The Destroyer of Finance

Company: Rackspace Hosting, Inc.

Symbol: RAX

Current Price: ~$10.40

Summary (per yahoo): Rackspace Hosting, Inc. provides information technology systems and computing as a service for businesses worldwide. It delivers enterprise-level managed services, such as Websites and Web-based information technology systems. The company’s portfolio of hosted services includes managed hosting, email hosting, cloud hosting, and platform hosting. It offers hosting solutions comprising virtualization, security services, email services, database services, storage and backup, reporting and administration, and professional services for small businesses, medium to large businesses, software as a service providers, and Web designers and developers. The company was founded in 1998 and is headquartered in San Antonio, Texas.

 2007 Net Income: $17.8M

 A profitable tech?  More specific, a profitable *IPO* tech?  Shocking.  I’ve never paid big money for a rack, but everything I hear says it’s a booming business (bada bing?).  Seriously though, it IS a growing industry and there is no real reason for RAX to suddenly become a money losing business.

 RAX has to be MORE than a money making business though.  It has to be an exploding business, one that continues to grow at 60%/yr over the next four years or so.  An influx of over $100M from the IPO is certainly going to help reach that goal by aiding in capital investments for new capacity (either directly or through debt reduction).  Asking any business to do this is always a risky proposition, although some do manage to succeed.

 You may remember that I steered away from a different company (Intuitive Surgical) for similar reasons, but there are some differences:

 - Known competition: No surprises in this industry as far as competition.  RAX has several established competitors and knows that it must constantly increase the value of its product for its customer to survival.  RAX is certainly at no risk of resting on its laurels at this time.

- Customer Savings: Unlike an expensive medical tool, RAX’s product is easily marketable in both down times and up times.  Every potential client is looking for ways to cut costs while maintaining/enhancing their technical abilities, which are both things that RAX offers.  It’s one thing to pitch a million dollar machine  based on superior surgical results for the patient and long term revenue enhancements, it’s another to pitch immediate cost savings to a profit seeking corporation.

 Sounds good, but there is also the regulation tech industry draw back:  over-build.  My brief in-depth research suggests that there has been significant expansion in the hosting industry and therefore greater than normal opportunity for some rough times should demand for services not continue to increase at the expected rate (think hi-speed internet infrastructure build out in the late 90’s that collapsed in the dot com bust).  The strong rise stronger for the shake out, but it’s not something you want to be a shareholder for.

 So what’s RAX worth?  After the IPO there are about 115.4 million shares outstanding.  Yahoo tells you that there are 101 million shares outstandings, but Yahoo is essentially retarded and never gets an IPO’s shares count right.  I’m right.  Check it with the man.

 Heck, that document in the link has all the numbers.

 Anyway, so 115.4M at about $10.40 a share amounts to about $1.2 billion dollars.  That’s fairly steep for a company that pulled in $17 million in profit last year, but if it can achieve 60% growth, then it’s worth it.

 But wait!  There’s more.

 22.8 million extra shares in existing options and warrants and an extra 6.8 million shares “available for grant” under employee incentive plans.  Wicked!  So YOU think there’s 115.4 million shares, but really there’s 145 million shares.  The “strike price” on the options are all either significantly below the current stock price (making at least a handful of employees instant millionaires) or about what it’s trading for right now.  As a shareholder you would HAVE to hope these options get exercised, because if they don’t that means that stock price has never gone up any.

 So 145 million shares at $10.40 = $1.5 billion!  WOW!  After all that, I can admit that if RAX holds the 60% line, it’s still fairly valued.  Still maybe even undervalued even.  If you could promise me 60% growth, it could be worth $30 in five years or so.  If you only get 50% though, it drops to more like $22.  And if it’s just a puny 40%/year, well, I’d probably only give you about $12 for that.

 So there’s definitely some range here.  What would I recommend?

 Hell, I don’t know.  How much more can the Western market for this product grow?  Let’s not talk about China… if you think an American company is going to bust into the dragon’s lair and storm the nacent hosting sector their, I’ve got a Georgian military offensive to sell you.  If you want, let’s consider stateside demand for the service by Chinese firms.  Let’s not worry about India, as I’m fairly confident that they’ll take care of their needs in house.  I hear they have some tech labor over there.

