Rackspace Makes a Move for Market Share: Are You a Buyer?

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

Last week Rackspace Hosting, Inc. (NYSE: RAX) announced that it was going to lower prices on cloud bandwidth and its content delivery network by 33%.  According to company spokesmen, the change in price is designed to attract larger accounts to the network by lowering the cost associated with bandwidth intensive processes such as video streaming and workloads that serve large amounts of content.  In addition to price reductions in content delivery, Rackspace is introducing a tiered pricing structure to the open cloud segment, which will incentivize large volume users to participate in open cloud computing exclusively with Rackspace in order to take advantage of volume based discounts.

In response to this announcement share prices took a tumble Friday, falling roughly 6 percent initially and finishing the day down 1.3% after a steady rebound throughout the day.  I wasn’t really tracking this stock until Friday when the headlines caught my attention, so I took advantage of the weekend and began researching the company in depth.  Here’s what I found.

The company is trading at a 73x earnings multiple, making Rackspace susceptible to violent price swings should sentiment towards the company's growth potential wane.  I believe the market is overreacting to the announcement of price reductions and the perceived impact that such changes will have on revenue in the near term.  It sounds like the implementation process will occur in structured increments rather than across the board cuts, allowing the company to monitor and adjust the process as they proceed.  Overall, Rackspace has delivered an industry beating standard of roughly 25% revenue growth year over year.  The forward P/E ratio is 40.43 with an average analyst earnings estimate for the fiscal year ending December 2014 of 1.36 per share, which indicates an expectation for growth in earnings going forward.

<img src="http://media.ycharts.com/charts/36a2621f266cbb767aae5e633e0aa400.png" />

RAX data by YCharts

Operating margins have been stable and in line with industry standards at 14%, indicating that the company is effectively managing the variable costs associated with providing their services to this point.  This metric will be important to watch going forward as a negative reaction to the new pricing strategy will likely reveal itself here.  Should the increase in net sales outpace growth in operating income, the company will feel the squeeze and the share price in the market will reflect that.

The price to earnings growth ratio is a measure of the stocks’ value taking earnings growth into account: the lower the ratio, the more likely that the stock is undervalued given its growth potential.  Rackspace currently has a PEG ratio of 1.85, which is slightly above the industry standard of 1.16, but still good in shape.

From a business model standpoint, Rackspace seems to be committed to innovating the way customers interact with the cloud.  This is a huge positive for the company considering how competitive this industry is.  Until recently cloud computing has been largely proprietary, meaning that applications offered little in the way of interoperability.  Rackspace has implemented an open cloud computing service that will allow interaction between many different cloud networks.  From what I understand, the basic premise behind the move is to make the cloud function in the same manner as the internet, where service providers can operate in conjunction with one another on a uniformed platform, rather than having to rely on internal processes that are incompatible with other cloud networks.

Now a look at the competition.  In an attempt to make an ‘apples to apples’ comparison I pulled data for two companies operating in the cloud space with market capitalizations between 1 and 15 billion, Rackspace currently has a market cap of  7.5 billion.

Citrix Systems, Inc. (NASDAQ: CTXS)

Citrix has a market cap of 13.2 billion and currently trades around 71 dollars per shareIts current P/E ratio is 38.04, with a forward looking P/E of 19.76.  As with Rackspace, both ratios are rather high, meaning that the company will live and die with earnings growth, or a change in analyst sentiment toward the company.

<img src="http://media.ycharts.com/charts/fb4ade99738ef4a7e2e48ef3f8268de5.png" />

CTXS data by YCharts

Operating margins are strong at 15.7%, and the company seems to be managing its expenses well.  Year over year revenue growth is not quite as attractive as Rackspace, though, with Citrix coming in at 19.5%, which could be a sign that the company is losing market share to competitors.

Citrix has a very good PEG ratio in comparison to the industry at 1.35, indicating that the stock could be relatively undervalued; however, the chart indicates that the market isn’t quite as excited about the companys future prospects as it once was.

Red Hat, Inc. (NYSE: RHT)

Red Hat has a market cap of 9.7 billion and trades around 50 dollars per share.  The current P/E ratio is 67.82 with a leading P/E of 35.94.  Again, the P/E ratios are high making the stock volatile.

<img src="http://media.ycharts.com/charts/da2dd49b0070a70690973af95660027f.png" />

RHT data by YCharts

Like Rackspace and Citrix, Red Hat has a healthy operating margin at 16.12%.  Where the company differs is in its earnings--year over year earnings are down roughly 10%, which is probably why the momentum in the market has shifted.

In addition, the PEG ratio isn’t nearly as comforting as the previous companies discussed in this article.  The PEG for Red Hat is 2.77, indicating that the stock may be a bit overcooked given the slower earnings.

In conclusion, Rackspace and Citrix edge out Red Hat from a fundamental standpoint; however, Rackspace tops Citrix on the technical side.  Ultimately your investment decisions will come down to the level of confidence you have in the industry as a whole, and where the company stands relative to its competitors.  Overall, I like the pullback and think there is a good opportunity to buy Rackspace here.

For more information on cloud computing visit http://beta.fool.com/sofjay/2013/02/21/information-the-worlds-most-valuable-commodity/25228/

SofJay has no position in any stocks mentioned. 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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