I thought that Rackspace (NYSE:RAX) had more or less imploded and was finished as a company. I have been hearing a little bit about its transformation and its projects with Amazon Web Services (NASDAQ:AMZN) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL). Is there something I really need to know about what is going on?
On Wednesday, April 6th, Rackspace and Google announced a cloud partnership to develop an open server based on IBM's (NYSE:IBM) Power CPU. The new server code named Zaius is a dual processor design. The partnership is really a product of RAX's expertise with the Open Compute Project (OCP) and its specific form factor.
RAX has had significant design experience with the current IBM POWR8 processor having already developed something called the Barrel Eye server motherboard for the OCP. As I found out, in looking up Rack's motherboard announcement, it happens that barreleye is the name of freakish fish - how that might relate to the motherboard design has me stumped.
Rackspace and Google Cloud Platform (GCP) will work together to develop data center servers as part of the OCP. In and of itself, the partnership probably is not of over-arching significance and certainly wouldn't warrant the 6% share price gain seen in trading on 4/6. There has been some speculation by industry observers that Google's partnership may be a sign that Google lacks the scale to buy enough of the servers to drive the economies of scale they are used to commanding. I have no real way to know whether or not the speculation is valid although since it conforms, to a degree, to a report I recently published on this site, I naturally feel that it is a valid piece of insight. Not really, but the speculation is in print.
Back in October of last year, RAX announced an agreement with AWS under, which Rackspace offers tools, expertise, applications management and operational support to AWS customers. The offering, which is known as Fanatical Support, is part of RAX's strategy to exit the public cloud business itself and to become a reseller and a consultant in the space. Rackspace also has begun to offer Managed Security for the AWS platform along with compliance assistance and something known as the managed cloud for the Adobe Experience Manager, which runs on AWS.
Rackspace had a similar agreement to support Microsoft (NASDAQ:MSFT) Azure for some time now. These partnerships are really the most likely component of future growth for this company. It won't most likely be anything like the kind of growth seen by vendors that are market leaders in the public cloud. Gartner describes, "cloud enabled managed hosting" as the evolution of a mature market. Gartner also rates the RAX service as the leader in the space by a significant margin.
Just putting a mature market in the cloud is not going to get users to consume more of it, per se. But Rackspace has some significant advantages in this market and it has executed part of its pivot reasonably well for the last several years in this market. Its partnerships make it more likely that the company will succeed in this space and achieve reasonable growth and margins.
As many investors perhaps realize, Rackspace has been trying to reinvent itself for several years now. The company came to prominence after the financial crisis and reached a peak share price of $78 in early 2013, a pretty incredible increase from the $5/share for which the shares sold back in early 2009. In those years, RAX was thought to be a pioneer in offering the public cloud to a host of SMB customers.
But this company has always had a reasonably promotional management - the shares would never have gotten to $78 without the presence of lots and lots of air pumped into its balloon. RAX was indeed a pioneer, but of something that used to be called infrastructure outsourcing, which was far less sexy and valuation expanding than being a public cloud vendor.
By 2013, the bloom had really come off the Rackspace rose. Growth slowed markedly by that time. Amazon was cutting prices rapidly and management was complaining of competitive losses to customers who wanted to do "science projects." By the middle of 2013, and in the wake of a couple of nasty downside surprises, the shares were cut in half. In the summer of 2014, the company announced its decision to exit the IaaS market and that helped the shares to reach back over $50.
But the company's revamped business model never really took hold and the shares continued their slide, reaching a low of less than $18 by the start of this year. There were a couple of quarters of some success along the way. In looking back, the company had hurt its franchise when it engaged Morgan Stanley to explore strategic alternatives and was unable to secure an attractive bid. The company also tried to hang on for too long in a market in which capital requirements easily dwarfed the company's available resources. And obviously moving from selling of total solutions to becoming a managed service provider was more of a transition than had originally been contemplated.