 You figure out how much room is left in the US, Canada, Europe… maybe even South America and Africa.  Then you’ll have a better idea how long RAX can keep up the growth.  I couldn’t even begin to claim to have the beginnings of an idea, though.

 I would, however, recommend waiting 6 months before buying into RAX.  Use it to research the stock if you want.  Why 6 months?

 That’s when pre-ipo shareholders can begin to sell their stock.  It might not hurt the price, but it won’t help it either.

 What a sultry, sweaty day… and on all such sultry days it is fitting that S all happens in the world.

 Some dude named Dell and his company had a good day after reporting a very nice improvement in sales.

 Oil has retreated somewhat to $127, but don’t expect gas prices to track perfectly.  Part of the reason is the refiners.  The profit margins for petrol refiners have gotten squeezed in recent weeks as they have been unable to fully pass along the increased cost of oil (this is me saying that if they had been able to, gas would be a good 10 cents a gallon more expensive).  The refiners will look to recover some of that margin as oil retreats in price.

 I know few out there are going to shed a tear for the refiners, but thems the breaks.  You could refine your own 87 octane if you wanted.  What… you can’t?  Guess you’re stuck then.  And all it would take would be a multi million dollar start up investment plus loads of money in federal compliance regulations.

 I was in the elevator lobby on my floor staring at the fairly large flatscreen we have hanging on the wall yesterday.  It was after market close and there were these people on CNBC with snazy ties and shiny shirts and perfectly groomed and producted up hair and stupid ass goatees just spouting stuff, and I’ve just got to say:

 D

 O

 U

 C

 H

 E

 .

 These same people were pondering which restaurants had hedged their food costs and which restaurants had decided to rely on the “free market”.  Sorry guys, by the ability to manage risk (hedges) is sort of a key element of “free market.”

 Also, I let my CFO onto the floor today.  My backstabbing fatass ex-boss would probably be green to see me greet a banking CFO by first name.

Company: USG Corp (NYSE: USG)

 Industry: General Building Materials

 2007 Profit: $76M

 Current Market Capitalization: ~ $3.37B

 Current Price/Earnings: ehhh… NA?

 Industry Avg. P/E: ~21.9

 Ok, so USG makes building products.  Home building products.  HOMEbuilding products.  Mostly they are gypsum based.  Now I don’t understand how you base your buisness around a wandering tribe of peoples from eastern europe, and clearly neither does USG.

 Where the housing market goes, so goes USG.  With the major part of USG’s business coming from sales of wallboard and related products in the US [84%, fyi] (although they do business in Mexco, Canada, and China as well) USG is tied to both the commercial demand from homebuilders (most important) and the retail demand from the home improving consumer.

 USG has recently stated that they believe the decline in homebuilding activity has leveled off… at about 50% of previous levels.  As for the retail consumer… well, have you seen retail sales numbers?  Things aren’t really expected to get any better anytime soon, either.  Analysts’ predictions for future earnings…, I mean losses, keep getting worse and some of this might be the three consecutive quarters with results at least 30% worse than expected.  From a profit of $1.06 a share in 2007 Wall Street now expects a loss of $1.30 a share in 2008… on a larger number of shares.

 On the other hand, USG is pretty much the world’s leader in production of gypsum wallboard.  They are in the middle of an effort to close old inefficient plants and open new plants in an attempt to lower costs and shed staff.  There will be costs associated with this plan (paying off all the people they let go, for one), and if the US housing sector stays in the doldrums it won’t really make so much of a difference.  While the cost that USG must pay for its raw materials has increased, the sagging demand from the housing sector has left USG getting only 64% as much per sq ft as they did a year ago.  Hell, they’re only getting 94.7% as much per sq ft as they did the previous quarter (nevermind last year).  USG’s gross margin on their products has fallen from 16.8% a year ago to only 3.5% this year.  USG does note that they successfully implemented a price increase near the end of the first quarter.

 On the positive side of things, USG has managed to hold onto more of its demand than the wallboard industry as a whole.  While the demand for wallboard fell 13% from a year ago, USG’s sales (by sq ft) fell only 3%

 The key will be holding onto their demand and making it through their reorganization effort.  Many of the the smaller wallboard producers will not survive the this shakeout, and with the attention given to cost efficiency now USG would definitely be in pretty good shape on the other side.  There is also, of course, the possibility of increased wallboard demand in emerging markets (in general) but China in particular, especially in the aftermath of the earthquake (they need to repair those lake dams after all).

