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After the close on Tuesday, Rackspace Hosting (RAX) posted earnings that beat analyst estimates and sent the stock soaring over 11% in after hours trading. Revenues jumped 29% year-over-year and net income soared 43% from last year.

The company is a leading provider of public and private cloud and hybrid and dedicated hosting services. It delivers open technologies and powers more than 190,000 customers worldwide

Unfortunately though for a company with a market cap of $6.6B, it continues to report relatively low free cash flows. This quarter the total free cash flow was only $28.7M or just over $100M on a annualized basis

Q2 Highlights

  • Net revenue of $319 million grew 29% year-over-year
  • Adjusted EBITDA (1) of $112 million grew 37% year-over-year
  • Achieved adjusted EBITDA margin of 35.1%, up from 33.0% year-over-year
  • Net income of $25 million grew 43% year-over-year

All solid growth numbers as the data center space remains hot. The company continues to grow hosted servers and customers each quarter.

Cash Flow

The ability to turn that huge revenue growth into cash flow remains the biggest concern with this company. It must spend heavily on capital expenditures in order to constantly upgrade services and attract customers.

The company generated $101M in cash flow from operating activities though it had to spend $82M on capex during the quarter. This leaves the free cash flow at $28.7M or just slightly higher than net income.

Net cash is only $66M when including debt and capital lease obligations totaling $149M.

Valuation

The stock currently trades at extremely high multiples including over 40x forward earnings. Based on Q2 free cash flow, the stock trades at a multiple of 60x the annualized amount. Clearly that valuation is not cheap.

For a comparative example, Frontier Communications (FTR) was reviewed just last week as the company is generating huge free cash flow numbers. It reported $285M in free cash flow in Q2 2012 alone. Yet the company only has a market cap of $4.4B, considerably less than Rackspace with 10x the free cash flow.

Sure Rackspace is growing revenue at a fast clip compared to the declining revenue at Frontier, but the valuation metric needs to go deeper to be relevant. How much more growth before Rackspace even approaches the nearly $1B in free cash flow that Frontier generates?

Conclusion

Rackspace continues to be a leader in the data center space and the growth in cloud computing. The stock though has already received a very rich valuation. One has to wonder whether investing in a reasonably valued dinosaur like Frontier isn't a better idea.

Clearly Rackspace is the more interesting company, but ultimately an investment decision should be made based on which stock provides the better total return option. Right now that appears to be the no growth Frontier stock that provides the better relative value and a huge 9% dividend yield.

Source: Rackspace Hosting: Q2 Growth Not Fast Enough For Valuation