John Winsell Davies Suntec City Tower Four 6 Temasek Boulevard 35-03 Singapore 038986

新加坡共和国

சிங்கப்பூர் குடியரசு

Skype: “John Winsell” j.winsell@bloomberg.net +65 6643 5362 direct jwd@devonian.ru

15 July 2015

JWD Weekly Call

Dark Clouds “Tut, tut, it looks like rain” Chicken Little Enterprise: Rackspace Hosting Inc. Ticker: (RAX US) Sector: Technology Industry: Infrastructure Software – Cloud Hosting Action: Short

Even before the salad daze of Templeton Global Value Investors (TGVI), fund managers have witnessed a dynamic rotation of innovation pioneers in the technology space. Many succeed in carving out an initial successful niche, only to be subsumed by well-resourced industry behemoths, typically stacked with deep legal departments. And not all have been by way of friendly take out. Netscape (NSCP) Navigator web-browser was eaten by Microsoft (MSFT) Explorer, RealPlayer (RNWK) media-player by Adobe (ADBE) Flash, America Online (AOL) and Yahoo (YHOO) internet service providers by Google (GOOG), Research in Motion <<BlackBerry>> (RIM CN) by Apple (AAPL) in the smart phone space, Nokia (NOK1V FH) by Samsung (005930 KS) in dumbphones … with we can anticipate, many more to follow. Imagine that Research in Motion (RIM CN) was once worth $77B per share (pre-crisis 2008). That is almost 50% larger than Hewlett-Packard (HPQ) $55B, the world’s largest maker of personal computers and printers. The renamed Blackberry (BB CN) today is worth around +/- $4B. As an investible industry theme and recognisable economic trend for my weekly call, I spent some time researching early first-movers from the short side. Which present day, industry Galileo’s are potentially exposed to the sharp elbows and fat wallets of present-day tech titans? But first an appropriate disclosure for this specific strategy: the greatest risk when delving into the space remains the possibility of an acquisition. Potential new entrants with an interest in the niche are not always identifiable. They are sometimes willing to make uneconomic investment in technologies, believed to enable

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them to either ‘catch up,’ or profit from cost cutting synergies. This means that shares like Compaq (CPQ) benefited greatly from the ill-advised and hotly contested, Carlie Farina flupper whilst in the captain’s chair of Hewlett-Packard (HPQ). Left on its own, CPQ may have gone the way of Dell Computer (DELL) or Gateway 2000 (GTW), but instead received $25B of HP investor capital. Too bad for them … now she is running for president … too bad for us

Likewise Steve Case’s investors received $164B in value when AOL (worth $3.9B - acquired by Verizon VZ US this month) merged with Time Warner (TWX); dubbed ‘The Worst Deal in History,’ to the shame and denial of deal maker and lamentable TWX CEO, Gerald Levin (left in dunce cap)

As such I focus on names which operate in sectors that may become commoditised. I look at companies whose technologies might be replicated, or are no longer a ‘requirement’ for operating in an industry. Names with no ironclad, proprietary advantage and otherwise unattractive to potential suiters, providing greater room for share price depreciation, were targeted. Nonetheless M&A must be acknowledged as the standout risk consideration in exploring this industry theme. But many were marooned with no buyers, left to a fate of slow emaciation, while others were taken out for pennies just before the funeral pyre. I am hunting for the sick and the weak; the inmates with the least hope of finding a sponsor in the big house. The macro Rackspace is a highly successful, early pioneer in the cloud hosting space. The shares advanced nearly 300% post 2008 IPO, 2x the benchmark Nasdaq (NDX) and 4x S&P 500 (SPX). ‘Cloud hosting’, however, is an industry sub sector of infrastructure software, which I believe will be decreasingly profitable going forward. My investment premise is hinged on the view that that cloud hosting as a standalone business, will cease to be economical for niche players, as tech giants compress their margins. Sounds pessimistic in a world where data traffic flow will certainly increase during the new age of ‘the internet of things?’ Certainly all would agree that volumes will rise, but the point is that margins will contract, as leasers of cloud real-estate will be removed from the ‘value chain’ and the industry will become commoditised. The infrastructure itself is capex and tech heavy. Cutthroat competition is rising quickly, led by heavyweights who are not interested in driving earnings or even breaking even in the sub sector.

