Every now and then, I get lucky: I look at a new, exciting company and see its future clearly, despite the hype. When I wrote about Exodus Communications Inc., a leading Internet hosting and outsourcing company in Santa Clara, Calif., in 1999, I thought it was primarily

a real-estate company/landlord with a lot of well-heeled tenants. Exodus (EXDS-Nasdaq) built buildings with lots of bells and whistles and threw in some services. But at the end of the day, it had to keep putting up more buildings to maintain growth rates. The problem with being a landlord is that you need continued high occupancy to make the economics work. Thus, I could never justify Exodus' share price, even in its heyday.

Exodus built major data centers (more than 5 million square feet) and accumulated a mountain of debt--more than $3 billion in long-term debt alone. Based on its current operations, Exodus won't break even on its cash flow until sometime in mid-to-late 2002, and that may be optimistic.

To get some flexibility on the balance sheet, the company may seek to do more asset sale-leasebacks. It recently did a $115 million deal and it may do an additional $500 million. Much of this money will be used to reduce capital expenditures next year, which are projected at around $200 million. Management projects that Exodus will end the second quarter of this year with $550 million in cash and reach the end of the year with about $200 million on the balance sheet. If the cash-burn rate for the second half of this year encompasses the cost reductions, there might be $700 million in cash starting in 2002 after the asset leaseback transactions. The cash-burn rate will be roughly $225 million per quarter, which includes $50 million per quarter of capital expenditures. This means Exodus has roughly three quarters to get to cash-flow breakeven, which is about the time it states it will be there. That doesn't leave much room to spare. The cash-burn rate has to slow. When a commercial building deal goes bad, the lender usually ends up taking over the building. In the case of Exodus, the balance-sheet risk is very high, and the landlord (i.e., shareholders) may find the lenders knocking on the door.

What other business risks did Exodus take on? Like a speculative builder, it kept adding capacity and took on staff in 2000 to handle projected revenue in excess of $2 billion. The company now projects that revenue won't exceed $315 million for the June quarter of this year; this would be less than $1.3 billion in revenue, annualized. Exodus is unlikely to see any major recovery in the second half of this year; management guidance for revenue next year is $1.6 billion to $1.7 billion.

These revenue numbers speak to the issue of excess capacity. It's estimated that data-center use is running around 50% of capacity. Even if hosting demand picks up, the price of floor space has come down aggressively because of the excess capacity. Like other commercial landlords, Exodus is competing for tenants. When tenants have a lot of choices, they get better pricing. Just look at the recent San Francisco rental market to see what a large negative change in the supply-demand balance does to rental prices.

This capacity issue affects operating cash flow. It's estimated that earnings before interest, taxes, depreciation, and amortization, a reasonable estimate of operating cash flow, will be around $70 million to $80 million this year--not enough to cover the interest costs on the current outstanding debt.

Most analysts estimate that earnings per share, excluding goodwill amortization expenses, will stay in the red through next year. I expect these losses to increase as analysts adjust their numbers downward. On 563 million fully diluted shares, equity market capitalization has dropped to less than $1 billion. With more than $3 billion in debt, you might compare this with a building leveraged with 75% debt.

Exodus' best hope is for a telco to buy it out, like the WorldCom-Digex deal, or, better yet, convert its sites into condominiums with great air conditioning and backup power. Now, that might sell in California.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].