Most of Rack's public cloud customers apparently decided to migrate new workloads to AWS over time, which was and is the safest choice. But most users are very sticky and continued to use RAX for existing workloads. RAX reported the lowest churn rates in its history last quarter. At the time, there was much written about how RAX could become an agnostic managed service provider, which was their initial strategy long, long ago. But it has been a very bumpy ride in the intervening 20 months.
While the company has actually managed to grow total revenues about 30% between 2013 and today and improve profitability such that net income has risen from $87 million to $126 million last year, free cash flow has been quite modest and capex has actually been ticking up recently. Analysts' consensus forecasts are for little growth in either this year or next year on the top line and for not much more growth in terms of EPS. Analyst opinion is pretty mixed at this point, with several downgrades in the wake of the company's most recent reduction in guidance, which drove down current earnings expectations by a few pennies per share.
My objective going forward is to see if the announcements the company made last autumn and recently are of sufficient magnitude as to warrant a more positive outlook for the shares or if they are potentially a harbinger of a long rumored acquisition transaction. If analyst expectations are right, the shares are reasonably priced overall. They aren't cheap enough to be called deep value nor are they nosebleed expensive. There is nothing particularly redeeming about the balance sheet or the company's cash generation. If RAX is going to work as an investment, it will be because the company gets acquired or because growth is significantly greater than the 6%-7% that the consensus is currently forecasting.
OK, that was somewhat painful reading, but I'm interested in the future. The question can growth at RAX re-accelerate and if so to what level? And can this company curb its capital intensity and finally generate some meaningful cash?
That's two questions that are only peripherally related. Cloud enabled managed hosting is a very crowded market space. Gartner evaluated no fewer than 18 vendors in its latest MQ report. Rackspace is a strong leader and the second and third companies in this survey are probably not household names. One of the competitors, CenturyLink (NYSE:CTL), was said by Gartner to have provided an uneven level of service over the past few years. The other competitor, Datapipe, is said to have higher prices than those of similarly sized competitors.
The company (Datapipe) is said to have what is called bare metal pricing in beta, but has been known to keep new offerings in beta for an extended period. Gartner commends Rackspace for its superior customer service and for its willingness to adapt its business models as market demands change. There were limitations that Gartner cites, to be sure. RAX has no data centers further west than Texas so it might have problems with latency for some West Coast customers.
And of course, the new service offerings that RAX has developed as a partnership with MSFT and now AWS are just that - new - and so Gartner wonders if managing third-party providers might not present new challenges for the company. But on balance, Gartner says that Rackspace is and has been the leader in the market for years. (Gartner can be a bit hazy in its definitions. It goes back and forth in the same report regarding cloud managed service providers who have a short history and managed service providers who have a lengthy history.)
One key consideration is whether there is a significant market for hosting for infrastructure to the service level. Many, if not most, larger users are going to essentially provide their own support after they decide to migrate their workloads to the cloud. The whole concept of the cloud is to save users money and if they are paying an additional vendor to provide support, some of that advantage is going to be lost. For smaller companies, who have far smaller IT capabilities, that issue is moot. If they want cloud, they are going have to get with some support that is unavailable in-house.
I think it is relatively evident to most observers that the cloud market is going to bifurcate. Most of the larger users are going to go with an unmanaged cloud or what is called IaaS. That is the market with the really big bucks where AWS and MSFT are seeing enormous growth.
The other market gets far less attention. 451 Research has recently published a study regarding the managed cloud market place. In all, it says that the Total Available Market for managed services within the cloud will total $110 billion by 2018. According to 451, managed services now account for 29% of total market revenues and will account for 36% of the market by 2018. It is important to remember in reading this data that the managed service providers have to get their cloud interface from someone. They are, after all, reselling the capabilities offered by AWS, Azure and Google Cloud Platform.