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The best comparison that I might put forth was the rise and fall of the backbone networking players like ‘Global Crossing’ (GX US), bankrupt in 2002, 7th largst filing in US history, or XO Communications (XOC LN) – delisted, or MCI Worldcom Inc. (MCW US) – bankrupt in 2002, single largest filing in US history. Global Crossing was the first player with designs on connecting the internet world via subsea fibre optic cables. Volumes were going to be huge as the internet exploded, but as it turned nobody is going to make any money on providing the infrastructure. In fact, few participants who build out the architecture were even going to get their money back. AT&T Corp. (T), Vodafone (VOD LN), Verizon (VZ US), Sprint Corp (S), Level 3 Communications (LVLT), and TeliaSonera (TLSN SS) came in later and the early pioneers exited. I see a similar parallel today with the Cloud Hosting industry, as a price war has already started between Google and Amazon Web Services (AWS). Industry giants see cloud hosting as a loss leader designed to ‘host’ (attract / commit / retain) captive clients who represent revenue streams to them, via their profit centre businesses (services). Think of cloud space like real-estate that can be leased. Or better, consider the analogy of hotel rooms in Macau/Vegas. The big players lose money on the rooms marketed at valuable clients, but promote them heavily anyway. This to attract customers who will spend money on earnings positive operations like the gambling tables, restaurants, conference centres, retail outlets, night clubs, bars, room service, and even the wedding chapel. The hotel property itself is significantly the highest capex and highest maintenance cap asset in the firm. But it is usually not the profit centre. This is a hugely expensive capital investment to build and to operate, but one that is of critical importance to the business’ ability to attract customers and extract earnings from them.

Rackspace is like an early ‘Strip’ operator, who built a great property and enjoyed early high occupancy at good margins on the rooms. But they don’t have any tables, restaurants, shoppes or profit generating venues for customers to visit. They are in the ‘room business’ and the rental rate for real-estate in the cloud is falling.

Executive Summary

Cloud hosting, as the name suggests is Rackspace’s core business product. I believe that like Global Crossing and other of the first-mover pioneers we have discussed today, they will not be able to compete with the mighty tech behemoths. In the small to medium (SMID) market, Rackspace is already getting pinched on price. Margin compression advances and EPS revisions are coming down. In the higher margin enterprise hosting (industry accounts) business, Rackspace cannot provide the same services as Hewlett Packard, Microsoft, and IBM (IBM US). In fact, all three are already coming down the food chain and encroaching on RAX SMB customer base.

So profitability is being squeezed in the middle by commodity players AWS and Google on the bottom, and large enterprise hosting providers, on the top. Microsoft, for example has commercial cloud revenue been growing at triple-digit rates for six consecutive quarters. So as the cloud pie expands, the largest, pieces are being swollowed by the strongest competitors, leaving Rackspace to fight for smaller, less profitable bites based on price. Some industry experts suggest that is Microsoft buys Salesforce.com (CRM), then Rackspace and other lesser acts will find it increasingly difficult to remain relevent.

Big sharks are circling, IBM bought privately held Blue Box, (managed cloud services) and Cisco (CSCO) is buying private Piston Cloud Computing, (CloudOS software). But what does Rackspace have that any suitor would be buying? ‘OpenStack’, the open cloud management platform developed by Rackspace, is no longer proprietary. And Amazon, Microsoft, and Google all use their own proprietary platforms.

The shares are trading at 48x earnings based in part, on the assumption that RAX’s 5 year EPS CAGR is close to 17% p.a. But YoY Q1 2015 EPS of $0.20 was only .02 cents better (+9%) than $0.18 Q1 2014 and estimates are now dropping. Management guidance for YoY Q2 2015 EPS growth was only 1.5% to 2.5%!

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Rackspace Q2 2015 EPS estimates have dropped from $0.35 to $0.20, and CY 2016 EPS estimates have dropped from $2.60 to $1.10

Butt for the sake of the bulls, lets momentarily suspend all doubts and share the street con model assumptions for a growth trajectory, that might seem unrealistic. Fine, like many managers, I would be happy to credit them with a multiple of earnings. But even $0.88 cents at 17x gets you to $14.96, okay $15 bucks, while the shares are trading at $38.56 this morning 14 July (early hours 15 July here in Tigertown S.E.A.) at the time of this writing. Description Rackspace (NYSE: RAX) is a pioneering managed cloud hosting company. It provides web hosting, websites, web-based IT systems, and related services. It delivers cloud services to companies which are not large enough to have internal cloud IT departments. Rackspace is the founder of OpenStack, the open-source operating system for the cloud. The firm has more than 300,000 business customers worldwide

Short Interest ratio of 6.29%

Shares trade at 51x free cash flow

The balance sheet is unleveraged; company is virtually free of borrowings, 4.56% debt to equity

