A Short-Seller's Dream

 | Nov 05, 2012 | 9:30 AM EST
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Short-trading ideas are highly risky but present an opportunity for significant payoff if they work. Such ideas are for only the most risk-tolerant investors, as the potential for 100% loss is high.

I have to admit it, I love using Amazon (AMZN). I find that I am increasingly relying on the service for more of my day-to-day needs. I love the convenience and delivery consistency that the site provides. My latest purchase was a 40-inch dog bed for my golden retriever, Cooper. It saved me the half-hour trip to PetSmart. It is nice getting products from a company with great customer service and does not seem to care about profit margins. As much as I love Amazon's product offerings, I remain short the stock simply because of that last point. The company never seems to produce any profit, and I don't see investors continuing to back a stock at a 130 forward price-to-earnings ratio without commensurate profit growth forever.

As wonderful as it is to be a customer of a company that consistently leaves money on the table, it must be next to impossible to compete against directly. One only needs to look to the demise of Best Buy (BBY) as an example of how challenging it is to go against this retailing behemoth and its razor-thin margins. In addition, part of Netflix's (NFLX) dimming prospects has some correlation to competing against Amazon's expanding video services.

Another company whose stock looks overvalued and is squarely in Amazon's sights is Rackspace Hosting (RAX), which provides cloud-computing services for small and medium-sized businesses and large enterprises worldwide.

Six reasons RAX is overvalued at $66 a share:

  • The stock is about where I went short the shares in late September; however, competition is heating up from Amazon, which cut its cloud prices for the 21st time in six years by another 18% recently. It also added offerings. RAX currently has a higher net margin (7.5) than average over the past five years (5.44), so I would look for Amazon to push this net margin down in the medium term with aggressive pricing and an expanding product set.
  • Earnings estimates for both 2012 and 2013 had already started to fall over the last three months prior to this latest announcement from Amazon.
  • The stock is selling at the top of its historical valuation range based on price-to-earnings, price-to-sales, price-to-cash flow and price-to-book ratios. RAX also has a forward PE above 60.
  • The company lacks consistency beating earnings estimates. In its last 12 earnings reports, the company has beaten earnings estimates just four times. It has missed three times and reported in-line five times.
  • RAX has averaged more than 33% annual revenue growth over the past five years. It is tracking to a 29% sales increase this year, slowing to less than 26% revenue growth in 2013, according to analysts. The stock has a stretched five-year projected price/earnings/growth ratio of (2.72).
  • The 14 analysts covering the stock have a median price target of just $64.50 per share, below its current stock price.



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