce their costs. Customers are talking to RAX because they can avoid buying equipment and hiring staff. RAX’s customers get to take their IT needs and move them off the balance sheet, and thus spread them out over time on their income statement. It gets buried in operating expenses.

RAX’s clients also get a second benefit of having their IT spending become a variable expense as opposed to a fixed expense. Previously, companies had to buy their own servers and had to maintain them through a business cycle. Companies also had to maintain the full IT staff throughout the business cycle. A company can’t just fire their IT staff when things get tough because someone needs to run and maintain the servers. These costs are fixed. IT hardware investment was previously no different than acquiring a factory or any other machinery.

Thanks to RAX and others, companies can now make these costs variable. Customers sign a deal with RAX, usually one to two years, and then if business grows faster they can always increase their allocation. If business slows down their only obligation is the obligation in their contract. If a customer is lucky enough to have a contact expire half way through a down turn, RAX gets stuck with the bill.

And that is really the problem. The risk of owning and maintaining IT infrastructure hasn’t vanished it has simply been transferred from the owners of real businesses to RAX and their competitors. It’s “just in-time” computing capacity.

Does that phrase sound familiar? In the late 1990’s there were a number of high flying contract manufacturers. Jabil, Flextronics, Sanmina, and few dozen others were some of the highest of the high flying dot-com era bubble stocks. They provided “just-in-time” manufacturing. When the going was good contract manufacturers built the factories and got a small premium for actually building the products others designed. When things turned sour however these companies were left with the manufacturing capacity and no business to run through it. Sanmina’s stock suffered the worst falling from around $350 per share to a low of roughly $1.50. Flextronics and Jabil also both suffered 90% declines from high to low. Funny thing is things never truly got too terrible. Sure we had two recessions, but technology hardware output is certainly higher today than it was in 1999. The fact is that the returns in this type of business don’t justify the costs. Worse yet there are very little barriers to entry. Already tight margins get squeezed into oblivion even during the good times, leaving company’s woefully undercapitalized in the bad times.

Contract manufacturers used to claim that they wouldn’t get their margins squeezed because they “added value” to the manufacturing process. Further they claimed that to “design in” (i.e. acquiring the manufacturing know-how to build certain products) took months or years and represented a barrier to entry. Today RAX’s differentiating claims are even less compelling. RAX claims world class service as a barrier to entry. RAX even has a name for it: “Fanatical Support” which is apparently only deliverable by RAX employees who the CEO calls “Rackers.” The CEO mentions the phrase “Fanatical Support” 6 times in his opening remarks during the last conference call. This “Fanatical Support” must be so good that customers are will stay loyal through down turns. I would bet that no matter how good RAX’s support is, customers will cut back in tough times.

A rapid expansion

Just like during the contract manufacturers’ heyday, the business makes a lot of sense for the early entrants. As companies attempt to grow too fast however, overcapacity and declining pricing is inevitable. If you look closely at this space you will see RAX and competitors like Equinix (NASDAQ:EQIX) are making the same mistakes that the contract manufacturers made. The industry is rapidly expanding capacity which even in a good environment will crimp margins. When the business environment turns south expansion will prove devastating.

In 2010 RAX spent 215.7m in capital expenditures (cap-ex). In 2011 it came into the year expecting to spend 275-335m (according to the 2010 10-K), but as of the last conference call it is now up to $350m to $360m for this year. RAX is going to have to spend roughly $100m in the 4th Q alone or roughly half of what it spent in all of 2010 in order to reach that goal. EQIX stated on their last conference call that it expects to spend $645-$665m for 2011. This is up from an estimated $580m at the beginning of the year (per the 10-K). These two companies alone are spending close to $1b in cap-ex this year.

RAX claims this spending is a good thing because it is for “support” of new customers and growth of existing accounts. This term support could be misleading. It almost makes it sound like this is something that can be turned on or off at will. It is not support of customers but purchases for the customers. RAX is buying the servers that the customers are not buying for themselves. It’s almost like a sale –lease back. RAX is buying business.

Watch the balance sheet deteriorate

One small item I would mention is that last quarter the company had a one-time sale of intellectual property to the tune of almost $40m which was quietly tucked into other non-current assets. That line went from 14m last Q to $53m this Q. This wasn’t mentioned much as it will be amortized over the estimated life of the IP. We don’t know how long the estimated life is. If it is ten years then the company will receive $4m in sales and EBT profits per year in excess of their normal business. It is generally inconsequential, but it did have the affect of bolstering the balance sheet last Q.

Moving beyond that issue the company’s debts are beginning to mount. The capital leases require payback and as its capital outlays have grown so too have its obligations. In the first 9 months of this year, the company has paid back capital leases to the tune of $50m, it will have to do another $43m in the 4th Q alone. Coming into the year RAX had obligations to repay capital leases in the 2012-2013 time frame of 161m and as of September 30th that number has increased to $221m.

Assuming the number doesn’t rise that’s roughly 110m next year. This company is not spending now for benefits down the road. RAX needs to spend money to make money (or should I say to make sales). If it is going to continue to grow at this pace it would be my expectation that it would need to continue with this fast pace of cap-ex. If we assume that is true, then it will need to spend roughly $400m next year (conservatively). Depreciation has grown more modestly. This quick ramp in cap-ex is causing an imbalance. Depreciation was $39m in September of 2010 only growing to $49m in September 2011. In the same time frame cap-ex doubled. Assuming depreciation of roughly $60m per Q next year, you have a difference of roughly $160m. If you remove the $110m analysts are expecting RAX to do in net income you have a potential negative free cash flow of roughly $50m.

This should continue ad infinitum if RAX continues to grow or it will worsen dramatically if sales and EPS decelerate because the company will quickly loose that net income but the depreciation won’t go away. True RAX can throttle back cap-ex, but the drag effect of the current high spending will linger for a few years, negatively affecting free cash flow.

Valuation

This risky business model has resulted in fast growth. That is not surprising because RAX is essentially giving away the store. In the out years, RAX is going to be stuck with old hardware and the customers are going to demand that they buy new products. Alternatively the customers can go to some other upstart outsourcer who is not sitting on old equipment.

This rapid growth has awarded RAX a rich valuation of roughly 91x trailing EPS and 53x forward. Wall Street is too focused on the top line and isn’t keying in on the fact that the foundation of the company is cracking. That foundation made up of the depreciating assets and the mounting debts will start inevitably emerge. Either a slowdown in the economy will further weaken free cash flow or capital constraints will limit RAX’s new hardware purchases.

“Fanatical” Insider Sales

Maybe the company’s management team is seeing the same thing I am seeing because if you look at the SEC filings on RAX you’ll see some insiders with itchy trigger fingers. It appears that the only thing more “Fanatical” than their service is the insiders yearning to rid themselves of this company’s shares. In the last 6 months according to Yahoo finance there have been 60 transactions involving 3.5m shares sold. Zero shares have been bought. If you assume an average price of $35 that’s over $120m in six months extracted by management.

In Conclusion

The business model around outsourced Infrastructure Technology is severely flawed. RAX’s current stock valuation (91x tailing EPS and 53x forward, nearly 11x book value and 6x sales) makes this situation perilous. RAX is rapidly expanding and the returns do not justify the spending. The industry is growing more competitive which will relentlessly drive margins lower over long periods of time. This will prove especially deleterious in a down turn. In the short run the ramping up of cap-ex by RAX and competitors represents a dangerous new phase with much higher risks, and an even more inevitable outcome.

Disclosure: I am short RAX.

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