Large free float; 19 insider’s control 14.6% of ASO’s

From August 2008 GS/CS/ML IPO, the shares have advanced 287%, double the 135% return for the Nasdaq (NDX) and 4x the S&P 500 +62%. Global equities (MSCI All Country World Free) gained 25% over the period

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Rackspace was trading $78.93 25 January 2013 and has since fallen by -53% to $36.57 13 July 2015 Peer Comps

Telecity (TCY LN), Equinix (EQIX US), Rackspace (RAX US) Equinix since surpassed Rackspace and the largest independent by market cap. Not a pure comp, EQIX has a higher growth trajectory with a diversified cloud product segment including co-location, security, interconnection, managed infrastructure and rental. Not only hosting. Telecity is a smaller UK-based hosting player in the niche and this is becoming a tough neighbourhood for the little guy.

Enterprise Ticker M Cap YTD TTM PE Est. PE PB Rackspace RAX US $5.277 B -21.11 14.91 48.19x 34.13x 4.57x Equinix Inc EQIX US $14.766 B 14.67 27.93 72.25x 41.74x 6.84x Telecity TCY LN $3.292 B 30.12 39.28 35.46x 22.39x 4.92x

Conclusion Renting real-estate in the Cloud as a standalone business, will be characterised by increasingly unattractive fundamentals. These are capex heavy warehouses to construct and maintain. They are being developed and managed by tech industry giants, as loss leaders <<removed from the value chain>> to ‘house’ captive clients which generate revenues for profitable internet services divisions. Cloud hosting is the ‘core business’ for Rackspace. They are the Macau/Vegas property trying to make it on the hotel without a casino, retail block, night club, sports book, or dinner shows … and nobody will be making real money on the room rates. The core business itself is being squeezed between SMI on the bottom (Amazon Web Services, Google) and enterprise heavy weights coming down from the top (IBM, Microsoft, Cisco, HP). I see Rackspace Hosting as an early industry pioneer being crowded out and unable to compete in an unprofitable niche. EPS revisions are accelerating, the shares have already come down >50% and they still have a long way to fall. Recommended Action Short Rackspace (RAX US)

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In Play

Initiating the investment methodology with the top down global macro, I have been generating standalone equity shorts by first:

a) Searching for unfavourable themes and deteriorating fundamentals within sub-sectors of larger industry groups then,

b) Identifying economic trends within a space that may result in ‘opportunity’ characterised by 1) systemic flaws in core business model, 2) inability to adapt/evolve to changing marketplace and new technologies/entrants, and especially 3) meaningful risk to earnings expectations and finally,

c) Conducting research and analysis to detail unique securities; those within a peer group which best demonstrate essential elements of the bear case, the theme, the short story

Ultimately I am trying to produce one name, ‘the best constituent’ which displays the most attractive risk-reward profile for asset price depreciation of the comps. Visible patterns are developing and we can identify recurring tendencies delivered by this investment process. What’s on the menu?

Telecommunications Carriers and Mobile Wireless Operators

The Tribble with Telco’s ‘Your phone’s of the hook, but your not,’ X - Los Angeles

Incumbent telecom carriers and wireless operators should consider a future of increasingly declining profitability, and shrinking market capitalisation

Like the traditional television broadcasting and cable companies, traditional telecom carriers and wireless mobile operators have already entered a period of long-term structural decline

Technology is irreversibly changing consumer preferences, buying habits, behaviours and choice. Innovators will not only benefit from the new economy in telecommunications, but will also likely determine the way that consumers communicate, what devices they use to communicate, who and how they will pay, for both the hardware and connectivity

Removed from value chain, the telecom carriers are ‘Data Mules’ (coined here) servicing dumb pipes. Google’s Project Fi latest example, fail to innovate, they remained indentured workers, tasked with oiling, cleaning and upgrading the profitless network

Core businesses under siege: o Wireless - price wars, consumer no longer needs to pay to make a wireless call. Voice over IP

(VoIP) technology built into iOS, Android, Windows, and Blackberry smart phone aps, by players like Apple Facetime, Viber Media

o Long distance - Long distance profitability is threatened by Voice over IP (VoIP) technologies allowing for free long distance communications with or without video. Mainstream acceptance was pioneered by Skype (acquired by Microsoft). In addition to Google Meetup and many others, free long distance is available on virtually any operating system Windows, Mac, Linux, Android, iOS, Windows Phone, BlackBerry, Nokia X, Fire OS, Xbox One, PlayStation Vita and PlayStation

o Data packet transmission - Data packet transmission revenues are being shorn by social media platforms like WhatsApp and Facebook Messenger who offer free messaging on far better platforms

