Lessons From Exodus Communications
27-Sep-01 01:00 ET
[BRIEFING.COM - Robert V. Green] Last July 9, we published a Stock Brief entitled "The Exodus Debt Problem and Coming Bankruptcy." Yesterday, this prediction came true, as Exodus filed for Chapter 11 bankruptcy. But whether you held Exodus or not, there are lessons in this story for everyone.
Brief Summary of the Exodus Story
Here is a brief summary of the important points in this story:
September 28, 2000: Exodus buys Global Crossing data centers for $6.25 billion in stock. EXDS: $53
February, 2001: Exodus takes on $500 million in debt, sells $250 million in stock and continues to invest heavily in more centers, even after the internet bubble had burst. EXDS: $30
April 26, 2001: Exodus reports earnings, but warns that Q2 revenues may decline. (Briefing Story Stock says "no compelling reason to buy EXDS here, at least not until the demand picture firms.") EXDS: $9
June 7, 2001: CIBC issues research report that states "Excess capacity in web hosting, industry prices to decline 30%." (Briefing Story Stock says "time to pull the plug on the group.") EXDS: $7.50
June 20, 2001: Exodus conference calls states "losing some potential customers because of concerns over company's finances." EXDS: $2.25
July 9, 2001: Briefing.com concludes research and publishes Stock Brief saying bankruptcy is inevitable: EXDS: $1.75
July 26: Exodus reports. Debt payments exceed gross margin for Q2. (Briefing Story Stock: "this is about as dark an income statement as you will ever see for a company with more than $1 billion in revenues.") EXDS: $1.25
September 26: Exodus files for bankruptcy. EXDS: halted at $ 0.17. Likely to open today at much, much lower.
One year's worth of events, with stock price declining from $53 to next to nothing. But even this brief list shows clearly: there were plenty of warnings along the way that Exodus was in trouble. They overbuilt, prices collapsed, revenue dropped, but debt payments stayed the same. It really is that simple.
Lesson 1: Read The Financials
Lesson one is read the financial statements of the company you own.
Exodus' problem was crystal clear in their financials. The debt payments exceeded gross margin in the most recent quarter. Gross margin is the profit left over after accounting for the costs of the basic goods of the company. In Exodus' case, that meant nothing was left over, after paying debt, to actually operate. Sales and marketing, research and development, and general administrative costs all were being paid out of the cash on hand. This is no way to run a business.
But financials have to be viewed over time to determine a trend. Debt is okay if you can make the payments, or grow revenues fast enough to make debt payments before you run out of cash.
Exodus might have made it, if revenues had continued to grow at the pace they had in 1998. When the revenue trend dropped off by 10% in Q2, it was a strong warning to investors.
The whole story of Wednesday's filing was in the financial statements months ago.
Lesson 2: Have An Investment Premise
Always have a reason why you own a stock.
Most people who bought Exodus bought it as a growth stock. The idea that Exodus would be the dominant player in a fast growing industry drove many stockholders to invest. As investment premise's go, this is basically ok.
But that premise hit a brick wall in April, when the company warned of lower revenues. In the face of the massive expansion they had just committed to, lower revenues should have been a red flag emergency warning for growth investors. After all, if you bought the stock because it was a growth company, and growth disappears, why exactly do you own the stock?
Having a growth investment premise, and being disciplined about it, would have demanded an exit in April, at $9, even if you had paid $50 six months earlier. Hard to do, we admit, but discipline would have gotten you out at a price fifty times higher than yesterday's close.
Lesson 3: Take CEO Statements With a Spoonful of Salt
CEO Ellen Hancock was adamant, right up until the day she "resigned," that the company would be profitable by Q2 of 2002. What this really means is that there was probably a spreadsheet in Exodus, which showed that profitability could be reached, given certain conditions. Ms. Hancock never elaborated on what those certain assumptions might be, but Briefing.com's interpretation is that the Exodus model assumed strong revenue growth, an assumption which was proven wrong by the Q2 results and the overall market conditions.
Ms. Hancock may have even actually believed the spreadsheet projections, making her statements sound all the more convincing to investors. But investors need to remember:
CEOs always have something positive to say about their company. That's their job!
It is your job to be skeptical.
Lesson 4: The Best Product Doesn't Always Win
One of ex-CEO Ellen Hancock's continual claims was that the investment community did not understand that Exodus hosting centers were the best of the bunch. She claimed that when Wall Street lumped all hosting centers together, they were ignoring the fact that Exodus had the best combination of hosting and data centers and service.
Whether that was true or not is irrelevant. Having the best product does not guarantee business success. If it were, Apple computers would never have been trounced by Microsoft and we would all be watching Betamax videos. An investment premise based on Exodus because "it is the best in its field," turned out to be a poor premise. The "best product" premise is rarely enough.
Lesson 5: Don't Get Emotional
How many Exodus shareholders are there tonight who feel betrayed? "More than we care to think about" is the likely answer.
The problem for many Exodus shareholders is that their faith in the company's future simply prevented them from seeing the problems. When we wrote about the company's likelihood of bankruptcy, we received a flood of emotional responses. Most claimed "we didn't understand" or asserted that with $1 billion in revenue, the company would never file for bankruptcy.
Emotion is great, but not when it prevents you from action. The best investors challenge their own ideas as much they can. If your reaction to negative news is hostile, how can you be subjective? Never forget that value is always determined by the person next to you, not by you. Your own emotion is irrelevant. Don't let it cloud your judgement.
What Now?
Chapter 11 proceeds are reorganization proceedings. In a reorganization, the company continues to operate. For customers, life continues as usual. Creditors are generally offered equity in the company, in exchange for cancelling or restructuring their debt.
The following course of events is likely:
Exodus proposes a reorganization plan.
Reorganization plans generally convert existing debt to new equity, diluting existing common shareholders to an insignificant percentage.
Creditors agree to the plan.
The plan is submitted to bankruptcy court.
The court decides it is fair, and the reorganization occurs.
The company emerges from bankruptcy.
Any one of these steps can be subverted if things do not go well. For example, if the company and creditors cannot agree on a "fair plan," they can each propose their own, separate, plans to the bankruptcy court. The court then decides which is fair, or rejects both, if both are egregious.
We expect that the new CEO, who is experienced in bankruptcy proceedings, will be able to negotiate an agreed upon plan with the creditors. The $200 million of "debtor-in-possession" credit from GE Capital will keep the company operating until the reorganization. Debtor-in-possession financing is superior to all other outstanding debt, and can only be obtained when a company actually files for bankruptcy. It is likely the bankruptcy filing was necessary in order to secure the credit.
Exodus will continue to operate. It will likely emerge from bankruptcy as a fairly strong company. But after $3.5 billion of debt is restructured into equity or a combination of equity and new debt, there is an overwhelming likelihood that little equity will be left for the common share holder.
EXDS stock will continue to trade during the reorganization. The Nasdaq will add the letter "Q" to the symbol, to indicate bankruptcy. The stock is likely to continue to decline, and be delisted from the Nasdaq before November.
When the reorganization is concluded, current stockholders will likely still own stock, but with little claim on the company. The current market capitalization is just 2% of the total debt. Common stock holders are likely to be diluted by a factor of 30 to 50, which would result in value of less than $0.005 per share, a "half-penny."
The best move for most holders of Exodus Communication is to request that their share certificate be issued and sent to them. Then, after framing and hanging them on the wall, the shares can serve as a continual reminder of the lessons learned.
Comments may be emailed to the author, Robert V. Green, at rvgreen@briefing.com--------------------
Back to Top
Copyright © 2001 Briefing.com, Inc. All rights reserved. |
