Rackspace Hosting, Inc. (RAX), Google Inc (GOOG): What’s The Big Idea?

Each week, I endeavor to report the results of the Big Idea Portfolio, a collection of five tech stocks that I believe will crush the market over a three-year period. I’ve done it before; my last tussle with Mr. Market ended with me beating the index’s average return by 13.35%.

Real money was on the line then as it is now, which means any one of the five stocks you see below could tip the scales in my favor. This time, Rackspace Hosting, Inc. (NYSE:RAX), once one of my portfolio’s top stocks, plummeted 26% after reporting an earnings miss and subpar guidance.

Revenue grew an impressive 20% year over year to $362 million, but that still came in $5 million below analyst targets. The cloud computing company’s Q2 sales target also came in lower than Wall Street was hoping for.

In a post-report interview, Rackspace Hosting, Inc. (NYSE:RAX) Director of Finance Bryan McGrath explained that Rackspace failed to pay enough attention to its oldest clients: those who pay for the company to host dedicated types of equipment for specific and complex jobs. These engagements require more time and investment by staff, but they also account for about 75% of revenue.

Most of Rackspace Hosting, Inc. (NYSE:RAX)’s newer customers have little need to know which equipment hosts their apps. All they want is a secure cloud environment and the promise of high-touch service. As a group, these clients have been slow to move to the more efficient OpenStack platform, McGrath says. Rackspace Hosting, Inc. (NYSE:RAX) nevertheless maintained its historically high levels of investment in R&D, infrastructure, and staff in the first quarter, which put pressure on operating margin.

Will Rackspace Hosting, Inc. (NYSE:RAX) adjust Q2 spending to reflect the transitional phase it’s entered? McGrath says no: “We believe we are playing in a mega market opportunity” that will persist for more than a decade. Investment is required to take advantage, he says. Recent bets include opening new facilities in Sydney, Hong Kong, and Latin America, plus five major data center expansions. McGrath says to also expect more hiring in R&D.

What’s the Big Idea this week?
For the week, Rackspace Hosting, Inc. (NYSE:RAX) erased noticeable gains by top stocks Google Inc (NASDAQ:GOOG) and salesforce.com, inc. (NYSE:CRM) in a strong week for Mr. Market, resulting in the Big Idea Portfolio’s forfeiture of 290 basis points in our three-year contest to see who can do better for investors. All four indexes gained again.