Cloud computing has been all the rage the past few years, and, rightfully so, because it's where a majority of the growth is in the technology sector. If you want to make money, just hitch your wagon to a company in the cloud space, and you'll probably profit in the long run, especially after the recent sell-off in the markets. As scribe Tim Weber of the BBC News reported in his May 19, 2011, article "Cloud Computing After Amazon and Sony: Ready For Primetime?":
According to a new global study by IBM, more than 60% of organizations plan to embrace cloud computing over the next five years to boost their competitive advantage.
Rackspace Hosting (RAX) is a "pick-and-shovel" cloud company that does just what its name suggests, hosts organizations' software on its servers, located in data centers throughout the globe in places like the United States, the United Kingdom and Hong Kong. As described in their most recent annual report:
Our services are sold to businesses in more than 120 countries... as of December 31, 2010, we served more than 130,000 business customers, and we managed more than 66,000 servers, 2,100,000 e-mail accounts, and 417,000 hosting domains. No single business accounted for more that 2% of net revenue in any of the past three years.
For just a bit of background information, cloud computing is an extension of hosting. With just your plain-vanilla dedicated hosting, a customer-specific dedicated server will be housed at a Rackspace data center, and clients have full administrative responsibilities and privileges. It's still a do-it-yourself environment, although you don't have to go out and buy a server, you just rent one.
In regards to the cloud, as written in the 2010 Rackspace annual report: "Cloud computing refers to pooled computer resources, delivered on-demand over the Internet. Cloud technologies allow us to effectively provision and manage a pool of computing resources across a layer base of customers and deliver more computing resources to a business when they need them." A good example of a company needing additional computing resources would be a retailer from Thanksgiving through New Year's, or a bank at the end of the day, when they process all of their transactions. Clients usually pay by the gigabytes of bandwith consumed.
Rackspace Hosting is no fly-by-night organization with a get-rich-quick-scheme. It has been around since 1998 and has slowly built the company into one of the more dominant players in the hosting sector. As CEO Latham Napier states in the Q2 2011 earnings call transcript:
Although it has taken us nearly 12 years to achieve our fist $1 billion of run rate revenue, we believe it will take a fraction of that time to attain a second... the cloud computing era represents the biggest market opportunity in all of technology. One that could represent a multibillion-dollar revenue stream for Rackspace, and we've only just begun to tap into that opportunity.
The Rackspace growth strategy is to give what they refer to as "fanatical service" and to build relationships slowly with the larger entities in the global marketplace. CEO Napier discusses this approach in the Q2 conference call:
Obviously there are only 500 companies in the Fortune 500. And so if you look at the top 100 of those, we only serve half of them... So we have a good opportunity with the other half, because our share of the wallet is so low with these guys... our upgrade potential with enterprise customers is exceptional.
As a growth story, Rackspace Hosting really found its groove the past four years. In the June 2, 2011, Bloomberg Businessweek article "How Rackspace Beats the Behemoths," author Ari Levy points out:
Since 2007, Rackspace's sales have grown by an average of 30 percent every year, and analysts expect net income to climb 49 percent this year... Wall Street has caught on: Rackspace shares are up almost tenfold since early 2009... Customers include 40 percent of the top U.S. companies by revenues.
Although this is a battle-tested company, it still needs to get up to speed in regards to its cloud offerings, because it is still primarily a hosting company. Napier didn't break down the business segments in the conference call, but as Reinhardt Krause accentuates in his August 1, 2011, article "Rackspace Using Open Source To Compete Vs. Amazon" in Investor's Business Daily: "Analysts say it's key for Rackspace to expand cloud services, because that business is more profitable than its low-margin hosting business."
In cloud hosting at this juncture in time, it basically boils down to two companies ready to duke it out: Amazon (AMZN), which uses proprietary software unique to Amazon, and Rackspace Hosting, which utilizes an open-source platform called OpenStack. Amazon is by far the leader in the industry, but Rackspace is snapping at its heels according, to the aforementioned article: "Many companies that buy cloud services prefer open standards because it gives them more choice among service providers and computing hardware."
To give a brief description of OpenStack, Vance Cariaga of Investor's Business Daily will do the honors in his April 19, 2011, piece titled "Rackspace's Big Customers Keep it on Cloud 9": "OpenStack is an open-source platform that provides computers and storage. It was co-developed by Rackspace and NASA, and is now supported by big names such as Intel (INTC), Microsoft (MSFT), Citrix (CTXS) and Advanced Micro Devices (AMD)." This sounds great but, let's not forget that Nokia (NOK) tried the same strategy with their Symbian Operating System, and that was given the kiss of death with the advent of the iPhone and Android smartphones.
In fact, although Rackspace was one of the original developers of OpenStack, it doesn't guarantee a steady revenue stream. Going back to the Reinhardt Krause article: "While Rackspace won't garner revenue directly from OpenStack, companies that use the platform might well require the company's support in building out cloud-based data centers." In the Q2 earnings conference call, CEO Napier states that only by the end of 2012 will they begin to see any sales traction from OpenStack build-outs. That's well over a year from now, and anything can happen -- especially to a stock that may be overvalued in a volatile market. Let's see if the equity measures up and is ripe for your portfolio.
Consensus analysts estimates on Yahoo Finance Earnings Estimates give Rackspace $0.52/share for 2011 and $0.79/share for 2012. If we go by its closing price of $35 as of this writing, we get a current P/E Ratio of 67, and for 2012, a P/E Ratio of 44. Those same analysts give it a growth rate of 18.71% for the current year and only 10.76% for 2012. A PEG Ratio with those estimates breaks out to 3.6 for this year and 4 for the next. That's really pushing your luck for just a hosting company. In fact, you'd be in way above your head for any company. On a positive note, those same analysts believe the 5-year compound annual growth rate will be 34.8%, so they see tremendous opportunity from 2013 to 2016.
Where analyst opinions are concerned, Yahoo Finance Analyst Opinions breaks Rackspace Hosting down to 14 that have a hold, while 5 say to buy and 6 contend it's a strong buy. I think it's time to batten down the hatches with this equity, especially in a market that is in a corrective mode. I am not suggesting that Rackspace will have the same fate at Exodus Communications, a hosting company that was a market darling back in the dot-com craze of the late 1990s. (Exodus went bankrupt after only a few years in business from expanding too fast, though they were flavor of the month for awhile.) Rackspace is in a good position to take market share from Amazon, but they must first monetize their OpenStack initiative before I would put money down on an organization with such high valuations.
Additional disclosure: I am short the markets with inverse ETFs.