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Summary

  • Shares of Rackspace have retraced about two-thirds from their highs.
  • Despite the sell-off, shares are not cheap based on their fundamental valuation.
  • Competition continues to intensify, putting continued pressure on margins.

Investors in Rackspace Hosting (NYSE:RAX) had a rough year. Despite seeing a bounce upwards on the back of first quarter results, I believe that investors might not have seen the worst yet.

Shares are still quite expensive on traditional metrics as competition for its services is increasing. I remain on the sidelines with a slightly bearish stance.

First Quarter Developments

Rackspace reported first quarter revenues of $421 million which is up 16% on the year, and up 3.2% compared to the fourth quarter of last year. Important to note, Rackspace actually enjoyed foreign currency tailwinds of $2.4 million compared to the fourth quarter ,and $6.6 million compared to last year.

Rackspace saw continued pressure on its gross margins which fell by a full two percentage points to 66.7% of revenues. This gross margin compression was the main driver behind the fall in operating earnings which dropped by 250 basis points to 9.3% of sales. As a result, net earnings fell from $27.3 million to $25.5 million.

The important server count came in at 106,229 with average revenues per server a month coming in at $1,336. The increase in the number of servers, up from 94,122 last year, is the major driver behind growth as average revenues per server rose by just $28 compared to last year.

Solid Outlook

For the current second quarter, Rackspace foresees revenues to come in between $434 and $440 million. This results in 3.5-5% sequential revenue growth and implies 16.3% year-on-year growth at the midpoint of the guidance.

No full-year outlook has been given at this point in time, yet investors are relieved with the second quarter growth. This came after competitors have slashed prices for their products in recent months.

Valuation

Rackspace ended the quarter with $314 million in cash and equivalents while total debt including lease obligations came in at $53 million. This results in a net cash position of about $260 million.

Trading around $30 per share, Rackspace's equity is valued at $4.3 billion which implies that operating assets are valued at $4.0 billion.

This values the company at roughly 2.6 times annual revenues of $1.53 billion which the company reported for 2013. The valuation comes down to roughly 46 times 2013's earnings of $87 million.

But What About Pricing?

Share of Rackspace have seen a huge sell-off over the past 12-18 months with shares retracing about two-thirds from their highs set around $80 in January of 2013.

The reason for this is slower growth and increased competition which has a dramatic impact on pricing. Cloud services are rapidly becoming a commodity with huge established players like Amazon.com (NASDAQ:AMZN), Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) all having launched their own service in recent years. These giants have announced steep price cuts in recent times.

Rackspace has refused to join the latest round of price cuts in what could be a dangerous move, yet the company has little choice as profit margins have already been squeezed severely.

Instead of offering a simple commodity product, it offers superior services accompanied by managed infrastructure and superior customer support. The superior reliability is a big strength as well.

As a matter of fact, Rackspace acknowledges that it has always commanded premium prices, which it has been able to ask given the superior service, quality and accessibility through OpenStack to access both public and private clouds.

Despite these service improvements the costs of Rackspace is quite a bit higher as illustrated by a very informative article from The Register. A 15GB Performance cloud server with four virtual CPUs, 40GB of SSD system disk and a 150GB SSD data disk costs $0.68 per hour at Rackspace. This compares to what the article calls equivalent but lacking service costing $0.28 per hour at both Google and Amazon.com.

Takeaway For Investors

While I'm obviously attracted to shares of a profitable and growing company which have seen a 65% sell-off from their highs, I must say that I'm not that impressed with the fundamental value at the moment.

Growth is solid, but around 15% per annum is not that impressive especially with shares trading at around 45 times earnings. This is especially true with competition continuing to increase, which could squeeze margins even further in this capital-intensive business.

Of course there are the valid counterarguments for the company. Rackspace could become a niche player and perhaps many businesses are happy to pay a premium for superior services. Still, I don't believe that the current risk/reward opportunity is appealing, despite a huge sell-off over the past year and a half.

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.

Source: Rackspace Hosting: Still No Fundamental Value Despite A 65% Sell-Off