The cavalry is not coming, FCC voted to retain net neutrality rules February 2015 and any future ‘save’ will likely be in the form of a regulated utility-type price setting arrangement such that one of four business units (data packet transmission) will be permitted to deliver utility-type returns in order to keep the pipe open. The patient survives but is not able to leave the hospital bed. Network might be spun off and the other three units are left on their own

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Long-term industry profitability has been marginalised by commodity pricing, which has ushered in a new era of value destructive, cash burning, price wars. (Cloud hosting analogy)

Verizon (VZ US) quantified w. financial analysis and enterprise-specific short rationale

Verizon is one bad quarter away from a house of cards. Investors are buying a 4% corporate bond with no maturity date, no return of principal and the real possibility of the dividend cut

On an asset basis the shares are grossly overvalued with P/B of 21x. The books are dangerously overleveraged, with total debt to common equity stands at 921% and $113 billion in debt

Erste Bank discontinued research and dropped the name based on inadequate coverage ratios

The primary business is haemorrhaging mobile subscribers and there is no credible growth strategy

Management is managing the company by walking tightrope, able to service $131B debt on $127B revenues. Razor’s edge, able to finance dividend with 90% pay out on $9.6 B in net income with $8.6 B paid out.

Once the dividend is cut, income funds, value funds, and retail investors will run Television (network broadcasting and cable)

Traditional American television and cable has entered into a period of irreversible structural decline

Channel bundling, timetable line-ups and the advertising-driven revenue model are unsustainable

Aggregators and distributors of content (middlemen) will be marginalised in the age of internet streaming media and ‘New TV’

The broadcasters are not capable of competing with the technology giants who are redefining the industry, and carving up the business landscape in the new age in television

Margin compression, negative revisions, and earnings decline will accelerate, leading to industry rerating’s, and perhaps even obsolescence

CBS Corp (CBS US) quantified with financial analysis and enterprise-specific short rationale

Publishing (print media)

The publishing industry in long-term and irreversible state of terminal contraction

Newspapers the next ‘Yellow Pages’, magazines become ‘adzines‘, books devolve to ‘special purpose’ usage

Old economy publishers unable to evolve in the digital media world

New economy of digital media is being shaped by entrants with superior technology and innovation capabilities

Margin compression, negative revisions, and earnings decline will accelerate, leading to rerating and ultimately operating losses

News Corp (NWSA US) quantified with financial analysis and enterprise-specific short rationale Technology (File Sharing Platform)

Box Inc. (BOX US) is a second-tier entrant in the fundamentally unattractive and largely unprofitable technology niche of cloud-based file sharing (software architecture). The company does not appear to have any competitive advantages over the competition and has of yet been unable to distinguish itself in the largely commoditised cloud storage industry

With just 37MM users and only 47K paying customers, Box is a tethered goat in a forest of industry apex predators including Microsoft OneDrive, Google Drive, Amazon Zocalo, Citrix XenMobile, IBM and a phalanx of independents including Dropbox

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The tech giants use file sharing as a loss leader to support well developed ecosystems, and thus crush the margins of participants like Box, whose core business is file sharing. Quite literally dozens of privately held start-ups offer file sharing technologies for free

The firm was unable to capitalise on initial first mover advantage during ten years of operations and with the arrival of powerful new market players, thus future profitability seems improbable (even to company IR colourists)

Following a much hyped public listing, Box shares have fallen 30% in six months and are making post-IPO lows. Lock up and quiet period ended 22 July and I would expect insider selling

The firm has been significantly lossmaking since founding ten years ago and has no viable path to positive cash flow, much less earnings in the next three years

SGA + Capex +78% YoY, are greater than revenues. High revenue growth is slowing demonstrably, but cost structures are such that higher sales do nothing to improve the profitability results, rather they equate to greater losses

The company is running a 2015 operating margin of -81.25% and is expected to remain profoundly negative until 2018; after which date, in such an evolving, rapidly transforming industry, even the most astute industry expert would be loath to provide estimates

Box generated $100 MM in losses on the bottom line 2013 and the company in expected to lose more than that ($101 MM) in 2018. And between now and then, the forecast is even worse with -$179 MM 2015, -$182 MM in 2016, and -$147 MM in 2017

ROIC is >100% meaning the company burns $1.00 for every dollar invested … annually

