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When it comes to "The Cloud", investors overanalyze the demand side of the business, and overlook the supply side of the equation. This is dangerous, because the price of data stocks is largely driven by supply. Think back to the early 2000s. Many investors predicted that there would be a massive spike in internet traffic, making the companies that laid dark fiber (which made quick internet traffic possible) fantastically successful. Investors in fiber companies were correct in thinking that the internet would become massively popular, but they overestimated the rate at which demand would grow. Unfortunately, fiber companies built infrastructure according to the overhyped demand rates, creating a massive oversupply of fiber which destroyed pricing in the industry; fiber companies never recovered from this.

Because servers require less of an initial buildout, and have much shorter lifespans than underground fiber, oversupply for "The Cloud" will never reach levels similar to the infamous "fiber glut". However, there are signs that supply in the cloud industry is rapidly increasing. While Amazon.com, Inc. (AMZN) and Rackspace Hosting, Inc. (RAX) have historically dominated the cloud industry, tech behemoths such as Dell Inc. (DELL), Google Inc. (GOOG), Oracle Corporation (ORCL), IBM (IBM), Hewlett-Packard Co. (HPQ), EMC Corporation (EMC), and most of the IT outsourcing and telecommunications companies are beginning to offer cloud services. Companies that sell server software have reported that they have seen an unusual spike in sales, a signal that the new entrants are causing a significant increase in cloud capacity. While supply seems almost certain to increase substantially, it is harder to forecast demand for the cloud. The cloud industry will almost certainly see significant growth in demand, but current expectations for decade-long exponential growth may prove unrealistic as IT professionals realize that cloud computing may have less cost savings than previously hoped. A chart (shown below) by Gartner illustrates how the hype surrounding cloud computing may have recently peaked.

Click to enlarge

So where does this increased competition leave Rackspace?

With tech behemoths like Dell pouring $1 billion into upgrading their cloud offerings (Rackspace only made $1.025 billion in revenue last year) Rackspace realized that it was in trouble. Through massive R&D investment, large companies could develop software that was better than Rackspace's software. Rackspace attempted to negate the large companies' ability to make better software by creating OpenStack, an open source software for servers. Rackspace hoped that OpenStack would become the industry standard, allowing Rackspace to compete on the basis of "soft" skills such as customer service rather than cash-intensive things like proprietary software. Although the move to open source was probably necessary, it creates many problems for Rackspace. The company's largest source of cloud-based revenue comes from Infrastructure as a Service (IaaS) where Rackspace provides companies with storage and computing power over the internet. Because IaaS is the simplest cloud service to implement, it will be the first segment to see increased competition from the new wave of companies entering the cloud industry.

Rackspace will find it hard to differentiate itself because all IaaS services are generally the same, and many of the new competitors will be running the company's open source software. Rackspace is trying to differentiate itself by offering "Fanatical Support®", but support is less important than price to most customers, especially large companies. Without much differentiation, IaaS will behave like a commodity and most competition will be based on price. The price mechanics of IaaS are also taking a turn for the worse. Cloud companies used to charge different prices to different consumers, allowing the companies to price discriminate and achieve maximum revenue. Lately, however, comes are moving towards a structure that charges a flat rate per hour to all customers, thereby unfortunately removing the price obfuscation that helped the industry get maximum revenue from each customer. This price competition means that Rackspace's gross margin of 71.1% is certainly unsustainable.

The other segments of the cloud industry do not look much brighter for Rackspace. While the Platform as a Service (PAAS) and Software as a Service (SAAS) segments of cloud computing will retain their high margins due to high differentiability, these segments will likely be won with high R&D budgets and the best proprietary software, and not Rackspace's open source software.

With the increase in competition and the threat of commodity pricing, massive consolidation is the only path for a profitable IaaS industry. The industry could resemble the computer chip market, where one company (Intel) survived freefalling chip costs by obtaining a massive amount of market share. Due to the fact that IaaS strength still varies from region to region (data centers still depend on proximity, and are very expensive), a more likely scenario would be the formation of regional oligopolies.

The question becomes, can Rackspace survive this consolidation? Rackspace's current advantages include its large market share (second to Amazon in IaaS), and its reputation among small businesses for strong support and ease of use. These strengths are enough to ensure that the company survives consolidation, but the effects of consolidation are potentially ugly. Rackspace would be hurt in a world of high volume and low margins (Amazon's dream scenario), and consolidation could render Rackspace a niche player. In this situation, even Rackspace's best case scenario couldn't avoid a fierce price competition for market share that would decrease margins.

Rackspace is more valuable to another company than as an independent entity. The company's main problem is that it is stuck in the commoditized IaaS segment, and isunable to win the PaaS and SaaS battle on a global scale, because it does not have the necessary revenue to write proprietary software. Again, Dell invested $1 billion in the cloud, while Rackspace made $1 billion in total revenue. All potential suitors of Rackspace have much larger revenues; IBM ($106 billion), Dell ($62 billion), Cisco Systems Inc. (CSCO) ($43 billion), AT&T Inc. (T) ($126 billion); this would allow them to compete in the profitable SaaS and PaaS industry segments on a global level.

Unless Rackspace can discover a way to leverage OpenStack in a way that allows it to make significant profits from PaaS and SaaS, it should recognize its limitations and sell the company. If Rackspace does not get bought out, expect a decrease in share price (after buyout rumors cease), as investors realize that Rackspace is not worth the 71 P/E ratio.

Source: How New Competitors Will Hurt Rackspace

Additional disclosure: My boss at Investors Mosaic is long RAX. I am not long or short RAX.