Rackspace: No Space Reserved For This Cloud Player In My Portfolio

| About: Rackspace Hosting, (RAX)

Shares of Rackspace (NYSE:RAX) took a renewed beating after the cost of offering its cloud services showed that it was eating into its profit margins.

The fact that Rackspace is operating aggressively to sacrifice earnings to rejuvenate revenue growth is disappointing to investors. I remain on the sidelines although long-term growth could re-ignite and large players might become interested in the company.

Third Quarter Results

Rackspace generated third quarter revenues of $389 million, up 16% on the year before, and up by 3.4% on a consecutive basis. Revenues were roughly in line with consensus estimates at $387.8 million.

The company reported a 40.0% fall in earnings compared to the year before, coming in at $16.3 million on a GAAP basis. Diluted earnings per share fell from $0.19 to $0.11 per share. Analysts were looking for earnings of $0.16 per share.

Looking Into The Results

While revenue growth is steady, both on an annual and sequential basis, the earnings developments are worrying.

Notably general and administrative expenses, as well as depreciation and amortization charges, are on the increase. Combined with relatively high income tax rates, net earnings attributable to shareholders are under pressure.

Average revenues per server continue to be under pressure, falling by $8 on a sequential basis to $1,290 per server. Note that revenues per server still totaled $1,310 in the fourth quarter of 2012. The total server base broke through the 100,000 barrier as Rackspace ended the quarter with 101,967 servers.


Rackspace ended its third quarter with $270 million in cash and equivalents. The company operates with $73 million in debt and capital lease obligations for a net cash position of around $200 million.

For the first nine months of the year, Rackspace generated revenues of $1.13 billion, up 17.8% on the year before. Net earnings fell by 12.7% to $65.9 million. At this pace annual revenues of $1.50-$1.55 billion are attainable as earnings could come in around $85 million.

Factoring in losses of 12%, with shares trading around $43 per share, the market values Rackspace at $6.0 billion, or its operating assets at $5.8 billion. This values operating assets of the firm at 3.8 times annual revenues and 68 times GAAP earnings.

Rackspace does not pay a dividend at the moment.

Some Historical Perspective

Rackspace went public in 2008 when the company sold shares to the general public at $12.50 per share. Shares quickly fell to lows of $5 at the start of 2009 and have steadily risen to levels around $80 at the start of the year. Ever since, shares have lost roughly half their value as shares fell to lows of $35 in July.

Between 2009 and 2012, Rackspace is expected to report cumulative revenue growth of around 140% to $1.5 billion. Earnings are set to roughly triple in the meantime, but fall from record levels set in 2012.

Investment Thesis

Rackspace has been focusing on rejuvenating revenue growth. The third quarter results indicate that the company is happy to sacrifice earnings to drive growth, something which investors clearly don't like.

Reported revenues show a 3.4% growth rate on a sequential basis, at the high end of the guided 2-3.5% range. For the fourth quarter, the company is seeing growth as high as 5% on a sequential basis.

So far this year, shares have already lost some 40%. Back in February, the company announced a price cut of a third for its cloud bandwidth and content delivery network solutions, as competition was intensifying and customer growth was slowing down.

These cuts were followed by usual and sizable competitors like Amazon.com's (NASDAQ:AMZN) Web Services and Microsoft's (NASDAQ:MSFT) Azure cloud computing offerings.

Back in May of this year, I last took a look at the prospects for the firm as shares were trading in their low forties at the time. In concluded that the long-term growth story remained intact, and that shares could find support at those levels. In fact, shares fell a bit further, but are trading at similar levels, even when factoring in Tuesday's losses.

I noted that Rackspace was a long-term darling at Wall Street as rapid growth was accompanied by solid earnings. Yet increased competition came at the worst possible time. Rackspace was in transition to its new OpenStack platform. Under this approach Rackspace is shifting from traditional data centers to a hybrid approach of software and cloud.

The long-term growth story is intact, although it comes at a high cost in terms of earnings. Yet churn rates remain very low, especially for such a new technological service. The valuation seems appealing at 4 times revenues, but for now it seems that Rackspace's cloud offerings become commoditized, resulting in premium earnings valuations as margins are getting squeezed.

I remain cautious, even though a large corporate technology giant might become interested to boost its cloud offerings in the future, a real possibility given the relative modest market capitalization.

I remain on the sidelines.

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.