Embrace Rackspace's SG&A Expense - It's A Positive Sign

May.25.12 | About: Rackspace Hosting, (RAX)

While no shareholder wants to see a company's expenses rise, sometimes it's a positive signal and should be embraced.

True, nascent industries that are on the cutting edge enjoy industry (and thus revenue) expansion with reckless abandon. And that's been great for Rackspace (NYSE:RAX) and the multibillion-dollar cloud computing industry. In Q1 2012, the company's revenues grew by 6% from Q4 2011, and 31% year over year. Inevitably, however, the success of this high-growth industry brings new competition. Rackspace's need for increased marketing comes with that territory. Market leadership always requires a company to stay on top of its customer base. The growth of end-market use (such as Dropbox, Evernote, Facebook, and now Instagram) also supports the need for an increase in SG&A in order to keep pace with these applications -- and maintain top share in the cloud industry.

Let's examine Rackspace's billion-dollar revenue composition: organic growth from existing customers and new customer acquisition. This is what's known as the razor-razorblade revenue model.

Rackspace's model requires new customer acquisition (razors) in order to grow organically (razorblades). Yes, as pointed out during the Q1 conference call, razorblade sales may ebb and flow. But there are a number of ways for Rackspace to continue to sell new razors: top customer service (its Fanatical Support), ease of use and affordability of its products, penetration into new demographic customer bases, and widespread product offerings (more razorblades can drive new razor buyers). It's the growth in razors that will impact Rackspace in the long run.

As such, large investment is required. Rackspace is preparing to offer seven new OpenStack products. Will they be embraced? Only time will tell, but, honestly, how many really have to exist in order to continue to grow revenues? Probably not all of them. We do know that IBM and Redhat are prepared to adopt the technology behind the new products. Just like a venture capital fund, Rackspace only has to hit one or two home run products to exceed its return on invested capital.

Rackspace is also spending money to acquire new customers in the enterprise space -- a key profit driver and a more loyal customer base. So far, it's paying off: Enterprise revenue is now more than 20% of its business, and carries with it a noticeably higher margin per dollar. Indeed, Q1 2012's gross margin of 71.05% was higher than its last six quarters, and the trickle-down effect should be very noticeable in the coming months because Q1 is always Rackspace's highest-spending quarter. And despite an increase in competition, Rackspace's churn rate remains impressively low at less than 1%.

In addition, investment is also required to service larger and more complex apps -- a key to staying alive. New product rollouts shouldn't hurt a company in the long run, but do impact short-term results. The same thing happens in many industries whenever any new piece of equipment comes online or any new store is opened: lower upfront margins, which pay off down the road.

With the rise in competition and the need to stay on top, why does an initial investment bother any long-term shareholder? In the case of the cloud, this is not a sign of an industry that is hitting maturity. Microsoft estimates revenues from cloud innovation will reach $1.1 trillion per year by 2015. The Cisco Global Cloud Index forecasts cloud traffic will have a 33% CAGR between 2010 and 2015, and that by 2014 more than 50% of all workloads will be processed in the cloud. We are far from that right now. Rackspace is in an industry that is largely untapped and poised for secular growth. It's an important time to shine in this industry, and a dominant player must always stay on top. Rackspace's financials underscore both the continued success of the firm and of the industry: The Q1 2012 report showed an increase in total servers, total customers, and average revenue per server.

As for the company hiring more employees to support the product ramp, it's estimated that 14 million new jobs will be needed between now and 2015 to support growth in the cloud. Let the company hire a few more. It will need it.

Near-term earnings fluctuation is a growing concern all high-growth companies face. But it's a necessity for leaders to stay on top, and investing in the market leader is a key thesis for any investor.

Disclosure: I am long RAX.