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Buy, Sell or Hold: Is Rackspace’s Cloud Being Vaporized? – Money Morning

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Rackspace Hosting (NYSE: RAX) is currently the number two provider of cloud computing. The company has been under the microscope lately as its stock has dropped nearly 45% year-to-date.

But the microscope is not just fixated on Rackspace, it’s also focused on the entire cloud computing sector.

This sector is growing rapidly with analysts speculating enthusiastically that the overall cloud market could reach anywhere from $40 billion to $70 billion by 2016 or earlier.

But with extreme growth comes extreme competition. This competition is not coming from the under $6 billion market cap companies similar to Rackspace.

The company’s competition comes from the largest names in tech – Microsoft and industry leader Amazon.

For those unfamiliar with the term “cloud computing” the business is quite simple to describe.

Basically, all the large computers, processing and computer data, which are presently sitting in companies and offices across the globe are being replaced by leased machines such as Rackspace’s, which are housed and maintained in a secure environment. Everything is managed over the internet.

Companies save greatly on costs by outsourcing all the startup, maintenance, data storage and general headaches that come with servicing their own machines.

Rackspace has 200,000 customers in nearly 120 countries with data centers on four continents. However, the key to Rackspace’s (along with its competitors) customer growth does not have much to do with the housing of these machines, but rather in the platform the customer will use to interface with their data.

Therefore, the competition is rooted in who can deliver the best platform along with the best customer service to corporate clients.

Rackspace’s Transition

Last year, Rackspace introduced its open-source public cloud – OpenStack. The platform’s advantage is that it is “open”, meaning it can be adapted by any IT professional so that it can interface with many different cloud networks.

Rackspace developed OpenStack in conjunction with NASA and is using this connection as cache along with its reputation of great customer service to cater to the higher-end of the market.

It is the company’s goal to migrate current clients from private (company specific) clouds to a public cloud or a type of ‘hybrid’ in the middle where OpenStack will be the centerpiece.

The company has some major clients that are on board with OpenStack such as IBM, Best Buy and Bloomberg. But the transition is slow going, and any time you see the word “slow” associated with a company that is overwhelmingly married to the idea of growth – that spells trouble.

During the last quarterly conference call CEO Lantham Napier admitted that they were not happy with Rackspace’s growth rates.

The primary reason for the slower growth came from lower-than-expected sales to Rackspace’s enterprise customers.

In addition, the future Napier painted was not as clear when he stated, “This product-cycle transition will likely continue for some time, given the large number of customers still using the legacy public platform.” This type of uncertainty doesn’t inspire much faith for the investor.

Is there any wonder now why Rackspace’s share price fell so drastically?

But wait there is more…

Amazon and Microsoft Raining on Rackspace’s Cloud

Amazon is well known for throwing caution to the wind when it comes to pricing. It has a history of continually cutting prices across its myriad business segments in order to increase market share and drive out the competition. Cloud computing is no exception.

With its Amazon Web Services – the leader in cloud computing – Amazon has lowered prices 31 times since its debut in 2006 and thus far in 2013 it has cut prices 7 times.

Microsoft, with its Azure platform, has very deep pockets with cash to burn. Microsoft realizes that in order for its suite of software products to remain relevant it must compete in the cloud market. In response to Amazon’s price reductions, Microsoft stated that it will match Amazon’s prices.

Back in February, Rackspace, rightly or wrongly, decided that it was getting painted into a corner and cut prices on some of its cloud services.

Common sense tells me that entering into a price war with these giants doesn’t seem like the best of strategies.

Rackspace does have an advantage over its competitors and that is its ability to offer custom solutions tailored to the customer’s needs rather than the one-size-fits-all solution that the competition offers.

The company develops strong relationships (which it terms “Fanatical Support”) with its clients and will offer a variety of solutions that best meet their needs.

These “hybrid” solutions are where Rackspace is headed once the OpenStack transition is complete. Hybrid may be the only way to carve out a niche for itself as Microsoft and Amazon go to battle over the rest of the pie.

As an example, Rackspace recently entered into an agreement with CERN openlab where it will deliver a hybrid cloud solution powered by OpenStack to help CERN conduct cutting-edge technical research into the origins of the universe. More projects and partnerships such as these will serve the company well.

Dark Clouds Looming

There are too many doubts or dark clouds on the horizon for Rackspace.

As mentioned, competition from formidable foes shed serious doubt on Rackspace’s ability to grow at historic rates.

However, I failed to mention a few other ‘minor’ companies that are looking to get in on this emerging industry – Google, Oracle and VMware are all looking to grab their share. How Rackspace will handle shrinking margins is still an unknown.

It is doubtful that Rackspace clients have the means or inclination to transfer over to the new OpenStack platform. Companies are extremely concerned with every cost outlay in this lackluster economy, and they are slow to implement any change that doesn’t produce positive balance sheet results.

And finally there is a dark cloud over Rackspace’s share price.

Rackspace Cloud Technology

Looking at the chart above I don’t see any way for the stock to recover, even partly, in the short term. I would consider a return to the $55 level by the end of 2013 quite remarkable – if not impossible.

Perhaps Rackspace will announce some good news when it reports quarterly earnings on August 5. And maybe Wall Street will fall in love with this company all over again – but I can’t imagine why that would be.

Suffice it to say, I think there may be a third shoe to drop – especially in light of the fact that the company has an absurdly high P/E ratio of over 50.

These dark clouds surrounding Rackspace make me a SELLER.

David comes out of the cloud to size up his appetite for top food provider Sysco Corporation. Check out how it tasted here.

[Editor’s Note: If you have a stock you would like to see us analyze in a future issue, leave us a note in the comments below and we’ll add it to our list.]

About the Author: David Mamos brings nearly 15 years of analytical experience to the table with a background ranging from big-picture fundamental analysis to highly technical trading decisions. He began his career working as a financial advisor with Royal Alliance in 2001 and helped clients with portfolio management as well as buy-sell decisions before transitioning to the development, implementation and execution of trading strategies for aggressive investors.

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