But at the end of the day, the $43 billion that 451 says will be the market for Cloud Service Providers by 2018 is a pretty decent target for a company such as RAX whose revenues are forecast to be just $2.1 billion this year, showing just 6% growth. If the CAGR for the managed cloud market is really 26% as is said by the 451 report, then why is RAX only growing at 7% or 8%.?
I think that the basic thing to understand regarding RAX is that at the moment it consists of two businesses, one, which might enjoy explosive growth and one, which is the legacy business, which is going through a significant growth slowdown. Just how much of a growth slowdown is not the easiest of questions to answer. Really, RAX still has a public cloud offering that it calls OpenStack. Although OpenStack actually grew double digits last year, most of the new workloads from OpenStack customers are migrating to either AWS or Azure or some other component of the MSFT IaaS offering. About 20%-25% of RAX's business is OpenStack and the balance is in the MSP space.
Unfortunately, most companies, and this one is no exception, really do not forecast to that level of granularity. But I think that the company's guidance, which calls for 6%-10% revenue growth this year is based on very little revenue from the AWS partnership because that business is all on a subscription model, coupled with the company's legacy business, which is both growing and transforming such that its revenue growth is in the range of 6%-10%.
During the company's past conference call, there was a significant amount of discussion or controversy regarding the guidance that this company gave and how it equated to the qualitative comments that it had made. I don't propose to reprise the exchanges but I think the net of the questions were two-fold. The first issue raised centered around the kind of seasonality that would cause RAX to have such relatively minimal sequential growth in Q1.
The other major topic discussed was the potential for RAX through its partnerships with MSFT/Azure and with AWS. At the time that this company provided guidance, the world economies were seen to be weak and vulnerable to a significant economic implosion. Some of the growth conservatism was said to be a factor of that as well as the increasing trend for users to migrate new workloads from the company's OpenStack to either AWS or MSFT platforms.
In addition, company CEO Taylor Rhodes discussed the recent Rackspace hire of a new head of sales, Alex Pinchev. Mr. Pinchev, headed sales at both Red Hat and Acronis. The head of Rackspace essentially said that Pinchev had been hired to clean house and reconstitute the company's marketing effort. Mr. Pinchev started with the company on January 1, 2016. It is more than likely that there will be a substantial amount of turnover in the field sales management. Hence, Rhodes and his CFO felt it was prudent to use lower first quarter sales numbers than would otherwise be the case.
Management, without providing too many details, suggested that much of the future growth for this company will come as the result of workload migration to AWS in the context of users electing Fanatical Support from RAX. The largest single order to date, said to be worth six figures per month, was apparently a new-name account that would never have chosen RAX absent its partnership with AWS.
Many analysts, not to say investors, have been burned once, twice or even three times during the course of the protracted evolution of Rackspace. Indeed, some might argue that this company has seen more transformation in the last few years than we humans experienced from the time we started to walk erect. But the issues are the current and long-term growth rate for this company. There are always risks during any transformation. There is always a chance that its current user base deserts en-masse. Highly unlikely but a chance.
There is always a chance that the market for managed cloud is far smaller than is being predicted by current analyst estimates. This being the information technology space, the likelihood of a black swan cannot be totally discounted. But considering all the factors that will influence this company's growth rate, I think it is likely that it will be able to achieve a top line growth somewhere above 10% and perhaps significantly above 10%.
The company's core legacy business, managed hosting is said by Gartner and others to have a long-term growth rate of 9% or more. The company does have a reasonable reputation for providing a "high touch" model successfully. I would be surprised that as cloud implementations become pervasive, if many potential users did not wind up outsourcing the issues of dealing with several clouds in a network, training and support. Most users, except for the very largest, are likely to find it far cheaper than trying to build up an internal cloud capability.
One of the biggest knocks on this company for many observers, including this present writer, is that the company has never generated a meaningful amount of cash. So far as I'm concerned, the best objective measure of a company's success or lack thereof is the cash that it is able to generate to potentially return to shareholders. Even cloud start-up companies have generated more cash than has Rackspace over the years. Building the infrastructure that is required to be in the managed service provider business is terribly capital intensive.
