Six Reasons Why Rackspace Hosting Will Fall Further

Vladimir 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) is a cloud computing company that manages web-based IT systems for all kinds of businesses worldwide. With the help of cloud computing, companies can use IT resources via the internet. This is a win-win situation for both the provider and the customer. The specialized service provider gets customers and revenue, while customers do not need to implement difficult solutions that take time, effort, and are costly to maintain.

Rackspace Hosting has recently released its first quarter results. The company has reported earnings of $0.19 per share, while it was estimated to report $0.20 per share. Net revenue for the first quarter of 2013 was $362 million, up 2.6% from the previous quarter. In the meantime, net income decreased 8.8% from the previous quarter.

The stock was already under pressure before the report, down 30% in 2013. The report made things worse for Rackspace, and the fall of its stock price continued. I think that Rackspace has more room to fall, and I’ll explain why.

1. The stock is not cheap at all. Rackspace is unattractive by both P/E and forward P/E, scoring higher than 30 on both metrics. Current P/E is usually not important for technology companies, because investors are focused on future earnings growth. In the case of Rackspace, analysts do not estimate future earnings are enough to justify the current price of the stock.

2. Rackspace Hosting lacks growth. In its earnings call, the company stated that it was not satisfied with its growth rates in the first quarter. Investors were not satisfied, either. Average monthly revenue per server was $1308 in the first quarter of 2013, compared to $1310 in the prior quarter. Rackspace states that net upgrade activity and new bookings from enterprise customers slowed.

3. There is a lot of competition from big players. Amazon (NASDAQ: AMZN), Microsoft (NASDAQ: MSFT), Google (NASDAQ: GOOG), Oracle (NYSE: ORCL) have their own cloud solutions. They also have better brand recognition and bigger budgets. Amazon’s Web Services is currently the main threat to Rackspace. Amazon offers computing, networking, storage, database and application services. Amazon's headliner products include Amazon EC2, a web service that provides re-sizable computing capacity, and Amazon S3, which provides storage for the internet. Amazon's products are used by the federal government, life sciences researchers, media & entertainment companies and for game hosting. 

Google's Cloud Platform has currently over 3 million applications running. While Google's main source of income is advertising, the company is known for its investments into perspective technologies. The power of Google would certainly make this platform more and more popular. Microsoft is more active on the software part of the business with its Windows Azure platform. The software giant also offers SkyDrive, a cloud storage with pre-installed apps that are ready for use. SkyDrive has yet to become popular with the general audience. Oracle provides sophisticated solutions for enterprise clients with its Oracle Cloud. It includes offerings for enterprise resource planning, budgeting, financial reporting and marketing. Oracle generally targets bigger clients than Rackspace.

4. Rackspace Hosting has made a terrible pricing move. In late February of 2013, it cut the prices of its cloud bandwidth and content delivery network by a third. This is a strange way of trying to grow revenue. Rackspace should have tried to compete on quality of its solutions, and not on the price. Price wars with giants cannot end happily. The results of the price cut are not fully reflected in the first quarter results. The company has operated with the new prices for only one full month. The second quarter results will show if the move was just bad or if it was catastrophic.

5. Companies all over the world are dedicated to cutting costs. While the stock market hits new highs, the real world is in a more difficult situation. There is no growth in Europe, and China is slowing down. Even those companies that do not feel the impacts of that are cautious about spending. Capital spending is revised downward in many industries.

6. Analyst earnings estimates have been revised downward during the last 90 days. Estimates for the second quarter fell 15%, while estimates for the full year 2013 fell 14%. These estimates could be cut further when the impact from the pricing cuts would be clear. During the earnings call, Rackspace executives were asked to provide some guidance about the impact of the cuts. Of course, they refused to do this because of the competition issues. No one wants to reveal the details of the business to competitors. However, they did not give any assurance that pricing cuts were the right thing to do.

In my opinion, Rackspace Hosting is an overvalued company. The company fails to deliver earnings that are good enough to justify the price of the stock. Rackspace has made an extremely dubious pricing move. The company has to deal with bigger and stronger competitors. Rackspace lacks growth, which is very bad for a technology stock. During the earnings call, company executives did not give a hint about how they are going to change things in the company’s favor. I think that Rackspace will continue to go down until there is evidence of positive changes in the company’s strategy.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Google, and Rackspace Hosting. The Motley Fool owns shares of Amazon.com, Google, Microsoft, and Oracle.. 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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