Why I'm Not Buying This Cloud Play

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

Rackspace Hosting (NYSE: RAX) promotes its service offers “fanatical support,” but I think that description rather aptly describes some of its shareholders. With a cursory view the stock looks expensive, but then again proper investors don’t just take initial views at face value. The stock is in very attractive end markets and 20%+ revenue growth rates can turn an expensive looking stock into a value proposition in no time at all. I decided to take a closer look.

What the Industry is Saying

I wouldn’t get too alarmed by the recent results from Rackspace or even the sector. I don’t think there was much wrong with them, but when the overall market slows down it is the outperforming sectors that are going to be sold off aggressively.

<img src="http://media.ycharts.com/charts/3f7e429ab57a4e3de964d6389659943f.png" />

RAX data by YCharts

Equinix (NASDAQ: EQIX) is more a pure data center play and I thought its recent results were okay. It was good to see the growth in capital expenditures forecast to slowdown next year. The big worry with data center companies is that they are aggressively rolling out capacity in response to customer demand and at some point this could turn into a capacity glut. So far so good and its gross margins are holding up well. For those interested I have a primer article on Equinix and Rackspace here.

Rackspace’s big initiative this year is to shift to OpenStack, which basically means its customers can have more flexibility with how they utilize and position their applications rather than be tied to one vendor. It’s a bold move and makes sense for Rackspace but it’s a different direction from what VMware (NYSE: VMW) is doing with its leadership position in the private cloud and similarly with Amazon.com (NASDAQ: AMZN) in the public cloud.

No matter the market has loved the cloud story this year and for good reason. Oracle (NYSE: ORCL), SAP and nearly every other major on-premise license based software company have been rushing to develop cloud based software as a service (SaaS) solutions. The trend is not turning anytime soon. If someone like Larry Ellison can seemingly be converted to the necessity of cloud based architecture and SaaS, then the whole industry will surely follow, even if it is disruptive to their traditional offering.

Rackspace’s Cash Flow Generation

I’m going to cut to the chase here. The question with Rackspace is not over its growth potential or its shift to its open source architecture. It is also not about its current weighting to private cloud services and/or a debate over private vs. public cloud preferences. No. It is about its cash flow generation. Simply put, as a service company which allows its customers to outsource their IT hosting requirements, it is committed to an ongoing level of expenditures just to support its clients. The fear is that in any slowdown it will be lumbered with high fixed costs. In addition, despite working on a contractual basis there is no obligation from its customers to keep up a level of expenditure commensurate with the top line growth that Rackspace might need to justify its stock evaluation.

With that said, I took a look at how revenues, cash flow, capital expenditures, and customer gear expenditures were developing in recent years. The ideal would be capital expenditures as a percentage of revenues to fall as revenues expand strongly. I’ve included customer gear because I think it is a good idea to try to separate maintenance from expansionary capital expenditures. Rackspace has to spend on customer gear-for the reasons discussed above- but things like spending on data center build out are more expansionary.

All figures are a percentage of revenues and a yearly trailing basis.

<img src="/media/images/user_12882/rackspace_large.png" />

Ideally this chart would show rising operating cash flow with falling CapEx and Customer gear percentages and that is exactly what we have seen in the last two quarters. Indeed, Rackspace has been lauding its sudden cash flow generation ability.

Now frankly this chart is going to impress the corporate finance’s guys demigod Aswath Damodaran, but then again I don’t know if any of them (or him for that matter) know how to make money from stocks. The key point here is that Rackspace still hasn’t demonstrated it can lower the key metrics for a sustained period. It may well do in future and the last two quarters have been good but if you are like me then you will not be that keen to pay 84x earnings or an EV/EBITDA ratio of nearly 22, until there is some more evidence.

Interpolating from the graph it is hard to see that Rackspace is on track to generate more than 10% of its revenue into underlying free cash flow.

Rackspace Evaluation

There is nothing wrong the above assumption, but it’s not what the current evaluation needs. Let me put it this way, if you want to buy the stock on a future free cash flow yield of say 5% this requires the stock to trade on 2x revenues.  When the reality is as follows:

 

<img src="http://media.ycharts.com/charts/4462312634cdddb10a7440fd7dfffda3.png" />

RAX Price / Sales Ratio TTM data by YCharts

However, Rackspace is growing revenues very fast. Analysts have forecasts of $1.31bn for this year and $1.65bn and its market cap is currently around $8.22bn. Roughly speaking, if it is still generating 10% of its revenues in free cash flow in future it is going to take over six years of revenue growth at 20% in order to hit that figure of 2x revenue.  It’s  not a bet I feel like taking right now. Don't get me wrong, these key metrics may improve in time and I suspect they will but, I’d like to see more evidence first.

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SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Oracle, and VMware. Motley Fool newsletter services recommend Amazon.com, Rackspace Hosting, and VMware. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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