RACKSPACE HOSTING INC RAX S
September 26, 2012 - 3:19pm EST by
msdonut940
2012 2013
Price: 64.52 EPS $0.76 $0.00
Shares Out. (in M): 143 P/E 84.9x 0.0x
Market Cap (in $M): 9,208 P/FCF 0.0x 0.0x
Net Debt (in $M): -66 EBIT 0 0
TEV ($): 9,142 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Data Center
  • Cloud
  • Competitive Threats

Description

Rackspace is an expensive stock.  It trades at 85x this year’s earnings despite slowing growth and a flawed business model.  Why does it trade at such a premium?  It appears that investors don’t realize this company is 1) not actually a public cloud company and 2) lacks any competitive advantage.  To be fair to the average investor, the company does disguise itself well as a “cloud” company, using all the appropriate buzz words at every opportunity (“OpenStack”, “public cloud”, “Infrastructure as a Service”, etc).  However, as their growth is beginning to slow, a re-rating of the stock is inevitable as people realize they’ve actually invested in Timi Garstang, not Usain Bolt.

The Story

Rackspace is a managed hosting company that provides an interim solution for those looking to outsource part of their infrastructure needs.  RAX offers people the comfort of being able to flex their server needs in a given year, while giving them the security that it is still “their server”.  As a bonus, if you wanted to go see your server, they are often conveniently located to their clients which would allow you to go see it in person.  In addition, through a significant investment in what they call “fanatical support”, the company has an employee who is happy to hold the CIO’s hand during any transition and answer any questions they may have ~ allowing there still to be an overall savings to an IT budget relative to hosting everything in house.  Now this all sounds like a lovely solution, right?

To me, this is a solution that had a time and a place.  There has been a desire to outsource, but CIO’s are still concerned about the security of a true public cloud solution.  Therefore, they have deferred to what I deem a bad solution ~ managed hosting, a solution that does not provide the same amount of scalability or expense savings as true public cloud, but allows a company to get their feet wet with the idea of outsourcing.  A true public cloud solution represents the intermixing of data between different clients on the same server pool ~ so Disney, Netflix, and JP Morgan in theory could all be running workloads on the same server.  Amazon Web Services is an example of a true public cloud player. 

To be fair, it does seem like RAX understands that their core business of managed hosting is a potential dinosaur.  As a result, they have been heavily involved in developing OpenStack standards.  OpenStack is an open-source initiative for cloud software, whose mission is “to enable any organization to create and offer cloud computing services running on standard hardware”.  By leading the effort behind OpenStack, RAX has been able to define themselves as a leader in the public cloud, even though less than 5% of their revenues come from it today.  Unfortunately, true success in this will likely commoditize the pricing of IaaS even faster than is already the case, as OpenStack standards will allow clients to easily switch between cloud providers.  One may question the ROI decision of pursuing IaaS given your competitors, GOOG, AMZN, MSFT, may not be looking at public cloud as a revenue generator so much as a means of offsetting their own server costs.  When dealing with competitors who don’t need an ROI, it becomes difficult to believe that RAX will ever earn an appropriate return in this business line.

For more background detail on RAX, please see conway968 write-up from 2010.

Why now?

The real question is why short it now, as the company has traded at an extremely high valuation for several years, and the potential market for managed hosting and public cloud is still unknown.  We argue that today, you are starting to see more pricing competition.  As a result, RAX stopped reporting a variety of key revenue metrics in Q4 ’11.  At the same time, there now appears to be a bit of a land grab occurring in the public cloud space, with MSFT, GOOG, and AMZN all lowering prices and improving service in an attempt to gain share.  And finally, as I mentioned earlier, RAX always provided a solution that I believe is destined to be transitory.  With public cloud becoming more and more established, it seems likely that those looking at the cloud today will either 1) make the leap directly to public cloud or 2) focus on their own private cloud development, making managed hosting unlikely to participate in the next leg of growth.

The Numbers

Market Valuation    
Stock Price   $64.53
Common Shares   135.03
Dilution              7.7
Total Shares          142.7
Market Cap   $9,209
     
Less: Cash   ($215)
Add: Debt   $149
Enterprise Value   $9,143
     
Multiples    
2012E EBITDA $446 20.5x
2012E P/E $0.76 84.9x
  • Note valuation is based off of street estimates.  A reasonable case as shown below, would have the company materially miss these estimates

 

Key Metrics

2010

2011

2012E

2013E

2014E

Revenue

$629

$781

$1,025

$1,307

$1,566

$1,795

% Growth

24.1%

31.3%

27.5%

19.9%

14.6%

EBITDA

$180

$235

$319

$415

$499

$568

% Growth

30.5%

35.4%

30.2%

20.3%

13.7%

Margin

30.2%

31.1%

31.8%

31.9%

31.7%

EPS

$0.24

$0.35

$0.55

$0.71

$0.81

$0.87

% Growth

46.7%

59.3%

28.6%

14.5%

7.3%

FCF

 

$8

($58)

($16)

$86

$125

 Risks
1) Acquisition by an irrational player

2) If an investor is willing to pay 85x earnings, maybe they are willing to pay 100x earnings?

Catalyst

1)      Missing growth estimates for 2013/2014
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