Why Rackspace Is Still A Buy Post-OpenStack

| About: Rackspace Hosting, (RAX)
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Seen in conventional terms Rackspace (NYSE:RAX) should be a sell right now.

It's best known for OpenStack,an open source cloud infrastructure it began working on with NASA a few years ago. But this summer it "lost control" of that software, placing it into a new OpenStack Foundation.

At the same time Rackspace, whose business is web hosting, was launching its own services under OpenStack, competitors like Hewlett-Packard (NYSE:HP) and Dell (DELL) were announcing plans to launch their own cloud networks, also under OpenStack.

So how has the stock responded? Over the last three months it's up 52%, and currently trades at over $60/share. Since there have been no hard earnings numbers to go on, it now has a PE ratio of over 100.

How is this possible? Former Sun open source guru Simon Phipps, now writing for Infoworld, offers an answer. He says that too many people mistake the "free" in "free software" for "zero price," and no pricing power generally.

But that's just not true. Open source software doesn't have to be free. It doesn't have to be supported by just one company. In fact, its value increases the more companies help work on it, just as it would if more individuals worked on it. Back when open source was new you would measure an open source project's strength based on how many individual "committers" it had, people with authority to make changes and improve it. Now you can measure strength by how many different companies put resources behind it, how many corporate committers it has.

Phipps calls this the flexibility frame:

Open source allows them to innovate, to leverage and complement the skills of others, and to respond to change without requiring the permission of others first.

In other words, open source doesn't just mean free stuff. It means you're free to respond to the demands of the market, and even individual customers, and free to use what other companies have learned in order to solve problems.

While there are now dozens of companies backing OpenStack, big customers know that if they're looking for OpenStack expertise, and OpenStack hosting, Rackspace is going to be a good place to go. Not only does it have a lot of committers, but it has a lot of people committed to this open source process, to looking for answers wherever they may be, and to responding to individual customer demands quickly.

At some point this has to mean accelerating growth for Rackspace, both in terms of hosting revenues and consulting revenues. Indeed the company is managing to take 13% of revenues down to operating earnings, its level of debt to assets is about 13% as well, which is pretty amazing in such a capital intensive space, and its quarterly revenues have doubled in the last three years and came in over $1 billion last year. (At its current run rate it could get to $1.3-1.4 billion this year.)

So you don't have to control open source to benefit from it. The more committed to it you are, the more you can benefit from others' commitments. And open source just makes you more flexible in general. That may sound to you like Yoda, but it sounds to me more like yoga.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.