In the nature of things, MSPs cannot generate cash so long as they grow at double-digit rates. The cost of the infrastructure that is necessary to support the growth can never really be equal to the first year revenue from a given contract. Last year, RAX actually generated some free cash for the first time in many years. Nice as it might be to say that RAX had devised some new strategy to decrease the capital intensity of its core business, the basic reason behind the company's positive free cash flow is the rise in depreciation that hits the net income line but doesn't consume cash.
Depreciation is up by 27% in the last three years and is now 84% of capex compared to 69% in 2013. The improvement in that ratio was primarily driven by the company's decision to exit the public cloud business with its very heavy infrastructure demands. So, while the company's operating margins have gone from 8.6% to 10.3%, it has moved from being a cash consumer to generating a small amount of cash.
The new business opportunity that Rackspace is attempting to develop will completely reverse its cash consumption tendencies. In point of fact, what it is now doing is selling someone else's infrastructure combined with its own expertise in supporting users who are moving workloads or who have decided to move to the cloud but have limited internal support capabilities.
Simply put, expertise is not a large capital consumption item in a cash flow statement. Investment in infrastructure is. As I tried to point out above, Rackspace will continue to be a managed service provider for the foreseeable future. It is considered by Gartner to be the leader in the space in terms of both market share and in capability. But to the extent that the managed cloud becomes an increasingly significant component of Rackspace revenues, it will have the impact of dramatically reducing the capital intensity of this company.
Concerns of some have been expressed that the profitability of the company's new business will be less than the profitability of its old business as barriers to entry are less. And it is certainly true that RAX is not the only vendor that will sell AWS and Azure infrastructure. Today, the company achieves gross margins of a bit greater than 64%. That is very likely to decline for the company's managed cloud business. But the company's SG&A number is 29% and the company charges its income statement with a 25% expense for depreciation. Both of those figures are likely to decline. The company certainly has not provided a new business model for its new business offering and it is unlikely to reveal its gross margin to potential competitors. Well run managed service providers typically have operating margins of 30%. There is no reason to believe that cloud managed services will have lower margins than non-cloud managed services.
It is my view, for what that is worth, that the company's new business of selling managed cloud is more likely than not to improve current operating margins which are only a bit above 10% on a GAAP basis and 14% non-GAAP. There are always issues of scale in starting up any kind of managed services business. But the fact is that this company has a significant cadre of trained professionals and many of those professionals have already been certified to work on AWS installations. I suppose I might be more worried about margins if not for the fact that the two largest "suppliers" to Rackspace are growing so rapidly that providing managed services to their customers is one of their lowest priorities and they are happy to see it outsourced.
Is this transition going to actually work and if it does what is the upside?
No one has a crystal ball and a company such as this that messed up one of the great opportunities of the 21st century does not get another free hall pass. While hindsight is 20/20 for all of us, it is interesting to see management now describing the impact of AWS as that of a tornado when little more than a year ago it was describing customers who signed up with that vendor as "conducting science experiments." It is that reversal, as much as any other single thing, that has led many analysts to distrust this management.
I have some of the same sentiments - there has been more than a bit not to like about some of the things in the past that management has said and has done. But I think the objective here is to present a reasonable evaluation based on current conditions and not to attempt to try to unravel past commentary.
The fact is, that whatever else, this company has been and remains the leader in the managed service provider business and that opportunity is still showing high single-digit growth. They are said to have the best capabilities in the space by a significant amount and they have a long list of both SMBs and blue-chip customers.
