In my last article on Rackspace Hosting (NYSE:RAX), I discussed the merits of an increase in SG&A spending in the face of an unprecedented increase in cloud use and competition. Specifically, I believe investors should embrace corporate spending when the industry growth justifies it - or in this case, demands it. Second quarter results and management's conference call underscore the payoffs that are to come from their upfront SG&A and R&D expenditures. In Q2 2012, revenues grew by 6% quarter-over-quarter and 30% year-over-year (on a currency-adjusted basis). Rackspace appears to be successfully following through on its sales model, which depends on two key drivers: organic growth from existing customers (up 1% during the quarter vs. +0.7% in Q1) and new customer acquisition. I refer to Rackspace's revenue model as a razor-razorblade business: It requires new customer acquisition (razors) in order to grow organically (razorblades).
The all-important enterprise space - which will prove to be a key profit driver and a more loyal customer base - also grew quarter-over-quarter, with the majority of upgrades coming from this segment. With new customers like Fox Networks Group and organic growth from existing customers such as the United Service Organization, this figure should continue to rise. Customers such as these will carry larger margins and will likely demand more complex products over time.
To that end, Rackspace has now begun deploying some of its seven upcoming OpenStack products. As stated in its Q1 conference call, these required a lot of up-front investment (hence, recent free cash flow has been lower due to high capex investment), but should prove to be high-margin, highly-scalable razorblades for Rackspace's growing enterprise segment. It is now time to see how each of these products will be received. The good news is only one or two of the seven products really have to hit in order to continue to grow revenues and exceed its return on invested capital. This is because the products are targeting larger customers and bigger price points. The better news is that though the rollout is only halfway done, early adoption has already started. SOASTA, the leader in cloud testing, already used Rackspace's new products to test applications for the 2012 Olympic Games. More to the point, anyone who is a new customer to Rackspace likely also has their eye on this new product suite. Why else would you become a customer at this stage in the company's product development cycle? Finally, these new products are meant to "work together." If you buy one or two of the razor blades, you're likely to try out all seven.
We know the return on capital employed will increase as Rackspace continues to penetrate the enterprise customer base. Even with the continued spending related to their new product rollout, annualized return on capital is already on the rise (up 2.4% sequentially). Where will it go once the business plan is fully executed? I'm willing to hold my stock and wait to find out. Rackspace is showing prudent capital spending - spending at the right rate, at the right time.
Disclosure: I am long RAX.
Additional disclosure: I believe in putting my money where my mouth is.