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

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.

What is it doing right?

Despite the lower than expected revenues, the company’s operating profit grew by 19%, matching analyst expectations. Further, the company has been able to maintain its operating profit margin, which increased 120bps to 13% in 2012. This is an indication that the company is able to manage its variable costs. Going forward, this will be an important metric to watch out for, as it will reflect the customer reaction to the reduction in prices.

Further, the CEO Lanham Naiper mentioned strong growth prospects for the company. It expects to deliver growth as companies migrate to cloud data centers from their internally managed, slower and expensive servers. This is further corroborated by the strong 49% growth in its cloud computing service segment, which now accounts for 25% of its total sales (up from 21% last year).

It is also committed to innovation, constantly developing different ways of interaction with the cloud network. Its OpenStack public cloud is one such product that distinguishes it from its competitors. Until now, cloud computing had limited inter-operability, while on the other hand the OpenStack public cloud will allow interaction between many different cloud networks. This means it will function just like the Internet where many service providers can operate in conjunction with one another rather than having to rely on it internal processes which generally have lower compatibility.

Further, the company is also focused on tapping the increasing demand in mobile technologies, which is expected to account for approximately 57% of total IT industry growth in 2013 (according to IDC).  Rackspace Hosting, Inc. (NYSE:RAX) recently launched a pre-configured mobile stack specifically for mobile applications, which will help to reduce complexity for mobile developers and will enable them to innovate faster.

Competition

As mentioned earlier, there are a number of companies in the cloud computing space. Two key competitors include Citrix Systems, Inc. (NASDAQ:CTXS) and Red Hat, Inc. (NYSE:RHT).

Citrix Systems, Inc. (NASDAQ:CTXS) is much larger in size versus Rackspace Hosting with $13 billion market capitalization and $2.5 billion revenue. Its operating margin is higher at 15%, which means that it is able to manage its expense well. However, its quarterly revenue growth of 19% is not as impressive as Rackspace Hosting’s 25%. But it is has a good PEG ratio of 1.26 meaning that the company is relatively undervalued versus its peers.

Next is Red Hat, Inc. (NYSE:RHT), which is more comparable to Rackspace Hosting with $9.7 billion market capitalization and $1.3 billion revenue. Again, in comparison with Rackspace Hosting, this company has much better margins of 18%. Red Hat recently reported its 4Q12 numbers with revenues increasing 17% but missing analyst expectations by a modest $1.6 million.  CFO Charlie Peters hinted that revenues were hindered by its aggressive investments in new categories like storage, cloud computing, management and big data, but at the same time also mentioned that they come with positive signs of long-term goals. But looking at its PEG ratio of 2.33, it seems the stock is overvalued.

On the balance sheet front, Citrix and Red Hat both have managed to maintain a debt free balance sheet, while Rackspace Hosting has a debt/equity ratio of 15%. Further, Rackspace Hosting has a lower cash balance of $292 million versus Citrix and Red Hat’s strong balances of $928 million and $879 million, respectively.

Conclusion

Out of the three, Rackspace Hosting has a strong historical return of equity of 15% and also a modest PEG ratio of 1.76. But the real test will be if the company can demonstrate that it has the requisite scalability to support this movement as well as be able to wade through the rising price competition. With the current pullback in share price it is a good time to invest but keep an eye on the revenue growth and its competition.

The article The Cloud War originally appeared on Fool.com and is written by Sujata Dutta.

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