One of the classic value investing strategies is to buy the companies that provide the infrastructure that an industry or technology needs to function. That is why Warren Buffett invests in pipelines, trucking companies and railroads.
It is also why many modern value investors have become very interested in hosting companies, the organizations that provide the digital infrastructure websites and blogs need to operate. Hosting companies have some other attributes of classic value companies: They are cheap, they are not very sexy and most of them operate on a subscription business model that requires customers to make regular payments to keep the service.
The problem is that some hosting companies do not make money despite those attributes. One of the more questionable players in the sector, Endurance International Group Holdings (NASDAQ: EIGI), reported a net income of -$18.74 million (€17.42 million) on September 30, 2015. Strangely enough, that dismal figure was a major improvement over Endurance’s net income for third quarter 2014, which was -$108.11 million (-€100.49 million).
Some of the other figures at Endurance were pretty awful as well. It reported a diluted earnings per share number of -.1471 and a negative profit margin of -8.14%. Investors unlucky enough to own Endurance received a return on equity of -10.9%.
These figures came in spite of revenues that are steadily growing. Endurance reported a TTM revenue of $720.21 million (€669.46 million) on September 30, 2015, a $125.88 million (€117.01 million) increase over Third Quarter 2014, when it reported revenues of $594.33 million (€552.45 million).
Nor was Endurance the only hosting company that reported such losses. GoDaddy (NYSE: GDDY) reported a net income of -$102.5 million on September 30, 2015. Disturbingly, that was a definite improvement over September 2014, when GoDaddy reported an income of -$181.95 million (-€169.13 million).
As at Endurance, some of the other numbers at GoDaddy were just as awful. GoDaddy reported a negative profit margin of -.61% and gave investors a return on equity of -27.57%.
GoDaddy’s revenues were also growing but not at the rate that Endurance’s were. In September 2014 GoDaddy reported a TTM revenue of $1.322 billion (€1.23 billion) that grew to $1.554 billion (€1.44 billion) a year later. That makes for a revenue increase of around $232 million (215.66 million) in a year, which is impressive.
How Hosting Companies Work
Naturally, many people will be confused by these numbers. Are Endurance and GoDaddy reporting negative net incomes while their revenues are increasing? The answer lies in the nature of the company’s business. It charges customers for hosting, but for every website it hosts, Endurance has to buy storage space from a data center. Instead of generating float from its increased business, Endurance effectively buys itself a higher cloud storage bill.
The real profit in the sphere is made by organizations like Amazon Web Services (AWS), a subsidiary of ecommerce giant Amazon.com Inc. (NASDAQ: AMZN). Amazon Web Services’ profits for Third Quarter 2015 were $1.7 billion (€1.58 billion), up from $97 million (€90.17 million) in the same period in 2014, The Wall Street Journal reported. Some analysts expect AWS to generate $4.5 billion (€4.18 billion) in 2016.
This means that companies like Endurance are basically brokers that purchase hosting from data centers and resell it to customers. A good way to think of it is the difference between an insurance company and an insurance agency. An insurance agent or broker makes her profit from the commission on the policies she sells. The bulk of the money is made by the company that issues the policy in the first place. That is why Warren Buffett owns insurance companies such as GEICO rather than insurance agencies.
Therefore GoDaddy and Endurance are basically running a marketing service for the product created by companies like AWS and, sadly enough, paying for the privilege. It is hard to see how long that can go on.
A Flawed Business Model
It looks as if the hosting companies have serious flaws in their business model, which keeps them capturing enough cash from their operations to avoid losses. Both GoDaddy and Endurance were able to generate significant amounts of cash from their operations but kept little of it.
GoDaddy reported making $223.77 million (€208 million) in cash from operations in third quarter 2015, and Endurance reported generating $172.18 million (€160.5 million) in cash from operations during the same period. Yet Endurance reported a free cash flow of $28.79 million (€26.76 million), and GoDaddy reported a free cash flow of $44.9 million (€41.74 million) in addition to their negative incomes.
If they wish to survive, these companies will either have to greatly increase their revenues or change their basic business models. The current business model is one of investing cash to buy future revenue in hopes that it will turn into income at some point in the future.
This creates a vicious cycle in which cash comes in but has to be spent immediately to purchase more revenue. The hope is that at some time the revenue will generate enough float to make the business cash rich. The danger is that the hosting company will need to increase revenue just to pay its bills.
Another problem is that hosting companies become willing to take on more and more questionable customers. This includes criminals and persons with little or no money. Gotham City Research even accused Endurance of deliberately marketing its services to customers engaged in what it described as “malicious activities” in this Value Walk guest post. Unfortunately, Gotham did not reveal what the malicious activities were.
Is Hosting Headed for Cash and Consolidation?
Endurance may have also been using debt to finance money-losing acquisitions, Seeking Alpha’s Stealth Tech Investor alleged. Stealth Tech made those allegations after noting that Endurance CEO Hari Ravichandran sold 30% of his stock in the company in less than six months, ending in April 2015.
It looks as if hosting companies are far from value investments. Even better, hosting organizations like GoDaddy are losing lots of money despite massive revenue increases. Based upon the financial numbers, the hosting sector looks as if it is heading for a crash followed by consolidation.
Value investors interested in Internet infrastructure would be well advised to look elsewhere. Hosting is still a risky growth industry funded by debt and driven by questionable business practices, not a value investment.