Rackspace Hosting’s Uncertain Future in Cloud Computing

The co-creator of the OpenStack project has several things going for it, but also plenty of tough competition

   
Rackspace Hosting’s Uncertain Future in Cloud Computing

Cloud computing darling Rackspace Hosting (NYSE:RAX) has taken it on the chin lately, down 25% since July 7. Its share price deceleration, combined with revenue acceleration, has analysts stumbling over each other to upgrade the stock. Not much has gone wrong for the Texas company since it went public, in August 2008. To be sure, almost no one is betting against it, so I’ll play devil’s advocate and provide investors three reasons to pause before putting their hard-earned dollars on the line.

Valuation

Raymond James analyst Frank Louthan estimates Rackspace’s 2012 EBITDA at $419 million. With a current market cap around $4.4 billion, it’s trading at a multiple of 10. He believes it should be around 12 times EBITDA, which is a market cap of $5 billion, or $39 per share. I have no reason to question his analysis, but I do have to wonder why anyone would make a 16-month bet on a tech stock with a slew of competitors and an uncertain future for a measly 12% appreciation.

There are certainly safer bets. Take Red Hat (NYSE:RHT), for example. Its revenues in its first quarter ended May 31 were $265 million. Rackspace’s revenues in its second quarter ended June 30 were $247.2 million. Red Hat’s revenues increased 27% while Rackspace’s were up 32% year-over-year. There’s not a lot of difference between them. In terms of operating profits, Rackspace delivered $28.7 million compared to $45.4 million for Red Hat. The leader in open-source software generated operating margins that were 550 basis points higher. Sure, Red Hat only grew operating profits by 32% in its quarter compared to 61% for Rackspace, but it does suggest there are other growth options available.

Customer Service

Rackspace believes that its fanatical customer support sets it apart from the competition, including Amazon (NASDAQ:AMZN). In 2007, when power outages could have crippled Rackspace’s business, its service team contacted thousands of customers to make nice. The proactive approach worked.

However, as the company moves from a billion-dollar run rate in revenue to $2 billion, it won’t be easy relying on good old-fashioned customer service. As hiring ramps up, it’s common for the quality of hire to decline. If you promise great customer service and then fail to deliver, Fortune 500 companies aren’t going to give you a second chance.

Amazon might have mishandled its cloud hosting crash in April, but with customer service zealot Tony Hsieh on board, it’s less likely to lose business from Fortune 500 companies because they know Amazon has the resources and experience to fix problems in a hurry. I wouldn’t bet against them in a customer service showdown.

OpenStack

To hear Rackspace CEO Lanham Napier tell it, you might think OpenStack — the open-source cloud computing project launched by Rackspace and NASA — is the second coming. Napier calls it the “… de facto open-source standard for cloud computing.” This might be, but it will take approximately 18 more months to make OpenStack reliable enough for service providers to use with confidence — and a lot can happen in that period of time.

According to Kyle Hilgendorf, an IT analyst at Gartner (NYSE:IT), there are too many companies involved with the development of OpenStack, and you know what happens when something has too many moving parts: It breaks down. Meanwhile, Eucalyptus has 25,000 clouds on the go, including enterprise clouds for 20 of the Fortune 100. OpenStack might get the buzz, but Eucalyptus, another cloud-computing platform, actually has working deployments. In this instance, first-mover advantage appears real.

Bottom Line

While Rackspace Hosting has Citrix (NASDAQ:CTXS) and Dell (NASDAQ:DELL) in its corner, its future in cloud computing isn’t a sure thing. You might want to think twice before you drink the Kool-Aid.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.


Article printed from InvestorPlace Media, http://investorplace.com/2011/08/rackspace-hosting%e2%80%99s-uncertain-future-in-cloud-computing/.

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