This Tech Stock Crashed, Is it Time to Buy?

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Investors in Rackspace Hosting (NYSE: RAX) weren’t seeing much ‘fanatical support’ in the share price after the latest set of results. As ever, the ensuing commentary and analyst opinion will adjus to the share price move. Excuse my cynicism but, in my opinion, that’s how it tends to work in these situations.

I prefer to take a step back and look at the bigger picture. In summary, I think this stock is still overpriced but there is nothing wrong with the cloud computing market. My problem lies with the ongoing capital expenditure requirements at the business and the overly optimistic assumptions the market has baked into the stock.

Why Rackspace Missed

Revenues of $352.9 million came in a little lighter than analyst consensus of $355.4m but this hardly a big deal.  In reality Rackspace is managing the aftermath of the launch of its OpenStack public cloud. The idea is that enterprises will appreciate the opportunity to have more flexibility over how they use and position their applications rather than be locked into working with a sole vendor. This is a key distinction between what Amazon (NASDAQ: AMZN) is offering in the public cloud and what VMware (NYSE: VMW) is doing in the private cloud.

Rackspace’s argument is that Amazon and VMware are offering a legacy model approach and trying to lock customers into their service. This may well be true but there are also security fears around cloud adoption, and with larger enterprises the operational risks are significant. In other words, they may well appreciate the legacy model or, at least, they may take their time over shifting to Rackspace’s open cloud model. Furthermore, Rackspace is going into unchartered territory here, and VMware also disappointed the market with its results. Meanwhile, Amazon can't appear to do anything wrong at the moment.

It wasn’t just revenues that got the market worried. Rackspace described the slower than expected installed base growth to be a function of its execution rather than anything structural in the industry.

With all this understood, it was only a revenue miss by a couple of million. No big deal. Revenue growth remains strong, and it is understandable if there is some lumpiness as RAX engages and educates enterprises with its open cloud offering.

Where Is the Cash Flow?

So if the revenue miss isn’t a big deal then is the stock good value now?

Frankly I don’t think it is. My concern with Rackspace was previously outlined in an article linked here. I would advise reading that article for a more in depth look. In summary, my worry is that in order to offer its ‘fanatical support’ to customers RAX is locked into buying large amounts of customer gear. I use the term ‘large’ because thus far there hasn’t been a clear sign that RAX has achieved the kind of scalability that it will need to justify the evaluation.

Granted this year has seen some improvement as indicated in this chart. Note how CapEx as a share of revenue fell in 2012 vs. 2011.

However, in these results RAX announced that CapEx for 2013 would be $375-445 million with customer gear expenditures of $235-275 million. Considering that the consensus revenue forecast for 2013 revenues is $1,640 the mid-point of these figures is 25% and 15.6% respectively. It’s an improvement but not by much, and it's possible that RAX will struggle to beat this year’s free cash flow figure of $119 million.

Where Next for Rackspace?

And herein lies the problem. As I write, the stock price is around $60, which gives a market cap of $8.3 billion and enterprise value of 10.2 billion. In other words, it is only generating 1.1% of its enterprise value in free cash flow, and the forward PE ratio is around 41x.

The challenge for RAX is to successfully migrate customers onto its open cloud architecture and grow its installed base by convincing customers of its benefits. However, the real test of whether the company can grow into its evaluation will be when it convincingly demonstrates that it has the requisite scalability. The jury is still out.


SaintGermain has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Rackspace Hosting, and VMware. The Motley Fool owns shares of Amazon.com 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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