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.
- 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).
- 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.
- Outstanding Stock Option Liability of $205mm or 6.5% of current market value
- Off-balance sheet debt of $198mm or 37% of Net Assets
- Deferred Tax Liability of $31mm or 6% of Net Assets.
- 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.
Note: Stock pick of the week is updated every Tuesday.