Rackspace: Beyond The Price War

| About: Rackspace Hosting, (RAX)


Rackspace decides not to join the latest price cutting war in the cloud computing market.

There are four strategic plans that give Rackspace the competitive advantages to ensure its future success.

All competitors in the cloud computing arena are subject to risks, but Rackspace stands out from the fierce competition.

Focusing on long-term value creation, Rackspace is in a good position to achieve long-term returns and growth.

Rackspace's Position in the Cloud Price War

On March 26, 2014, the day after Google (NASDAQ:GOOG) (NASDAQ:GOOGL) announced that it was slashing the price of its Google Cloud platform, Amazon (NASDAQ:AMZN) followed with similar (albeit slightly less drastic) price cuts the next day on its Amazon Web Services (AWS). Less than a week later, Microsoft (NASDAQ:MSFT) announced price reductions on its Azure products similar in magnitude to Amazon's cuts.

This price war drove the stock price of Rackspace (NYSE:RAX) even lower than it became shortly after CEO Lanham Napier announced his retirement in February. The combined effect of this double-whammy caused the price of RAX to plummet from just over $40 to a low of nearly $31. Many stockholders have lost confidence due to this drastic decline in Rackspace's stock price. Nevertheless, Rackspace is brave and smart to stand on the sideline of the price wars as internet giants Amazon, Google, and Microsoft slash prices and collectively reduce their profitability.

On April 8, 2014, John Engates, Rackspace's Chief Technology Officer, told The Register:

"We pay close attention to market conditions and make periodic adjustments to ensure that our prices are competitive on a total-cost-of-performance basis... We do not base our prices on competitors' rental rates for raw infrastructure. Rackspace has for 15 years charged premium prices for premium service, expertise, performance and reliability."

The Secret Weapons Behind Rackspace's Future Success

Now is the perfect time for Rackspace to move beyond the cloud price wars and reach its full potential. So what is Rackspace's strategic plan for success? Rackspace has a number of competitive advantages that will separate them from their competitors and ensure profitability.

1) Open Source Architecture

Rackspace utilizes OpenStack, an "open and scalable operating system for building public and private clouds." OpenStack reduces the risk of lock-in to proprietary software. Amazon cannot make this claim because its software is proprietary, and AWS relies on other software to enable the possibility of creating a hybrid cloud.

2) Industry-Leading Customer Support

Failure to address an IT problem in a timely manner can rapidly result in significant revenue loss; thus, wise businesses are willing to pay premiums for timely, high-quality support. Rackspace has addressed this need by offering the "gold standard" in customer service. Rackspace's award-winning "Fanatical Support" provides a support team (rather than a call center) that is available to address its customers' needs 24/7/365.

3) Proven Performance and Expansion to Niche Clientele

Rackspace aims at keeping its existing customers happy while addressing the unique technical needs of new customers. As cloud computing services have evolved, massive gains in performance, cost-effectiveness, and unmatched customer support have enabled Rackspace to deliver what they have promised to their existing customer base. This performance, coupled with its Fanatical Support, has earned Rackspace an incredibly loyal customer base. At the same time, market niches have developed with specific needs, and Rackspace has the technical expertise and manpower to cater to these niche markets as well. Rackspace's ability to innovate and diversify for new clients while maintaining its offerings for core clients will enable the company to remain highly competitive.

4) Employee Loyalty

In a recent interview with Dr. Frank Strangenberg-Haverkamp, Chairman of the Family Board of Merck, Strangenberg-Haverkamp stated that one of the reasons Merck has enjoyed success for over 300 years is that it has maintained a culture that effectively copes with mistakes and works to overcome them. He emphasizes that in the end, culture is the spirit of the company. Similarly, Rackspace is dedicated to providing an outstanding work environment for its employees. In March, Rackspace was ranked 26th of 100 best companies to work for in 2013. This was Rackspace's ninth consecutive year in the listing.

Rackspace's four areas of competitive advantage can be summed up in a single word: quality. The company has clearly established a firm foundation with its customers as a luxury brand. As such, Rackspace can afford to sidestep around the price wars and emerge in the long-run as a high-quality industry leader.

Analysis of Financial Conditions and Operational Risks for Rackspace

Despite the highly competitive market environment, Rackspace generated net revenues of $408 million in the fourth quarter of 2013, a 5% increase over Q3. Adjusted EBITDA increased 5.2%; diluted earnings per share increased from $0.11 to $0.14. Rackspace forecasts that their Adjusted EBITDA margins in the first quarter 2014 are anticipated in the range of 31% to 33%, while they are expected to range between 32% and 35% for 2014.

In 2013, Rackspace incurred some significant costs that impacted revenue, namely employee-related costs for R&D activities associated with OpenStack and investment in worldwide data centers in the UK, Hong Kong, Australia, and New Zealand. In 2014, Rackspace is expected to increase R&D expenditures in order to maintain a competitive edge, and sales/marketing expenses will increase slightly as a percentage of revenue growth. However, these increases will be substantially less than the large costs incurred in 2013. This reduction in costs will put Rackspace in the position to deliver significantly improved revenues in the first and second quarters of 2014.

The ultimate risk to Rackspace is whether new customers will be willing to pay premiums for open architecture and dedicated service teams rather than enjoying the significant discounts being offered by competitors. There is no doubt that the aggressive pricing policies implemented by companies like Amazon, Google, and Microsoft have increased this risk for Rackspace, especially since they have substantially greater financial resources to devote to sales and marketing. However, all competitors in the cloud computing arena are subject to risks, including potential implementation of improperly-targeted growth strategies, failure to operate in a cost-effective manner, and the inability to capitalize on market opportunities and trends. For example, the prediction that the cloud computing ecosystem will continue to evolve into more specialized fields could result in a significant threat to market leader Amazon, since AWS only provides general-purpose cloud services. Moreover, unlike simple hosting services that a client can manage, cloud service has become so complex that users need trusted partners to help them manage their products. Rackspace's investment in its reputation to become the market leader in Fanatical Service should prove to be an invaluable strategic advantage.

Next Generation Rackspace

In the midst of the market downtrends of Q1 2014, investors overvalued the impact of Napier's retirement and competitor price cuts. Rackspace has proven both its technological expertise and dedication to customer satisfaction. Armed with its competitive advantages and the anticipated energy brought to the company by a new CEO, Rackspace is ready to take on its competitors. In the past six months, there has been significant acceleration in Rackspace's web traffic - a harbinger of good things to come. The old-school thinking that larger firms are more reliable will be tossed away as new customers gravitate toward Rackspace, helping them to increase their market share and bolster their stock price in the months to come.

Disclosure: I am long RAX. 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.