 So am I going to keep rambling?  Always.

 Risk level: moderately high

 Current price: $34.05

 So the question is: Is there a reasonable probability that USG worth at least 30% more ($44.25)?

 I really don’t see it.  In fact, I’m not so sure that it’s worth $34.  Mid $20’s and I get interested OR if the second quarter’s results indicate that the restructuring is going well I’d re-examine.  Problem is that USG would have to have a profit level equivalent to 2006 levels (the height of the housing boom) to justify $44, and that’s assuming no further share dilution.  That’s pretty hopeful for any time in the next few years.

 Everyone knows that I love wallboard,

 Manny Ramirez

 In the matter of Union Pacific (here referred to as “UP”) and Burlington Northern Santa Fe (“BNSF”), we see two very similar rail companies.  Cut off your left arm.  Now clone it.  Draw a smiley face on the original (if you can figure it out), and you’d have about what UP and BNSF are to each other.  Well, that and two severed arms.

 But if you had to pick just one to entrust with your future and the health of your children, how could you chose?

 I have looked over these two damn companies, and I will assure you that there is not much to seperate them.

 Advantage UP:

 Union Pacific has the edge in both network size and rail fleet size. 

 UP’s system of owned tacks (not including trackage rights) is about 10% bigger than BNSF’s, both in terms of main line route track and inclusive of sidings, yard, and multiple tracks.  While a bigger system does entail more maintenance cost, it also present greater opportunity for additional volume and more fees form other rail shippers to use your track.

 UP also has about a third more locomotives in their fleet (including switching engines and all leased engines) and nearly 11% more rail cars (again, including leased equipment) than BNSF.  All that amounts to, again, a greater volume capacity and more operational flexibility to haul more freight from an outside source (say, Archer Daniel Midland, Cargill, or… Trinity?).

 Advantage BNSF:

 BNSF has younger equipment, more complete west coast coverage.

  While both companies have locomotive fleets of roughly the same age (about 14-15 years), and therefore approximately the same efficiency and maintenance, there is a dramatic difference in the age of the freight car fleet.  UP’s freight cars average almost 28 years old (avg for all car types) while BNSF, having undertaken to modernize their fleet, has an average freight car age of 14 years.

 I know, I know.  It’s just a damned steel box on wheels, right?  What does it matter how old it is?  In truth, improvements have been made over the years so that new freight cars are almost always more efficient and require less maintenance than old cars (both because they are new and because they are made better).  For some cars, like flat cars, this isn’t such a big deal.  For others, it is a big deal.  And you can’t just throw ethanol (our savior) into any old tanker car, you’ve got to have a new tanker that’s lined to prevent corrosion.

 Yeah, ethanol is way more corrosive than gasoline.  Aren’t you glad you’re putting it in your car?

 BNSF also has very good access to the Seattle area, while UP has no owned track in the area (and barely any in the state).  Since they both have the required access to the Bay area and to Los Angeles, the Seattle access gives BNSF a more complete West Coast coverage.

 Pick ‘em:

 UP seems well situated to handle growth any type of rail shipping and has the biggest and best switching and processing yards.

 BNSF seems well situated to handle growth in Intermodal container shipping and operates the biggest and busiest intermodal yards.

 So, I guess that’s a pick ‘em.

 Fundamentals:

 Hell, it’s basically the same stock.  The dividend payout is about the same, the PEG ratio is about the same.  BNSF has a little bit more debt, but also has had more revenue and cash flow growth in the last few years and has slightly better profit margins.

 All in all, gun to the head, I think I’d lean toward BNSF.  I personally like the advantages BNSF has in the newer rail cars and intermodal facilities.  UP will have to modernize their freight fleet eventually, and domestic growth, in terms of replacing reliance on the 18 wheeler, will be undoubtedly based on intermodal containers.

 However, they are so much the same company, in the same geographical region, that it’s hard to see one having great success where the other one doesn’t also enjoy some level of gain.

