Rackspace Hosting, Inc. (RAX), Oracle Corporation (ORCL): Should We Take Advantage of This Stock’s Significant Drop?

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Buy low, sell high! It is a simple investment strategy that investors should follow. That is why I am quite excited to examine stocks which have recently experienced a free fall. Since the beginning of the year, Rackspace Hosting, Inc. (NYSE:RAX) has dropped significantly, from around $78 per share to only $48 per share. Should investors consider this recent drop as a chance to invest in the company? Let’s find out.

Rackspace Hosting, Inc. (NYSE:RAX)

Co-founder of OpenStack

Rackspace Hosting, Inc. (NYSE:RAX), incorporated in March 2000, is an open cloud company providing open technologies to more than 200,000 business customers in around 120 countries and territories. The company is also the co-founder (with NASA) of the fastest growing open cloud platform and developer community, OpenStack.

The majority of its revenue, $1 billion, or 77% of total 2012 revenue, was generated from Dedicated Cloud product sales, while the Public Cloud produced around $304 million in sales in 2012. In terms of geography, Rackspace Hosting, Inc. (NYSE:RAX) derived most of its revenue, $974 million, or 75% of total revenue, from the U.S.

A fast growing business with a strong balance sheet

What impresses me is its rapidly growing operating performance. For the past five years, Rackspace Hosting, Inc. (NYSE:RAX) has delivered consistent growth in both top line and bottom line. Revenue increased from $532 million to more than $1.3 billion in 2012, while net income rose from $22 million, or $0.19 per share, to $105 million, or $0.75 per share. Its cash flow position has also been on the rise. Its operating cash flow has increased from $137 million to $399 million since 2008, while the free cash flow jumped from $(29) million to $129 million.

Furthermore, Rackspace has achieved consistent growth in its operating performance without the help of too much leverage. Its balance sheet is quite strong. As of December 2012, it had $844 million in total stockholders’ equity, $292 million in cash, and only $4 million in long and short-term debt. The capital leases stayed at $60 million. Interestingly, Rackspace does not have much goodwill and intangibles. Thus, Rackspace’s historical growth has been quite organic.

Still quite expensively valued

At around $48 per share, Rackspace is worth around $6.6 billion on the market. The market still seems to value the company quite expensively, at more than 15 times EV/EBITDA. However, Rackspace Hosting, Inc. (NYSE:RAX)’s valuation seems to be much cheaper than that of Red Hat, Inc. (NYSE:RHT), a provider of open source software solutions.

Red Hat, Inc. (NYSE:RHT) is considered to be the second biggest contributor to the OpenStack community. Red Hat, Inc. (NYSE:RHT) is trading at nearly $50 per share, with a total market cap of $9.6 billion. Red Hat is valued as much as 31.2 times EV/EBITDA.

Oracle seems to be a better buy

Oracle Corporation (NASDAQ:ORCL) is another big player in the software industry and an aggressive player in the cloud business. However, Oracle Corporation (NASDAQ:ORCL) and OpenStack seem to be quite opposite endeavors. While OpenStack is a free, open source software allowing different companies to create and offer cloud computing services running on standard hardware, Oracle is trying to build a complete cloud solution themselves.

Indeed, Oracle Corporation (NASDAQ:ORCL)’s current clients are all big companies, which consider Oracle as a place for all IT solutions. Recently, Oracle announced that it would buy out Nimbula, a startup engaged in providing private cloud infrastructure management software. The acquisition would let Nimbula’s products to be integrated with Oracle’s cloud offerings.

Oracle Corporation (NASDAQ:ORCL) is a much bigger company compared to Red Hat and Rackspace, with nearly $160 billion in total market cap. It has the cheapest valuation of the trio. At around $34 per share, Oracle is valued only at 8 times EV/EBITDA. Interestingly, it is the most profitable company with the highest operating margin at 38.5%. While Rackspace Hosting, Inc. (NYSE:RAX) has the lowest operating margin at 13.2%, the operating margin of Red Hat is nearly 15.4%.

My Foolish take

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