Why Rackspace Remains Hot

Mar.20.12 | About: Rackspace Hosting, (RAX)

For Rackspace (NYSE:RAX) success is in the margins.

Since beginning its management of OpenStack, an open source cloud project first developed by NASA, Rackspace has been taking down gross margins of 70%. That's enough to fuel growth, fund strategic options and make lots of money for shareholders.

How much money? Well, when Michael Dell (NASDAQ:DELL) drives his $14.9 billion fortune down I-35 in Austin, he now has to look in his rear-view mirror, toward San Antonio, where RAX chair Graham Weston is now worth $1.1 billion.

Dell and Weston are almost the same age but while Dell is saddled with a huge PC business that is being hammered by Apple, Weston has a fast-growing Web hosting business that may be the best-positioned of all companies to take on Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG). (For those who care, Dell got his start as a student at UT Austin, while Weston is a graduate of Texas A&M.)

The main reason for Rackspace's hyper-growth is OpenStack. While management of the software is being spun-out to an independent foundation, the plain fact is it's got more open stack bonafides, and thus more support from companies that should be RAX competitors (including Red Hat) than any other cloud stack on the market.

That's important. When large corporations collaborate, as they have on such open stack projects as Linux, Mozilla and Apache, they can in time overcome any proprietary vendor's technology lead. So while VMWare (NYSE:VMW) is large and growing fast, with a PE of 62, RAX has the potential to grow even faster, which is why its PE is over 100.

Scaling cloud matters because while the sector is currently in a gold rush phase, the long term winners will be those that can execute cloud efficiently. OpenStack gives RackSpace that advantage, and the margins prove it's executing on that advantage. OpenStack is already helping RackSpace close big deals with enterprise customers, for both cloud services and managed hosting.

Rackspace can get more in margin than big rivals like IBM (NYSE:IBM) or HP's (NYSE:HPQ) EDS unit because OpenStack lets it successfully offer a single, standard, non-customized system, rather than having to spend money on customization. OpenStack also gives Rackspace a private cloud story - enterprises can build their own clouds with it, using Rackspace for support, and be ready to go directly to public clouds when they feel their security, privacy and service level questions have been answered.

The advantages over IBM and HPQ also hold true for Dell, whose Perot Systems unit is equivalent to EDS, and which is building its own global cloud infrastructure out of parts. And it announced last week it's buying SonicWALL, a cloud security vendor, after previously buying AppAssure, a back-up and recovery company, under software head John Swainson.

While Dell is having to buy-into cloud and create custom solutions for each customer, in other words, Rackspace is prospering with a one-size-fits-all model based on OpenStack.

I spent the last week with relatives in San Antonio. The town's growing. Unemployment is well under 7%, traffic on I-35 between Rackspace's Windsor Park headquarters and Dell's offices in Austin is bumper-to-bumper.

And it's not all one-way any more.

Disclosure: I am long AMZN, GOOG, IBM.