 In retrospect, I shouldn’t promise anything on the 4th and 6th business day every month.  If I do, then prepare for disappointment.

 I don’t think Union Pacific investors are normally called “Youppers”, nor does the company has an overwhelming amount to do with the Upper Peninsula of Michigan (the UP, whose residents are called Youppers).  I just thought it fit.

Company: Union Pacific Corp. (NYSE: UNP)

 Industry: Railroad, Shipping

 2007 Profit: $1.6B

 Current Market Capitalization: ~ $38B

 Current Price/Earnings: ~ 20.5

 Industry Avg. P/E: ~15.4

 The railroad industry, as far as actually operating rail lines goes, can be boiled down to this:

• In the Western US you have the great Union Pacific, measuring at just over 32,000 miles of track squaring off against the cumbersomely named Burlington Northern Santa Fe, also throwing down with about 32,000 miles of track.
• In the Eastern US the matchup is between Norfolk Southern (21,000 miles) and CSX (again, 21,000 miles)
• Two to bouts meet only along the Mississippi River corridor and in rail yard central: Chicago.  To keep the two arenas separate, a fifth big rail player (Canadian National, 20,400 miles) operates a rail line from Canada to New Orleans almost straight down the Mississippi (and from coast to coast in Canadia, of course).

 Canadian National actually provides a cracking good system map to show the absurd overlays between the two sets of competitors.  Find it here.  (It’s a pdf, so deal with that.)  There’s a couple more bit players in Canadian Pacific and Kansas City Southern, but if all you knew about North American railroads was UP, BNSF, NS, CSX, and CN then you’d have it covered.

 This isn’t what you’d call an exciting sector of the economy, and there’s not even likely to be any cool mergers.  I’m not sure that government regulators would even allow one of the western rail companies to buy an eastern company, but I seriously doubt they’d allow the regional competitors to consolidated with each other.  I also doubt that they’d even try, to be honest.  All this means is that future rail growth will have to be internal, and for the last couple years, at least, Union Pacific has been successful.

 Not so much from increased traffic, either.  While the number of cars have increased since 2005, it’s not steady growth (nor can you expect it to be with as many cyclical industries using rail shipping as there are).  Instead the growth has come primarily from rate increases as Union Pacific (and its brethren) have exhibited an ability to pass on prices increases to the customer.

 Their success in the department has been, perhaps, too… successful?  Rail customers, agricultural customers in particular, have started agitating for increased government controls over shipping rates.  Needless to say, such regulation would be quite detrimental to the rail industry.  This sort of regulation would also put a dent in the new found desire to pump new money into upgrading the rail infrastructure (something that has been needed for some time).

 In the end, Union Pacific is fairly valued compared to their industry and has a pretty solid balance sheet.  Wall Street seems to expect pretty respectable earnings growth, and as long as oil prices remain high (and the government stays hands off) they will likely get their growth.  The railroads will have to pay a higher fuel bill too, but rail shipping is pretty energy efficient and then you get the whole “pass the price increase onto the customer” thing.  As far as the merits of the industry go, Mr. Buffett seems to be enthused by rails that he (his company, Berkshire) now owns over 10% of Burlington Northern in addition to significant, yet smaller, holdings in Norfolk and Union Pacific.

 The industry has also attracted less welcome attention, such as that of the activist The Children’s Investment Fund which has a very significant holding in CSX (and other notable holdings in Norfolk and Union Pacific, although neither as large as Buffett’s).  TCI has never been one to let steady positive performance in the past stand in their way, and will often seek to impose their will on the company even in spite of this.  For this reason, I would avoid investing long term in CSX due to TCI’s position. (TCI is attempting to oust the board of directors right now, actually.)

 Ultimately, I think any of the railroads (except CSX) are acceptable investments, although Union Pacific (UNP) and Burlington Northern (BNI) are probably the strongest bets due to their access to the west coast shipping ports (commercial goods imported and raw materials [eg coal for China] export) and Gulf coast.

 Confrence calls are great times for blogging.

 So, I was thinking, really “banks” aren’t worried about millions of dollars of loans failing, banks are worried when Hundreds of BILLIONS of loans go away.  I just defaulted to “millions” because my bank is small enough to notice that sort of detail (that would be a rounding error at a place like Bank of America of JPM Chase).  Well, ok, maybe it takes something in the tens of millions.  I digress.

