Rackspace - As Long-Term Growth Story Remains Intact, Shares Should Find Support

| About: Rackspace Hosting, (RAX)

Shares of Rackspace Hosting (NYSE:RAX), the open cloud company, lost a quarter of their value in Thursday's trading session after the company reported a disappointing set of first quarter results.

As the long term growth story is intact despite a 50% sell-off in recent months, shares should find support around current price levels.

First Quarter Results

Rackspace generated first quarter revenues of $362 million, up 20% on the year before. Sequential revenue growth slowed down considerably, with first quarter revenues being up just 2.6% compared to the fourth quarter. Revenues missed consensus estimates of $367.2 million.

Adjusted EBITDA came in at $125 million, up 24% on the year but down 3.6% from the fourth quarter. EBITDA margins came in at 34.5% which is up 110 basis points on the year, but down 230 basis points from the fourth quarter.

Net income came in at $27 million, which was still up 18% on the year, but down 9% from the fourth quarter. Diluted earnings per share came in at $0.19 per share. This is up two cents on the first quarter of previous year, but down two cent from the previous quarter. Earnings missed consensus estimates by a penny.

The total server count of the company stood at 94,122 up from 90,524 at the end of 2012.

CFO Karl Pichler commented on the developments in the first quarter, "We got off to a slow start for the year. Building a lasting, successful business is our number one priority. However, our immediate focus is on restoring our growth trajectory. We are excited to see the industry momentum behind OpenStack and we are determined to claim the service leadership position in the Open Cloud movement."

Looking Through The Results

Rackspace had some minor headwinds during the quarter which can only explain a small portion of the disappointing performance. The higher dollar impacted revenues adversely, although only by $1.0 million compared to last year, and $2.9 million compared to the fourth quarter.

Profitability was furthermore impacted by a non-cash charge related to Rackspaces' data center operating leases, by an amount of $4.0 million.

Average monthly revenues per servers came in at $1,308 which is up $70 on the year, but down $2 on the quarter as the company build a new center in Australia and introduced price cuts and tier pricing. To service the growing operations, Rackspace net hired almost 200 workers over the past quarter bringing the total headcount to 5,043 at the end of the quarter.


Rackspace ended its first quarter with $279 million in cash and equivalents. Total debt, including capital lease obligations, stood at $106 million, for a solid net cash position of around $173 million.

For the full year of 2012, Rackspace generated annual revenues of $1.31 billion, up 27.7% on the year before. Net earnings rose by 38% to $105.4 million, coming in at $0.75 per diluted share.

After the 25% sell-off, the market is valuing the company at $5.43 billion, valuing its operating assets around $5.26 billion. This values the company at 4.0 times annual revenues and 50 times annual earnings.

Rackspace does not pay a dividend at the moment.

Some Historical Perspective

Long term holders in Rackspace have seen decent returns as cloud-based computing became the hottest thing in the industry. Shares rose from levels of around $5 in 2009 to a peak around $80 as recent as January of this year. Shares sold off hard after the company announced a 33% price cut for its services in February.

Shares fell $60 following the announcement and have lost more ground in recent weeks, currently exchanging hands around $40 per share.

Between 2009 and 2012, Rackspace more than doubled its annual revenues from $629 million to $1.31 billion in 2012. Net earnings more than tripled in the meantime, expanding from $30.2 million to $105.4 million.

Investment Thesis

Rackspace was loved by Wall Street and investors for a long time as the company reported rapid growth accompanied with solid profits. Yet increased competition came at the worst possible time for the company. As Rackspace was in transition to its new OpenStack platform, investments decisions and bookings by enterprises slowed down. Rackspace is shifting from traditional data centers to offer full services in software and cloud, by offering a "hybrid" approach of cloud-based solutions.

With the new OpenStack platform, which has seen a successful introduction, the company anticipates to be able to compete in an ever crowded market against the likes of Equinix (NASDAQ:EQIX), Amazon.com (NASDAQ:AMZN) and InterNAP Networks (NASDAQ:INAP), among others.

CEO Napier commented on the transition: "Our first quarter results demonstrate that we are still working through our product cycle transition. This product-cycle transition will likely continue for some time, given the large number of customers still using the legacy public could platform."

As competition intensified and growth slowed down, Rackspace had to announce an unprecedented 33% price cut of its cloud bandwidth and content delivery network solutions halfway through February. This price cut affected the company already in the first quarter, but the full effect will only be felt in the current second quarter.

In the light of this information, the guidance for second quarter revenues of $369 to $375 million is not that bad, even as it missed consensus estimates of $383.9 million.

At the midpoint of the guided range, revenues are expected to increase by 2.7% despite the fact that prices were impacted for the entire quarter. In the past quarter, the new OpenStack public cloud service grew revenues by 75% sequentially, as growth in the legacy cloud platform was flat.

For the second quarter Rackspace sees EBITDA margins of 30% down from 35.1% a year ago and 34.5% in the first quarter of last year. This translates into EBITDA of $112 million, down from $125 million over the past quarter, a development which could severely impact the bottom line.

Despite the short term headwinds, Rackspace expects that investments in OpenStack represent a large long term investment, developing the company into a much stronger competitor for the cloud market. The company is already working with IBM, Best Buy (NYSE:BBY), Bloomberg and PayPal (NASDAQ:EBAY) which are using Rackspace's new solutions.

While growth is slowing down and price cuts are impacting margins, the long term growth story seems to be intact, given the well-received introduction and expectations for OpenStack. The continued low churn rate of just 0.8% is impressive and very low for a new technological services.

After a 50% sell-off the valuation of Rackspace has increasingly become more acceptable at 4 times last year 's revenues. While profitability could be under pressure in 2013, the long term expectations remain solid enough to support the current valuation. With large corporate interest by the likes of Oracle (NASDAQ:ORCL), SAP and Hewlett-Packard (NYSE:HPQ) in the cloud market, a take-out is always among the possibilities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.