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Summary

  • Investors have missed the good and the significant trends in Rackspace's recent reports.
  • The good news is, business conditions in the enterprise cloud are improving. And there are now signs that the company's recent struggles are on the mend.
  • On the basis of ongoing subscriber and revenue growth these shares should reach $40 in the next 12 to 18 months.

With year-to-date stock declines of 24%, shares of IT-hosting and cloud-computing giant Rackspace (NYSE:RAX) have been grounded. The stock closed Friday at $30.37, up 1.44%.

The shares, however, are still down 44% from their 52-week high of $54.20. And investors are stuck deciding whether Rackspace has become a value play or a falling knife. With the company due to report second-quarter earnings Monday, that's not an easy distinction to make. But after chronic punishments in 2014, I believe Rackspace is now worth the risk.

The good news is, business conditions in the enterprise cloud are improving. And there are now signs that the company's recent struggles are on the mend. What's more, to the extent Rackspace can affirm its position as a cloud juggernaut amid fierce competition from larger rivals Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOGL), Rackspace will (at least) emerge as a top acquisition candidate. I can see Cisco (NASDAQ:CSCO) making the call.

Outside of VMware (NYSEARCA:WMW) and Red Hat (NYSE:RHT) there are very few companies, outside of Rackspace, that truly understand the cloud and the new battleground known as OpenStack. Rackspace, along with NASA, pioneered that standard. And despite concerns about the company's near-term margins and long-term position within the cloud, Rackspace is not going to go away overnight. Management can make this known Monday when speaking to analysts.

Wall Street will be looking for earnings of 16 cents per share on revenue of $436.91 million, representing a year-over-year revenue increase of more than 16%. For the full year, analysts will be looking for earnings-per-share of 69 cents on revenue of $1.79 billion, both growing at 13% and 16% year over year, respectively.

That does not sound a like company in decline. Recall, back in May, Rackspace reported first-quarter revenue of $421 million. Not only was this a 16% year-over-year jump, the company beat Street estimates. This was also enough to be Street estimates by $2 million, or roughly half of a percent.

The company also posted $25 million in net income, or 18 cents per share, which was a penny above the year-ago. Equally impressive, the company beat analyst estimates by 6 cents per share. Investors, meanwhile, missed the significance of this report.

While Rackspace is far from a perfect company, the results showed that the situation is not as dire as the share price might indicate. Analysts, on the other hand, saw it another way. They wasted no time lowering their price targets, while citing fears about the competition.

In a research note, Rick Summer of Morningstar 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."

Summer's concerns are not without merit. When compared to, say, Amazon and Google, Rackspace does not have the financial muscle to withstand a price war should either of the larger giants decide to apply margin/pricing pressure.

At the same time, though, it assumes that Rackspace's customers are going to be swayed by price alone. So far, the company's results have yet to show pricing weakness. Analysts Greg Miller of Canaccord beleives Rackspace is worth $35 per share, or 15% above Friday's closing price.

From my vantage point, I will have to side with Miller. With the stock trading at around $30, I believe Rackspace has seen the worst. And investors looking for a better entry price may not get it following the company's second-quarter results. On the basis of ongoing subscriber and revenue growth these shares should reach $40 in the next 12 to 18 months.

Disclosure: The author has 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.