 I’m hoping that I won’t make so many people distraught today as I did with Intuitive Surgical, although the massive traffic spike was great fun.  I’ve come to the realization, while I was on the treadmill yesterday, that I’ve apparently become fascinated with boats.  To one extent or another, every company I directly own stock in (other than my current employer) is involved with boats.  At one end, Trinity Industries makes river barges, and at the other end of the spectrum…

Company: Dryships, Inc (NASDAQ: DRYS)

 Industry: Shipping

 2007 Profit: $474M ($333M excluding asset sales)

 Current Market Capitalization: ~ $3.55B

 Current Price/Earnings: ~ 6.53

 Industry Avg. P/E: ~11.6

 DRYS engages, primarily, in the business of shipping bulk dry goods.  Stuff like coal, grain, metal ore, etc.  They prefer to ship different items separated, but if you’re willing to pay to ship coal with rice mixed in, they’ll do it for you.  As you might assume, the primary product of Dryships is:

 Big ass boats.  The above pictured ship (and not the tug boat) is the Alemeda, a 170,662 deadweight ton(dwt) freighter, and about 400 dwt short of being the biggest in DRYS’ fleet.  By the end of 2009, the Alemeda will be no more than the 4th largest in the fleet.

 The current fleet is constructed of 38 ships ranging from a couple 51,000 dwt ships, through a host of Panamax class boats and up to the 4 large Capesize craft topped by the 171,061 dwt Manasota (probably not a misspelling of Minnesota).  There are also 8 more craft currently on order (inc. 4 more massive Capesize hulls).  All said, Dryships hulls can claim to have a capacity of in excess of 4 million tons.

 That’s pretty good and places DRYS among the largest fleets in the world.  The company seems to be shrewdly run by George Economou (don’t ask me for pronunciation), and has undertaken an aggressive expansion program while also divesting older, smaller less efficient craft while acquiring bigger, more efficient hulls.

 Oh, and DRYS is in the final stages of acquiring Norwegian firm Ocean Rig ASA, operator of two ultra-deepwater oil drilling rigs (oh, and two more under order for delivery in 2011).

 Strengths:

• Management has incestuous tentacles in a half dozen or so other shipping interests and so has an extensive social network in the shipping industry.
• Fairly young fleet of boats keeps operational costs down.
• High demand for ultra-deepwater rigs will continue to provide very competitive environment for charter rates for foreseeable future.  Plus, plan to spin off drilling unit after year and a half or so.
• Boats not locked into long term charter rates at current low point in pricing cycle.

 Downsides:

• Management has incestuous tentacles in a half dozen or so other shipping interests and so you’re never totally certain how above board transactions are.
• Expansion has required expanding debt load and issuing more stock.
• The shipping industry can be volatile as rates can swing from historic highs to historic lows in a relatively short period of time (thus the low PE ratios).

 All in all, I’m enthusiastic about the future of Dryships.  Although all their cashflow gets absorbed by the expansion programs, the operations do produce strong cashflows and they are well positioned to serve as the dominant dry bulk shipper into the future.

 Oh, and the approximate net fair value of the company’s assets (as of 12.31.07) is about $50 and change.

 The shipping industry will have its swings, but I think that if you’re willing to hold onto it for a while you’ll be pleased you did.

 Depends on your definition of “important,” I suppose.

 So, nothing much important is happening out there right now (other than a strike at a Scottish oil facility), so I’ll do something a little different.

 Company: Intuitive Surgical, Inc. (NASDAQ: ISRG)

 Industry: Medical Appliances/Equipment

 2007 Profit: $144.5M

 Current Market Capitalization: ~ $11B

 Current Price/Earnings: ~ 68

 Industry Avg. P/E: ~37

 ISRG is the producer of what sounds like a very nifty surgical system called “da Vinci” that really looks like some sort of Star Wars set up.  Am I kidding?  You decide.

 Wiggle your fingers over here, and over there the multi armed android picks up Luke and throws him in the bacta tank.  Unfortunately, ISRG seems to suffer from a few flaws as a company: It’s expensive (PE), it seems to be a one trick pony, and I question its management real hard.

