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Summary

  • Investors holding the stock shouldn't rest easy.
  • The $19 target makes Racksapce a good short to $20.
  • The good news is that business conditions are improving and there are now signs that the company's recent struggles are on the mend.
  • To the extent that Rackspace can build on this, the company should do fine. But it's going to be a long and treacherous road.

Shares of IT-hosting and cloud-computing giant Rackspace (NYSE:RAX) has soared to the clouds recently. The stock closed Tuesday at $29.88, up 8.5%. But the shares are still down roughly 24% year to date. But in yesterday's session, there was (at one point) a 10% spike upward following the company's better-than-expected first-quarter earnings results. But it's not yet time to party, according to some analysts. First, let's go through the numbers.

Rackspace reported first-quarter revenue of $421 million. Aside from representing a 16% year-over-year jump, this was also enough to be Street estimates of $419 million. Net income for the quarter came in at $25 million, resulting in earnings of 18 cents per share, a penny below earnings from the year-ago. Equally impressive what that this was six cents above the 12-cent per-share analyst estimate.

In a space dominated by larger rivals such as Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG), Rackspace, which developed the now-popular OpenStack standard, had come under significant margin pressure. There were concerns about the company's long-term position within the cloud.

So, understandably, investors cheered the earnings beat, which came as a sign that things were beginning to turn around. But not everyone is buying this story. At least not yet. Several analysts have wasted no time to lower their price targets, citing the strength of the competition. One, in particular, is Rick Summer of Morningstar. In a research note this morning, Summer said:

"The company will be challenged to differentiate itself from competitors and achieve sufficient pricing to deliver excess returns on capital. In the 'unmanaged' cloud segment, we aren't convinced Rackspace can avoid the competition and believe it is likely to experience slowing growth or limited profitability for its public cloud offerings."

I have to agree. Given Rackspace's recent struggles and its limited capital when compared to Google and Amazon, it will be hard for the company to go toe-to-toe if/when Google and Amazon decide to cut their prices. Rackspace will be squeezed out of infrastructure services.

Summer later added, "We remain concerned that Rackspace will not be able to earn returns above its cost of capital over any meaningful period." As it stands, Morningstar has a $19 price target on the stock, which suggests a decline of 36% from Tuesday's close. And even though other analysts such as Greg Miller of Canaccord still have strong targets, they've just lowered their projected valuation from $39 to $35.

Note, Rackspace, which is being lead by interim chairman Graham Weston, still has not appointed a permanent CEO since Lanham Napier retired in February. In that regard, Canaccord's Miller offered:

"Without a permanent CEO and with increasing levels of competition from competent competitors, we remain concerned for this subsector in the second half of the year and remain cautious on the stock."

I understand the need for caution. But Rackspace management didn't guide as if they are afraid of any challenges the company might face. Looking ahead, with second-quarter revenue expected at $437 million, management set the midpoint of its revenue guidance just above Street targets. Analysts polled by Thomson Reuters had estimated revenue of $435.5 million.

And following the announcement, while praising the company's strong performance, Graham Weston suggested that the company added "thousands of new customers." Later in the statement, he hinted that of the new customers added, one was "the largest we've ever landed."

For now, investors holding the stock shouldn't rest easy. Analysts have decided to take a wait-and-see attitude. But the $19 target makes Rackspace a good short to $20.

The good news is that business conditions are improving and there are now signs that the company's recent struggles are on the mend. To the extent that Rackspace can build on this, the company should do fine. But it's going to be a long and treacherous road.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.

Source: Why Rackspace Is A Good Short To $20