Storm Clouds for Rackspace Hosting, Inc. (RAX)?

Let’s look at the competition., Inc. (NASDAQ:AMZN)
To its credit, Amazon ranks a “B” for earnings quality, but that could be even better if it weren’t for its unsustainable short-term boosts to operating cash flow. Amazon’s payables are four times as high as receivables, and the status of days payable outstanding is worrisome at nearly 58 days, with a rising seasonally adjusted trend line.

AMZN Accounts Payable Chart

AMZN Accounts Payable data by YCharts.

Amazon’s stock-price appreciation has been nothing short of ethereal. The company has lofty visions for cloud-based retailing, but it won’t unseat Wal-Mart Stores, Inc. (NYSE:WMT) anytime soon as the world’s biggest retailer. Amazon’s latest quarterly revenue of $21.27 billion was only 18% the size of Wal-Mart’s nearly $114 billion. Amazon’s revenue also missed expectations by nearly $1 billion for the most recent quarter, and because of negative earnings for the quarter ended Sept. 30, the stock has no trailing P/E ratio. Yahoo! Finance indicates a forward P/E of 73.7, which is sky high.

Like most retailers, Amazon’s metrics reflect seasonality and low margins. Yet despite missing revenue estimates, investors didn’t burst Amazon’s bubble and instead took the stock higher because of their perception of a slight margin expansion. And so the bubble continues to grow.

This company is clearly a momentum play, and for now investors are content to push its stock price higher. I’m not sure I want to climb on board, though.

Google Inc (NASDAQ:GOOG)
You might not guess it from Google’s lofty stock price, but Amazon generates more revenue per quarter than the search king does. From an earnings perspective, however, Google is far more profitable. But that’s not the end of the story. Google has an EQ score “F,” based on two factors: Its stock price has outpaced its revenue or earnings growth, and more importantly, its costs are rising faster than revenue is growing. Its year-over-year rise in the cost of goods sold last quarter was 68%, and administrative costs rose 39%.

Google’s stock has appreciated by 40.5% between June 14 of last year and Feb. 8, compared with year-over-year revenue growth of 36% and earnings growth of only 7%. Yes, that’s impressive, but it doesn’t make up for the disconcerting expansion in costs. See for yourself the effect on margins.


GOOG EBITDA Margin TTM data by YCharts.

To put a finer point on it, look at the decline in operating cash flow margin for the trailing 12 months, as well as the rise in days sales outstanding and receivables as a percentage of revenue.

Metric 12/31/12 12/31/11 12/31/10
Operating cash flow margin, TTM 32% 38% 38%
Days sales outstanding (DSO) 50 47 46
A/R as a % of revenue 55% 51% 50%

Source: S&P Capital IQ.

Foolish bottom line
These companies, and countless others too many to mention, are embracing cloud computing as the next big paradigm. But the future of the cloud may be murkier than the media would have us think, given a fair amount of privacy and security issues. And there’s also the reality that costs must still be controlled. Large data centers that manage the immense amount of information of Web-based companies have become the “bricks and mortar” equivalent of yesterday’s traditional retailers, and they don’t come cheap.

As always, Foolish readers should base investment decisions on earnings quality. If you believe in this new paradigm, then be prepared to weather the inevitable turbulence it will bring to your portfolio.

The article Storm Clouds for Rackspace Hosting? originally appeared on and is written by John Del Vecchio.

Fool contributor John Del Vecchio is the index provider for the Forensic Accounting ETF (FLAG), an exchange-traded fund using forensic accounting analysis. He owns none of the shares in the companies mentioned in this article. The Motley Fool recommends, Google, and Rackspace Hosting and owns shares of and Google.

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