Stock Pick of the Week: Short Rackspace Hosting Inc (RAX) – Ignore the Takeover Hype

Rackspace Hosting Inc (RAX) is one of October’s Most Dan­ger­ous Stocks. A copy of our report is here: RAX. It details how RAX, like all of our Most Dan­ger­ous Stocks the company has (1) Mislead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing while true, eco­nomic prof­its are neg­a­tive and falling and (2) a High Val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation.

RED FLAGS:

1. Mis­lead­ing Earn­ings: RAX reported a $30mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $13mm (a dif­fer­ence of $43mm or 7% of rev­enue).
2. Very Dan­ger­ous Val­u­a­tion: Stock price of $25.636 implies RAX must grow its NOPAT at 25% com­pounded annu­ally for 17 years. A 17-year Growth Appre­ci­a­tion Period with a 25% com­pound­ing growth rate is quite a high stan­dard to beat, as per my post on How To Make Money Pick­ing Stocks. Note that expectations are even higher with the takeover speculation that caused the stock price to jump today (7%+ to over $27 at the time of this writing): now the company would have to grow NOPAT 25% compounded annually for 18 years to justify the $27 stock price.
3. Outstanding Stock Option Liability of $205mm or 6.5% of current market value
4. Off-balance sheet debt of $198mm or 37% of Net Assets
5. Deferred Tax Liability of $31mm or 6% of Net Assets.
6. Asset write-offs of $4mm (1% of reported net assets)

Over­all, the Risk/Reward of invest­ing in RAX’s stock looks Very Dan­ger­ous to me. There is lots of down­side risk given the Mis­lead­ing Earn­ings and Red Flags while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

The primary cause of the dif­fer­ence between Eco­nomic ver­sus Account­ing earn­ings is that RAX’s Invested Cap­i­tal grew faster than its NOPAT. Our report on RAX has detailed appendices for you to see how we perform all calculations. See Appen­dix 4 to learn how RAX’s NOPAT rose last year while though slower than Net Income. See Appen­dix 5 for details on RAX’s Invested Cap­i­tal. Appen­dix 7 (in the Return on Invested Cap­i­tal sec­tion) shows how a ris­ing NOPAT Mar­gin but falling Invested Cap­i­tal Turns result in a decrease in ROIC (from 6.5% to 5.72%) and Eco­nomic Earnings, which fell by $13mm while Net Income rose by $9mm.

As per Invest­ment Strat­egy 101 and How to make money pick­ing stocks, RAX fits the pro­file of a great stock to short or sell.

See Finance 101 and Eco­nomic Ver­sus Account­ing Prof­its for more detail on why account­ing prof­its are not reli­able indi­ca­tors of cor­po­rate prof­itabil­ity or value creation.

See my blog for all of my Stock Picks and Pans. Samples of some recent picks: Buy MSFT and buy IBM. Short CBG and short VMC.

Note: Stock pick of the week is updated every Tuesday.