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Rackspace’s Dive: One-Off or Ominous Sign?

Cloud computing's rising costs and recession-wary customers could mean more earnings disappointments for the sector


Over the past year, one of the hottest sectors has been cloud computing. But today feels decidedly chillier, with Rackspace (NYSE:RAX) shares down 12%, to $51.

Wall Street’s consensus for 1Q net income was 18 cents a share, while Rackspace reported earnings of just a penny off that, at 17 cents. Seems minor, right? But even a slight miss can make investors nervous.

Does this performance shed light on the sector? Or is it just a one-off?

The cloud trend is certainly real. It leverages Internet technologies to deliver business applications and tends to be cheaper than traditional on-premise software solutions.

The sector has also been the target of aggressive acquisitions. Mega-players such as Oracle (NASDAQ:ORCL) and SAP (NYSE:SAP) have spent billions on deals.

The top cloud operators have reached nose-bleed valuations. Here’s a look:

stock price-to-sales ratio (NYSE:CRM) 9X
Netsuite (NYSE:N) 12X
Cornerstone OnDemand (NASDAQ:CSOD) 13X
Concur Technologies (NASDAQ:CNQR) 9X

There are other issues as well. For example, the costs of running a cloud company are increasing. (This was a problem for Rackspace’s first quarter.)

It isn’t cheap to operate data centers and invest in the latest software. It’s also getting more expensive to hire engineers because of the “hiring wars” in Silicon Valley.

At the same time, there may be pressure on revenue growth. Many cloud companies are focused on the U.S. and Europe, and unfortunately, growth rates have been disappointing. In light of this, it’s easy for customers to put off commitments for new software.

Finally, the recent hot IPO activity for cloud companies — including ExactTarget (NYSE:ET), Proofpoint (NASDAQ:PFPT) and Guidewire (NYSE:GWRE) — is another concern. Investment bankers have a good sense of  market timing and have rushed to capitalize on the cloud trend. In other words, all this IPO activity could be a classic sign of a top, at least for the short run.

All in all, the cloud space faces two major challenges: The revenue ramp is coming under pressure because of the slumbering U.S. economy, and costs continue to climb. It’s a tough squeeze. And it may mean there are more nasty earnings surprises ahead.

Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “The Complete M&A Handbook”, “All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli or reach him via email. As of this writing, he did not own a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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