The big trend in tech over the past few years has been cloud computing. It exists in may shapes and forms, and every technology company has integrated the cloud into their business plans over the past few years. However, many new companies that specialize in the cloud tend to get very high valuations and so far, none have achieved the earnings to justify their high valuations. In the end, there will be winners and losers, but on the whole, cloud appears to be a bubble, with institutional investors and company founders keeping share prices artificially high. In this article, I highlight two cloud stocks that I believe are very overpriced: Rackspace and Workday.
Rackspace Hosting (RAX)
Pros: Rackspace was founded in 1998, and is now one of the market leaders in hosting. The company specializes in managed hosting, and has 40 percent of the Fortune 100 as clients. Rackspace has consistently been profitable. At the end of 2011, it grew revenue by 24.4 percent per year over the past three years, and had revenue growth of 52.1 percent per year over this same period. Analysts expect a similar growth trend over the next two years.
Cons: Although Rackspace has a solid business model and will most likely succeed, I believe the stock is overpriced when looking at the nature of its business, along with the potential for competition. Hosting costs are one of the key expenses that companies look to reduce when they want to save on their systems. Because of this, I believe that Rackspace can only be marginally profitable, and will have to depend on high sales to raise profitability in the long run. As a result, it may lose some of its margins. Equinix (EQIX), a data center company with a similar business model, had a problem boosting profitability in 2009 and 2010, despite growing revenues at expected rates. With this in mind, Rackspace will need its earnings per share to cap off at around $4.00 to justify its current price of $68.34. With EPS not expected to eclipse $1 until 2013, Rackspace is about six or seven years away from reaching that mark, assuming no new competitor comes in and the company does not face major setbacks in its earnings.
Putting it Together: Rackspace appears to be overvalued, and it looks like analysts may begin cracking down. Although I don't recommend shorting shares, I do believe this is a bad stock to hold right now, and I would put a Sell recommendation on it. I believe a more realistic price for Rackspace is in the $40 to $50 range, which was its price before a major upturn in August.
Pros: Workday is a cloud-based software as a service (SaaS) company that was founded in 2005. It provides Human Capital Management and Financial Management systems for mid-sized to large businesses. It has over 310 clients, and it has brought in $199 million in revenue in the last four quarters. The company has a lot of venture capital backing, and was founded by the founder and chief strategist of PeopleSoft, which was bought by Oracle for $10.3 billion in a hostile takeover in 2005. Workday's current market cap is $8.33 billion, so investors will make money if a similar takeover happens.
Cons: Workday is still nowhere close to being profitable. Because of its subscription model, it books expenses up front and recognizes revenue over the life of the agreement, but even with a sales model, I doubt the company would be profitable any time soon. In its most recent quarter, the company reported a $26.88 million loss on $62.7 million in revenue. In addition to this, the $8.33 billion valuation on such a small amount of revenue, with no major future expectations, seems absurd. The price undoubtedly is based on a huge demand for cloud, coupled with the possibility of a buyout.
Putting it Together: It is obvious there is no fundamental way to value Workday right now. With such a big jump on its IPO, it is very likely that shares will come back to Earth once there in some liquidity in the stock. I recommend staying away from Workday right now, and possibly going short via put options in a few months if shares perform well and there is no takeover bid. I believe the fairest valuation for the stock would be its initial $28.00 IPO pricing, as it was priced by the same people who will come up with a bid price during a takeover.
Cloud stocks are hot right now, but buying technology blue chips is probably the better option for investors who want to get in on the cloud. Stocks like Rackspace and Workday are very similar to tech bubble stocks around 2000. Social media darlings like Facebook (FB), Groupon (GRPN), and Zynga (ZNGA) have already taken big hits, and the cloud could be next.
Disclosure: I am long IBM.