How do you tell if a stock is overpriced? How about when an earnings miss of a penny causes the stock to plummet by 25%. That’s exactly what happened with Rackspace Hosting, Inc. (NYSE:RAX) after reporting its Q1 results a few days ago. Even with revenue increasing by 20% and net income increasing by 16.4% year-over-year, a slight miss of analyst expectations led to a gargantuan decline in the stock price. Expectations were clearly set pretty high.
What does Rackspace do?
Rackspace Hosting, Inc. (NYSE:RAX) is an IT hosting company with a big focus on the cloud. In the past web sites and applications were often hosted on dedicated servers. This made scaling difficult as more servers would need to be added and integrated, and if a server went down the whole site went down with it. But the cloud allows for the site or application to reside on a large array of servers, along with other sites. If a single server fails the application will continue to function because there is often redundancy built in, and scaling the application simply involves allocating more resources for it.
Rackspace Hosting, Inc. (NYSE:RAX) is one of many companies that offer this kind of hosting environment. More and more companies are moving to this type of hosting as it can greatly reduce IT costs, and companies like Rackspace Hosting, Inc. (NYSE:RAX) have benefited greatly from this migration.
The growth story
Since 2008 Rackspace Hosting, Inc. (NYSE:RAX) has grown its revenue at an annualized rate of about 25%, with net income increasing by nearly a factor of five or 48% annualized. This is impressive, but you have to remember that Rackspace was a much smaller company 5 years ago. It’s much easier for a small company to grow at these kinds of rates than it is for a large company, and Rackspace Hosting, Inc. (NYSE:RAX) has now hit a size where it will be difficult to maintain this kind of growth.
Growth should still be quick as demand for cloud-based hosting rises, but growing faster than the industry will become more difficult over time. And that’s to say nothing of the competition.
Amazon.com, Inc. (NASDAQ:AMZN) web services is the current market leader in cloud infrastructure services, with Rackspace at number two. Amazon is a company willing to completely sacrifice profits for growth, and it shows with the aggressive price cuts enacted by the company. Rackspace’s Q1 earnings came in below expectations because the company was forced to cut prices in response to Amazon’s aggression, and it seems that Amazon.com, Inc. (NASDAQ:AMZN) won’t be letting up anytime soon. Amazon is running its business with margins close to zero, making it very difficult for Rackspace to compete.