Why Rackspace Won't Be a Rock Star Stock

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The fastest way to a billion dollar valuation is to announce that your company is working on the cloud or a new mobile app. Either way, your company is sure to get plenty of analyst attention, and also a bloated valuation. Rackspace (NYSE: RAX) is one company enjoying its sky-high valuation due solely to its association with the cloud, not its underlying business.

Recent earnings and the subsequent shareholder response shows how the company is falling out of favor with investors. In Rackspace's Feb. 12 earnings release it posted revenue of $352.9 million and GAAP earnings per share of $.21. The company beat on revenues and met consensus on earnings, neither of which seemed to matter when the stock price shrunk by nearly 20% in just two trading days.

Why investors are dumping Rackspace

Rackspace competes in one of the most commoditized businesses out there: website hosting, cloud computing, and server leasing. Rackspace is a tech company in datacenters only; to its customers it is little more than a financing scheme through which businesses can pay a set price for a shared part of one or many servers.

That's what the cloud is all about: borrowing a little bit of computer time only when necessary and paying for it in piecemeal. This business model has been done over and over again, just in different industries.

It's really not all that different than Amazon's (NASDAQ: AMZN) Web Services, which sells EC2 cloud computing at comparable prices to Rackspace. And truthfully, Rackspace isn't very different from ZipCar, which bought cars then leased them by the hour or day. ZipCar was once as hot at Rackspace, only to be bought out at a forward earnings multiple of 28 and two times book value with the assumption that Avis Budget Group could bring cost-saving synergies to add value. Rackspace would be hardpressed to find a suitor at the current multiple of 46 times forward earnings and 10 times book value given the few cost savings that could be squeezed from the much more competitive cloud computing industry.

Rackspace and Amazon are both in the business of building out large datacenters then effectively leasing them in bite-sized pieces to thousands of customers. The problem is that once one accounts for depreciation and amortization, the business really isn't all that profitable. It runs on the same basic microeconomics as an unregulated utility company. It's a high capex, low value-add business where the customer does not have a shred of loyalty to his or her provider.

Rackspace's biggest problem

Perhaps the biggest problem Rackspace faces is that it is competing in a commoditized business without the inherent ability to compete on price. Mind you, Rackspace's products compete directly with Amazon's, a company which has a shareholder base that cheers it on every time Jeff Bezo's brainchild posts a bigger quarterly loss.

Amazon has the lower cost of capital. It can undercut Rackspace at every turn and keep its shareholders happy. Rackspace doesn't have that ability as demonstrated by shareholders' response to its latest earnings report.

Investors should be reminded that Amazon isn't Rackspace's only problem. It's just one of many. There are thousands of hosting companies out there, all with the same servers from the same company, fiber from the same sources, and IT workers trained by the same schools. There is virtually no differentiation between one cloud company and another.

If it weren't for the high tech appeal, Rackspace would be put in the same column as airline stocks for being certain to generate negative economic returns on capital. Investors, however, cannot deny the appeal of technology, even if the business is really just basic leasing under a different name.

The bottom line

Rackspace shareholders should look out below. The company can either compete on price, cannibalizing its share price, or hope to fool smart customers into paying too much for a commodity product. Neither option makes for a particularly good choice for your investment capital. Stay clear.

valuemagnet has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Rackspace Hosting. The Motley Fool owns shares of Amazon.com. 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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