I've been burned by doubting Rackspace (NYSE:RAX) in the past. Turns out that the stock has been incredibly resilient. I spent a considerable amount of time trying to figure out what was causing the rise and if it was sustainable. I'll go into deeper details but as you can deduct from my title, I do not think it is sustainable and expect RAX to underperform significantly over the next 2-3 years.
Cloud Computing Is A Fast Growing Business
There is no doubt that cloud computing is a safe bet to grow very quickly over the next 5-10 years. Despite some issues such as the recent NSA findings, most corporations and individuals are relying increasingly on cloud based data. Businesses like Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOG) and even more traditional industries are quickly moving their data and processes to the clouds.
|Ticker||Name||Price||EPS||PE Ratio||PE Next Year||Return YTD||Sales Growth||Analyst rating||Book Value||Beta||Earnings||Mkt Cap||Revenue/Share||Sales 5Y Avg Growth||EPS 5Y Avg Growth|
|RAX||Rackspace Hosting Inc||38.21||0.78||57.03||50.88||-48.55||27.72||3.63||7.07||1.02||2/12/2014||5.34B||9.68||23.1||26|
Cloud Margins = 0?
Rackspace's valuations seems to be mostly based on its expected growth as it continues to grow in an exploding industry. The big issue, though, is that the margins in cloud-based services are quickly moving towards 0. Rackspace is competing with players such as Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Google (GOOG) which is a significant problem. Why? Because both players do not expect to make significant profits in that segment of their business. They view it as a way to get users in their ecosystems. Think of how Google offers its "Google docs" for free. Or how Amazon has been able to dominate thanks to its AWS services. Those players are able to optimize so much that it becomes very difficult for RAX to compete. How? Building data centers around the world including in areas where cooling costs are smaller, working on data centers that are as efficient as possible, etc.
Google, Amazon, Facebook and Co. Do Not Offer Hosting Services
While it's true that in many ways, those companies do not try to compete with RackSpace in offering the same services, they do offer interfaces (especially Amazon) that make it increasingly easy for independent companies to build applications and services that are built on top of AWS for example. I only see that trend becoming stronger over time, which will make it very difficult for RAX to grow those profits consistently.
Disclosure: No position in RAX.