In addition, the cloud managed service provider business is a huge opportunity just in its infancy. RAX certainly has the appropriate partners in terms of Amazon and Microsoft and the fact is that the prodigious growth those vendors are experiencing makes it inevitable that they are going to look to an ecosystem to provide their customers who need support and consulting with appropriate solutions. The early signs of the AWS partnership, which included closing 100 clients, most of them new names to RAX, is promising although hardly dispositive. Yes, the company's guidance for both the March ending quarter and perhaps the full fiscal year is somewhat disappointing, especially compared to prior assumptions. But I think investors and analysts are perhaps being unreasonable to think that a company like this that got knocked out of the IaaS market for public cloud is likely to be particularly optimistic in an environment of economic uncertainty with a new head of sales and marketing who is expected by management to clean house. I know that under those circumstances, I would hardly be optimistic and the fact that this management is cautious is more likely a good thing than a bad thing.
The company really seems to have a "loyal and sticky customer base" who like the service that RAX provides and they should provide modest but consistent revenue growth. That is a trend of many years standing and it ought to continue into the future.
It is difficult, if not more or less impossible, to handicap the potential for success in a nascent market for which there is no meaningful experience. But the market is composed of the kinds of customers that RAX has essentially been dealing with since it started. Not all customers, not even all of the largest customers are going to want to manage their own infrastructure. And the two leading IaaS vendors are simply not able to provide support as their growth is of an order as to stretch even their resources. They are simply not set up to handle cloud services at any kind of high touch level.
Many new cloud customers are seeking help in architecting, migrating, securing and operating their applications. It makes sense for most of these prospective customers to outsource those kinds of tasks to someone that is known and trusted in the space. I think it is reasonable to believe that RASX ought to be successful in this transition and to achieve a meaningful and profitable market share.
RAX shares today are moderately valued. The shares sell for 1.54X EV/S based on 2016 estimates. They have a P/E based on 2016 non-GAAP estimates of 20X. The company has just started to generate some free cash flow and there is not quite enough experience to make a meaningful projection for a free cash flow yield for 2016. That being said, the cloud service provider market is far less capital intensive than is the market for managed service providers.
I don't think that some long-term growth estimate in the low teens percentage is an unreasonable assumption. I think it is also reasonable that if the cloud service provider business grows, then operating margins will grow significantly beyond current levels of just over 14% non-GAAP and that free cash flow can expand several times in a few years.
I would hardly suggest that any new thing in the IT space is a slam dunk. But all the portents are there for RAX to be successful in this transition.
Some Final Thoughts:
Rackspace has abandoned its misguided effort to participate in the IaaS space and has instead become a company that OEMs build from - both Microsoft and Amazon. It is a big transition and a big letdown from attempting to compete directly in the IaaS market.
RAX remains the leader in the managed service provider space and that remains the core of its revenues. The space according to industry consultants is growing in the high single-digit range. The company has a leadership position in terms of both market share and user satisfaction.
The company has acknowledged past execution issues by bringing in an industry veteran who built Red Hat's sales and marketing organization. Understandably, it will take him a while to cut away the deadwood at RAX and to build a competent and successful organization.
There's always much that can go wrong with these transitions. I have seen too many of them not work out to think this one, despite its portents, is any kind of slam dunk. But the upside if it does work is significant, given that the company is selling at just a bit over 1.5X sales. The cloud managed service provider business is far less intensive than most of the company's past endeavors. With that in mind, it seems likely that RAX can start to generate some reasonable free cash flow.
Will RAX get bought? It certainly could. What they have that other cloud providers might want is a significant customer base in the managed service area that are eventually going to be a target for migration to the cloud. And they have several thousand trained cloud implementation and support personnel. In the current environment, it might be worth paying just to get those people. But I would avoid making a recommendation to buy or own RAX shares because of merger speculation. Just because the company has announced a partnership with Google in designing new hardware to work on an IBM platform is far, far away from reasonable speculation that Google might buy them.
I think the reason to buy these shares is, simply put, that the transition that the company is trying to pull off is eminently reasonable and the market opportunity, like most else to do with the cloud is enormous. If it works - there is loads of upside. If it doesn't work - well the MSP business isn't going away any time soon. There aren't better odds out there these days.
Disclosure: I/we 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.