Thursday, January 9, 2014

Rackspace Hosting, Inc. (NYSE:RAX): Faces An Uphill Battle Amid Rising Competition

Rackspace Hosting, Inc. (NYSE:RAX) is in a high-growth market but facing increasing competition while making some execution errors that threaten Rackspace's long-term competitive position. This could result in financial underperformance despite a valiant effort at repositioning.

Rackspace is a Texas-based cloud services provider. It is a co-founder of OpenStack, with NASA, and uses it extensively in its computer systems. The company offers Public, Dedicated and Private Cloud, and Hybrid Hosting.

The company has data centers in the US, UK, China, and Australia. Rackspace's competitors include Amazon, Microsoft, Google, Verizon, IBM, HP, and Century Link.

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Gartner expects the market for infrastructure-as-a-service cloud industry (Rackspace's Public Cloud, 27 percent of sales) to grow from $9 billion in 2013 to $31 billion in 2017, with compute services representing 83 percent of the spending in 2017. Gartner expects managed hosting (Rackspace's Dedicated Cloud, 73 percent of sales) market to grow 12.6 percent a year to $102 billion in 2017.

Rackspace is lagging behind the competition on certain fronts. UBS analyst Steven Milunovich said the growth in hosting has shifted to the public cloud, most successfully represented by Amazon Web Services (AWS). Management recognized that its platform had scale issues relative to AWS and lacked many features and functions. Consequently, Rackspace finds it needs to reposition.

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Successful repositioning should be about differentiating against the market leader. To Rackspace's credit, it is not attempting to copy Amazon. Unable to compete in engineering resources, the company is making a bet on OpenStack and the support of the open source community to enhance functionality.

Rackspace now brands itself "the open cloud company," offering best-fit infrastructure, including public cloud, managed hosting, and private cloud. Furthermore, it is not attempting to compete on price but rather differentiate on superior service.

This positioning modification—continuing a high service level while underscoring an open cloud approach (suggesting a contrast to competitors' closed approach) is creative and probably the company's best chance at success.

However, Milunovich have doubts that it is enough. Public cloud is a major shift in the tectonic plates, attracting not only AWS but also Microsoft, Google, VMware, IBM, and other giants. Moreover, customers tend to prefer low-cost vendors unless the more expensive offering is substantially superior.

The Infrastructure-as-a-Service (IaaS) market is dominated by Amazon's AWS with Microsoft Azure and Google Compute Engine vying for second place. Gartner's Magic Quadrant rates Rackspace a Visionary but in the pack with CSC, Verizon, Savvis, and others.

Rackspace needs OpenStack to succeed to have a shot at a differentiated offering on limited R&D. OpenStack could be the next Linux. It is open source and gaining endorsements from mainstream enterprise vendors, including AT&T, Brocade, Citrix, Cisco, Red Hat, Juniper, Facebook, NetApp, EMC, Yahoo, Intel, Huawei, Seagate, VMware, Dell, HP, and IBM. However, OpenStack is neither an open standard nor interoperable and portable today.

Meanwhile, Rackspace runs its business using a strict EVA (economic value-added) discipline, which results in a cost plus pricing policy and ensures the company does not compete on price. The company sees the continual commoditization of infrastructure driving costs down, passing savings on to customers.

Milunovich is concerned that the company's strategy of pricing at a premium and differentiation through superior service may not hold up against the onslaught of competition from AWS, Microsoft, Google, and IBM SoftLayer. In the meantime, the server build out should continue and likely will keep return on capital at improving but still-lower levels.

The company has suffered a disappointing top line with growth slowing from 28 percent in 2012 to an expected 17 percent in 2013, a rate that is expected to continue for the next couple of years.

Rackspace needs to fix the go-to-market errors it made, and it needs OpenStack to succeed. It needs to overcome the scale advantages of AWS, Verizon, Microsoft, IBM, HP, and now Google. Further, it should transition from managed services to cloud services, but the company's attempt to differentiate through superior service and use of OpenStack may prove insufficient.

If Rackspace can improve automation, it might be able to grow revenue on less server growth, but more likely the staffing levels would increase gradually, and operational cost savings will be passed on to customers.

Milunovich expects revenue growth of 15-17 percent for the next few years despite increased competition given the growth of both public and private cloud. He believes the company can boost EBITDA margin from the weak 31-32 percent level of the last two quarters to near 35 percent with improving scale and some OpenStack adoption.

The cloud trend should keep prices from dropping too quickly, and EBITDA growth should rebound from an estimated 8 percent in 2013 to 19 percent and 24 percent in 2014 and 2015, respectively.

Rackspace looks expensive on earnings at 52 times its forward earnings and free cash flow at 72 times given Rackspace seeing flat revenue growth, increasing competition, and internal issues to fix.

The stock, which has dropped 51 percent in the last year, has been in a clear intermediate-term downtrend with the price well below the 200-day moving average and the average line having a negative slope

Rackspace has to show acceleration in revenue growth with improving margins. Otherwise, the stock could languish.

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