February 16, 2010 - 12:40pm EST by
2010 2011
Price: 18.50 EPS $0.27 $0.41
Shares Out. (in M): 125 P/E 68.5x 45.0x
Market Cap (in $M): 2,300 P/FCF na na
Net Debt (in $M): 0 EBIT 59 84
TEV ($): 2,600 TEV/EBIT 44.0x 30.0x
Borrow Cost: NA

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Rackspace provides on-demand IT services delivered over the internet.  They differentiate themselves through emphasizing customer service, an approach called "fanatical service."  They have two business segments, hosting and cloud computing.  Hosting is an okay business that is slowing in growth and faces a good amount of risk from both changing technologies and pricing pressures.  The company is currently able to earn 9% return on assets and revenues are growing at about 12%, perhaps depressed by the weak economy.  Cloud computing is a group of high growth but commoditized IT services, such as webmail hosting, where Rackspace faces significant competition from Amazon, Google, Microsoft, ATT, and others, and has no competitive advantage. The market has become enamored with cloud computing as a secular IT trend, and Rackspace has successfully promoted itself as the ideal cloud computing pure-play.  Valuation has become delusional, with the sell side playing their usual shameful role as cheerleaders on the road to shareholder destruction.  With a return on capital of 9% and declining on a capital intensive business, no amount of growth can justify the current valuation of 7x EV / capital base.  For investors that are willing to wait out the hype, Rackspace is a good short. 

Rackspace's core hosting business

Rackspace's hosting business takes software that would traditionally have been hosted on a client's own server and moves it to Rackspace's servers, leaving Rackspace in charge of maintenance and support.  It is analogous to a partial sale-leaseback of a company's IT department.  Contract terms are 1-2 years, with Rackspace bearing the risk of redeploying the hardware should the customer not renew.  The business is somewhat sticky, as services are typically mission critical and somewhat complex, such that satisified customers are unlikely to switch to a competitor for a small price improvement.  Churn has been stable around 12% annual, a good portion of which is probably due to inability to pay in the face of the recession.  It has been offset by net upgrades (price increases and up-sells) of about 15% annual.  However, net upgrades has been trending down with the maturity of the customer base.  Combined with slowing rates of new customer acquisition, this has led to decelerating revenue segment revenue growth.  

Cloud Computing

Cloud computing is jargon that refers to pooled computing resources delivered over the internet.  Examples include gmail, Mozy (file storage and backup performed over the internet), and Salesforce.com ("software as a service").  Cloud computing is expected to be a powerful secular trend in IT, as it has the potential to provide substantial cost savings while delivering improved quality of service, increasing operational flexibility, and freeing up on-site resources to be devoted to the highest value opportunities.   We don't disagree with either the importance or size of this trend.  Rackspace, however, is at the commodity end of the trend; their products are hosted web mail, remote disk storage, and shared processing, none of which are differentiated offerings.  Rackspace's offering is still small relative to the company, but has grown rapidly.  Cloud revenues are up 250% over the last year, though they still only represent 9% of revenues as of the last quarter.


Stk px $18.24
SOS: 125mm.  145mm with dilution from options (avg price $5)

Debt: $170mm
Cash: $100mm ($200mm with option exercise)

Mkt Cap: $2.6B (with options dilution)
EV: $2.6B roughly
Net working capital + long-term assets: $385mm

TTM Sales: $602mm
growth y-o-y:18%
EBITDA: $168mm
Net income: $26mm
Capex: $115mm
D&A:$116mm (very important to emphasize their entire capital base is depreciated in 3 years at this rate, and must be replaced in order to maintain business)

Oper margin: 8.6%
EBITDA margin: 27.9%

How is the current valuation being justified?

The sell-side is universally bullish due to near-term growth outlook.  They focus on the lack of private equity overhang (shares were distributed) and outrageously use EBITDA multiples to justify the valuation.   EBITDA is not appropriate for such a capital intensive business.  It seems that the capital intensity is something the street is choosing to totally ignore, both by using EBITDA multiples and ignoring the 9% return on capital.  RAX's growth has been fueled by capital, leading to weak cash flow.  

The problem with using EBITDA multiples to value Rackspace is, if one wanted to milk Rackspace for cash, shutting off capex would lead to two, possibly three, years of cashflow from Rackspace's enterprise as customers jumped ship.  The services Rackspace provides require constant purchase of new and faster servers just to stay even with the competition or what corporations can deploy internally.  
Using 10x ebitda seems comparable, or perhaps even more egregious, to using 10x EBITDAX for an E&P like Chesapeake Energy. Capital intensive fast growers may deserve high earnings multiples, but not high ebitda multiples.


The cloud computing crowd moves on to the next big growth play

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