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Rackspace Hosting, Inc. (RAX), Amazon.com, Inc. (AMZN): The Cloud War

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According to Gartner research, the convergence of a “Nexus of Forces” i.e. social interaction, mobility, cloud, and information, will drive growth in technology in 2013. Specifically, Gartner has forecasted that the public cloud services market will grow 18.5% in 2013 to a total of $131 billion worldwide, up from $111 billion in 2012. Further, Infrastructure as a Service (IaaS), including cloud computing, storage and print services, is the fastest-growing segment of the market, growing 42.4% in 2012 to $6.1 billion and is expected to grow 47.3% in 2013 to $9 billion. One among the many that provide cloud-computing services is Rackspace Hosting, Inc. (NYSE:RAX), that has seen phenomenal growth in the past but recently is under the scanner as its share price has declined almost 60% to $48 from its recent high of $79 in January 2013.

Rackspace Hosting, Inc.Rackspace Hosting, Inc. (NYSE:RAX) was founded in 1998 as an application developer for end-users but soon realized the market opportunity in hosting applications, which many companies didn’t know or didn’t want to be involved in. This lead to creation of the company’s most important product “Fanatical Support” that offers service and support across its broad portfolio of IT products, including Public Cloud, Private Cloud, Hybrid Hosting and Dedicated Hosting.

The company has historically rewarded its investors well with share prices increasing almost four times since its IPO in August 2008. Its share price peaked at $79 in January but recently its share price is witnessing a downtrend due to its fourth-quarter revenue shortfall.

What went wrong?

There have been increasing concerns as to whether the company will be able to survive the strong competition from Amazon.com, Inc. (NASDAQ:AMZN), which has been slashing its prices. In February, in an attempt to fend this competition, Rackspace Hosting, Inc. (NYSE:RAX) announced that it was going to lower prices on cloud bandwidth and its content delivery network by 33% and will also start rolling out tiered pricing for other services.  According to the company, this slash will help to attract larger companies by lowering the cost associated with bandwidth intensive processes such as video streaming and workloads that serve large amounts of content. Further the tiered pricing structure will help large volume users to take advantage of volume-based discounts. The market however did not favor the price reduction and its share prices initially tumbled 6% but finished down 1.3% at the end of the day.

The main problem here is that Amazon.com, Inc. (NASDAQ:AMZN) has a lower cost of capital. With a focus to gain market share, it can resort to price reduction with minimal/no profit and still manage to keep its shareholders happy. On the other hand, Rackspace Hosting, Inc. (NYSE:RAX) is finding it to difficult to do so which is clearly evident from the shareholder reaction to the announcement as well as the 20% decline in share price on the release of its fourth-quarter results. Furthermore, important to note, that Rackspace Hosting doesn’t face competition only from Amazon.com, Inc. (NASDAQ:AMZN) but there are thousands of hosting companies out there with virtually no differentiation.

The company is also facing the brunt of analyst downgrades. Post its fourth-quarter results, Stifel Nicolaus downgraded it from a “Buy” to “Hold” as it is of the view that it will not be able to sustain its 25% growth. Further, analysts were also disappointed due to lack of clarity for 2013 with no guidance on revenue or earnings target. Further, the company also lowered its capital expenditure guidance which is not reflective of the large spends that are generally required for infrastructure improvements.

Next is its lesser than expected fourth-quarter revenues. Its $352.9 million revenues missed analyst expectations by $2.5 million. Though the decline may seem modest but it fueled investors’ concern that its growth may be slowing down.

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