Who Gets Hit in the Cloud Hangover?

Dana is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

According to the famed Gartner HypeCycle, the cloud hangover has begun. 

The HypeCycle , which Gartner has been hyping since the mid-1990s (meaning it's well past its own hype cycle) describes the bipolar way in which analysts view new technologies. That is, their perceived value peaks well before anything like real value comes about.

This means trouble for most cloud stocks, in the near term. But these falls in price could also mean value for your portfolio, if you take the opportunity now to buy the companies that are going to be long-term winners.

Why Buy Red Hat?

Few companies have been hit as hard by the cloud hangover as Red Hat (NYSE: RHT). In early February it was at over $56 a share. Now it's struggling to hold $47.

There is little in Red Hat's financials to indicate trouble. The top line has been growing at a steady 20% a year, and it blew by the “open source ceiling” of $1 billion a year in sales two years ago. There is no debt. Operating cash flow continues to rise.

What's happening here is the cloud hangover. At its former price Red Hat had an unsustainable PE of about 80. Now it's at 62. Still high, but institutions aren't bailing, either – they own 96% of the common.

Red Hat's contribution to the cloud is OpenShift. This is a set of tools that turn an OpenStack cloud infrastructure into a platform that can use all of Red Hat's other software, in particular its JBOSS middleware. JBOSS is actually the company's biggest profit driver, not its Linux, because middleware sits between data and the operating system, allowing you to create real applications.

One example of how this turns into money is JBOSS Data Grid, which just got a new release this week. The software sits on memory chips, rather than on disk, and turns those chips into a very high-availability, high-transaction storage system. It can hold the most-used stock market quotes at a security firm, or the most common transaction types at a bank, for instance.

While Linux and OpenShift get the headlines, it's JBOSS that drives Red Hat's profit because it can actually turn the cloud into applications, high-value applications that drive more sales, and more license renewals. That's why this stock should remain on your buy list, and why weakness is a great reason to buy it.

Why Be Wary of Rackspace?

Rackspace (NYSE: RAX) has a similar chart pattern to Red Hat. Since announcing a disappointing fourth quarter in February, the stock is down over one-third in value, and now stands at close to Red Hat's price, just short of $47 per share.

Rackspace' revenues have been climbing even faster than those of Red Hat, and its profit margins have been rising, ever since it became the initial corporate sponsor for OpenStack. Sponsorship has since moved to an independent foundation, but more programmers from Rackspace contribute to the code than those from any other company. They're the OpenStack experts.

Rackspace is also “eating its own dog food,” having transferred its infrastructure to the open source cloud infrastructure without a single financial hiccup. But at the end of the day this is still a Web hosting company – that's the primary source of its revenue – and that's a problem.

It's a problem because, since OpenStack is open source, it is drawing competition. Dell, Hewlett-Packard and the nation's three phone companies have all committed their futures to OpenStack, and are at various points in developing their own OpenStack clouds. Meanwhile, as a public cloud infrastructure, OpenStack badly trails Amazon's Amazon Web Services.

In terms of price-performance, an OpenStack cloud sits midway between a typical enterprise solution and a public cloud. It's a great choice for private cloud, and many enterprises are now going through the detailed study needed  to move into a private cloud environment.

As this happens, there will be a growing need for a public-private cloud hybrid, something that is compatible with new enterprise systems and the economics of a public cloud. This is where Rackspace hopes to make its money. But there will be enormous competition in this space, as it develops, and from companies whose sales teams have the inside track on those clients, and a life-or-death motivation for keeping those clients.

As a cloud consultant, in other words, Rackspace is a buy. As a cloud host, it's a sell.

Look for Lightning Bolts

The best way to evaluate all cloud stocks is to follow the money and the technology.

Companies that have the strongest revenue streams are those that offer solid cloud technology with a long shelf life. Those that sell true services are in a very competitive place, and those that sell software have to be measured against the general trends in the cloud market.

This is going to be the first of a series of stories where I evaluate the potential of major cloud players, and hopefully give you some analytical tools you can use in looking at others. If you want to buy clear skies in the cloud, you want to see a wide moat with a solid future. I think Red Hat has one. I'm less certain about Rackspace.

Dana Blankenhorn owns shares of Red Hat. The Motley Fool recommends Rackspace Hosting. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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