Q1 2015 cash flows from operations delivered a >100% YoY loss of -$32.2M vs. -$15.6M Q1 2014 … with just $284MM in cash vs $40MM in debt, it appears that without a secondary offering (fool’s gold), bond issuance (sucker born every day), or strategic sale (of what?), Box may be insolvent by mid-2017

M&A buyout risk seems low as the only reported offer of $550MM represents a near -75% discount to current market cap

Wildcard: share price is significantly leveraged to ‘street’ perceptions and credibility of charismatic Chairman, CEO and co-founder. Post-IPO disappointment and losses for virtually anyone who bought since the first trade, suggests that the believers are losing their conviction. My expectation is that investors and backers will look back on this meteoric rise with twinges of embarrassment

Technology (Pioneer Harvest, early niche entrants subsumed) – two parts Infrastructure Architecture (Cloud hosting) – part 1

Dark Clouds, ‘Tut tut, it looks like rain’ Chicken Little

Core business increasingly uneconomical as technology leaders compress margins

Leasers of cloud real-estate removed from value chain

Cloud hosting requires heavy capex and m-cap to build occupancy

But occupancy as standalone business niche is not profitable

Parallels with internet backbone network builders and Vegas hotel room operator without a casino

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Margin compression, negative revisions, and earnings decline will accelerate, leading to rerating perhaps marooned or eaten

Rackspace Hosting (RAX US) quantified w. financial analysis and enterprise-specific short rationale Internet Media (Streaming Music) – part 2

Highly developed technology ecosystems have added or are adding proprietary streaming music services to their existing platforms

Streaming music is literally being given away for free (ad based radio model) or to attract users to larger environments (door prize)

Similar to niche operators like online gaming, online dinner reservations, online travel, and online messengers, the standalone online music pioneers are too small to survive with their singular product offering

But at the same time, high R&D is required to compete with the massive scale of Apple (AAPL), Google (GOOG) and others; accelerating losses and leading to rerating, obsolescence

Reminds of a mini-Netscape or mini-RealNetworks (Explorer or MediaPlayer bundled in Windows, Adobe gives away Flash for free … who is going to go out and buy Navigator or RealPlayer)?

Pandora Media (P US) quantified with financial analysis and enterprise-specific short rationale

Perhaps a takeout candidate for proprietary content or existing customer base? More work required to move forward, indicating high risk

Internet (Chinese niche freebies)

Deluge of unprofitable niche entrants, in high-flying Chinese internet space, unable monetise site users

Chit chat, video games, streaming music, photo share and friend making services given away for free

No mobile cash payment platforms

Unable to compete with large and highly developed ecosystems Alibaba (Baba), Baidu (BIDU) and Tencent (700 HK)

No earnings, untenable valuations, in the absence of white knights possibly left orphaned to die

Changyou.com (CYOU US) quantified with financial analysis and enterprise-specific short rationale Entertainment and Leisure (Macau Casino Operators)

‘If you build it, they will come’ Ray Kinsella, Iowa corn Farmer

Casino run rate already down -46% YoY to date

Flood of new capacity (rooms) does not equal to revenue expansion; rather it foretells of impending operating losses

Declining occupancy rates will free-fall on the surge on new property openings

Vacancies will further rise against the backdrop Beijing driven anti-corruption crackdown, smoking ban and heightened scrutiny

Transition to family-oriented sports, leisure and entertainment destination is doomed to fail impressively

Profitability outlook darkened by deteriorating demographics, falling real-estate, recession on the SAR, and significantly higher COGS driven by pay role inflation due to systematic labour shortage

My model and sensitivity analysis of peer comps to headcount and occupancy assumption scenarios points to operational losses

Wynn Macau (1128 HK) quantified with financial analysis and enterprise-specific short rationale including possible dividend cut and delayed launch to miss 2016 Chinese Lunar New Year

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9 July HSBC raised to buy, 6 July Credit Suisse “worst is over” relief rally wishful thinking; filling rooms with lower quality, non-gaming ‘overnighters’ and increasing guest visits by enabling visa-free travel for mainland ‘day trippers’ is not a solution, it is a validation of short analysis

John Winsell Davies is CIO of Tano Singapore Advisors Pte Ltd. This is an original opinion piece which may not reflect the views of the Firm The opinions expressed here are his own Linked-In format does not allow for my charts, graphs, tables and illustrations. As such clarity and impact of original report has been marginalised. Original report available by e-mail Questions and comments; please write to me in Singapore j.winsell@bloomberg.net Skype ‘johnwinsell’