When Will Rackspace Shares Bottom?

Dec. 9.13 | About: Rackspace Hosting, (RAX)

Bearishness in Rackspace Hosting (NYSE:RAX) accelerated after the company revealed a disappointing third quarter on November 11, 2013. The sell-off continued at the beginning of December. Google (NASDAQ:GOOG) announced that it would reduce cloud computing and persistent storage prices by 10% and 60% respectively. With short interest rising, share price falling, and a mediocre growth forecast from the company, should investors still accumulate Rackspace shares?

Short interest dropped between June 14 and June 28 2013, but rose steadily since then. Bearishness jumped in November 15 to 18.66M shares after Rackspace reported Q3 earnings:

Settlement Date

Short Interest

Avg. Daily Share Volume

Days To Cover

11/15/2013

18,664,606

4,057,168

4.600403

10/31/2013

15,695,441

986,932

15.90327

10/15/2013

14,024,727

2,326,969

6.027036

9/30/2013

13,945,568

1,229,555

11.34196

9/13/2013

13,168,530

1,780,625

7.395454

8/30/2013

14,346,398

1,102,107

13.01725

8/15/2013

13,850,430

2,462,309

5.624976

7/31/2013

13,050,495

1,698,232

7.684754

7/15/2013

11,872,086

2,063,362

5.753758

6/28/2013

9,880,719

2,332,798

4.235566

6/14/2013

10,689,816

2,104,433

5.079666

Click to enlarge

Source: Nasdaq.com

Rackspace grew revenue by 3.4% last quarter. It expects sequential growth to be between 3% and 5% in the current quarter. Leadership changes and a boost in marketing for OpenStack capabilities are expected to benefit the company long term. Investors chose instead to sell shares now and to ask questions later. Conversely, Google and Amazon (NASDAQ:AMZN) shares continue to rise:

RAX Chart

RAX data by YCharts

Rackspace has a number of advantages in its solution offering. It supports hybrid clouds and sells managed service solutions. Hybrid cloud support means customers may run public cloud apps while private clouds could support e-commerce. Capacity also scales better in a hybrid cloud.

Healthy margin

Rackspace generated 32.3% in adjusted EBITDA margin in Q3. This would have been higher had the company not boosted its staff levels by around 200. The hiring in R&D and in the technical levels will prove beneficial in the quarters ahead. Still, the quarter was disappointing, as net income dropped 40% from last year, to $16M ($0.11 per diluted share).

Hybrid cloud

Rackspace boosted awareness for OpenStack in the quarter to the benefit of supporting sales for hybrid cloud solutions. It launched HADOOP services, and developed its managed hosting product. The latter investment will further improve the service levels offered on top of infrastructure product sales. Performance Server helps support complex customer workloads and generates higher revenue (ARPU or average revenue per user). Even as Amazon and Google lower cloud computing costs, customers who want a wider and fuller level of support will consider supporting Rackspace.

Valuation

Rackspace earned $0.75 per diluted share in fiscal 2012. At a recent close of $33.61, shares trade at a trailing P/E of 44.8. The premium is justified: Rackspace earnings are triple where it was 3 years ago in 2009:

2009

2010

2011

2012

Diluted EPS

0.24

0.35

0.55

0.75

Click to enlarge

Source: Kapitall.com

Rackspace earned $0.67 per share in total, in the last four quarters. It had $269.99M in cash as at September 30, 2013 and negligible debt.

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Diluted EPS

0.21

0.19

0.16

0.11

Click to enlarge

Source: Kapitall.com

Bottom line

Google's entry into IaaS (Infrastructure as a Service) will certainly contribute to further pricing erosion. Yet Amazon's AWS still has an edge over Google. The rapid growth for AWS is not preventing Rackspace from growing. Rackspace boosted its product offering, developed support for hybrid clouds and continues to grow internationally. Seasonal weakness in Q1 could accelerate the negativity growing in shares of Rackspace. When Rackspace updates investors in February 2014, the light outlook could mark a bottom in its shares. After that, the investments made by the company should provide meaningful growth.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in RAX over 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.