 A) It’s expensive.  I’ve stated before than P/E isn’t everything.  It’s commonly calculated based on historical profit levels, which can be a mistake because you aren’t investing for what a company HAS done, but what it might DO (and if you are investing in the past, then you might be used to investing in dot coms in 2000 and homebuilders just last year).  A stock with very high growth expectations can support a high PE because such great things are expected going forward.  ISRG is one such company with high expectations, yet even then the stock seems over priced.  While ISRG’s PE is a steep 68 using historical profits, its a still pricey 56.8 using average estimates for 2008 profits.  Even taking the estimated 2009 profits, we still come out with a P/E of about 41.  Further, this with large increases in profits built into the estimates… and a recent history of beating estimates.  I have a strong feeling that this is a company that will be punished for failing to outperform expectations.  Merely having as great a year as expected will probably cause the stock price to drop, bringing the PE more in line with its expected growth.

 Adding more cause for concern, of the 11 analysts covering the company (as listed by Yahoo), 6 have lowered their expectations for 2nd quarter earnings in the last month (4 have increased), and 10 have lowered their forecasts for the 3rd quarter.  So given that the current future earnings estimates are accurate, the stock seems expensive, but factoring in that their seems to be some softness in the future earnings expectations….

B) One trick pony.  ISRG has the da Vinci and… and… well, a different configuation of the da Vinci.  This one comes with a bacta tank, this other one has welder arms to fix up your droids.  In a world of wild, wild technological innovation, being a one trick pony carries a high level of risk (polaroid?).  Sure, sure… patents, I know.  Patents won’t keep GE, Hitachi, or some other company from coming up with the new things that makes your ass obsolete, patents or not.  The best way to fend that off is to do the hard R&D to keep yourself at the forefront or to use your piles of profit to acquire promising rivals/complementary companies that might both enhance and diversify your product offering.  Sadly, ISRG doesn’t appear to be spending enough money in R&D to protect their advantage, as to the second point…

C) Bad management.  Why do I point the bad management finger at ISRG?  As a medical equipment and technology company, you’d think their business arena is fairly well defined.  Why, then, is this company sitting on almost $700 million in cash and conservative bond investments?  $101M in MONEY MARKET accounts?  Another $101 in US government debt??  What the hell?  On top of that, the company has very little in the way of liabilities (about 5x as much cash and investments as liabilities).

 So, maybe this just sounds prudent to you, and if we were talking about personal finances I’d agree.  This is a company, however.  They have R&D they could be spending money on.  They have competitors that they could be buying controlling stakes in (and with such a strong balance sheet, finding financing to leverage the buyout would be easy).  They have shareholders they need to be delivering value to (read: stock buy backs).

 No no no!  We need to put out money in safe, low return investments.  We don’t need to expand our product line or do R&D.  Our product will live FOREVER!!

 I’d like to point out, also, that this company would rather put $100M in bonds and government debt and collect a fully taxable 4-6% return than to spend money buying back stock from the open market.  Most companies, when sitting on a treasure chest of money and nothing else to do (since a tech company clearly doesn’t need to invest in itself), will usually either pay a dividend or buy back a ton of stock (which is a different way of distributing returns to shareholders).  Look at Exxon: ton of cash, not much to do with it, so they A) pay a dividend ($1.40/share right now) AND B) fund a massive stock buyback program (buying up $78 BILLION in company stock in since Jan 1, 2005).

 Maybe ISRG management considers a cash a better investment that company stock?  Either way, their balance sheet management doesn’t impress me.  In fact, ISRG has been too busy issuing new stock to buy back any… and for what are they issuing this new stock?  To buy more bonds?  It’s hardly like they need to raise more funding.

 To conclude, if you couldn’t guess: Thumbs down on ISRG.  Their product seems great, but the stock is overvalued even assuming the ability to reach lofty earnings goals.  In addition, I am clearly not impressed by the strategic direction (or lack thereof) that has been imparted by the company management.  IF, suddenly, management showed some sack and started building a company that appeared to be durable (and not a one ring circus) by putting some of the lazy cash sitting around to good work, then maybe – MAYBE – it’s worth investing in.

 Enjoy your tasty treat,

 Oskar Schindler