Rackspace: What is OpenStack?

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With shares of Rackspace Hosting (NYSE:RAX) trading at around $39.36, is RAX an OUTPERFORM, WAIT AND SEE or STAY AWAY? Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

C = Catalyst for the Stock’s Movement

May 9, 2013 will not be remembered as one of the happiest days for Rackspace or its investors. The stock dropped over 24 percent due to missed expectations and weak guidance for Q1. This information was reported on Wednesday afternoon, and the stock gapped down to open at $40.50 on Thursday morning. This was a tricky spot for traders (not long-term investors) as they weren’t sure to look at it as an opportunity or a sign to stay away. Those who chose the latter course of action were likely pleased with their decision – the stock closed at $39.36 on Thursday afternoon. The question now becomes: is this a good entry point?

For those who don’t already know, Q1 EPS came in at $0.19 on revenue of $362.20 million. Analysts expected EPS of $0.20 on $366.70 million. Rackspace also announced that it expected revenue of $372.00 million for the current quarter, and the consensus was for $384.00 million.

Rackspace is currently dealing with increased costs, price cuts, and slowing revenue growth. However, many OpenStack analysts believe it has good long-term potential. If you’re not familiar with OpenStack, the following is an easy-to-follow and highly informative video produced by Rackspace:

Now let’s take a look at some numbers. The chart below compares fundamentals for Rackspace, Microsoft Corporation (NASDAQ:MSFT), and Amazon.com Inc. (NASDAQ:AMZN). Rackspace has a market cap of $5.43 billion, Microsoft has a market cap of $272.75 billion, and Amazon has a market cap of $118.44 billion.

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RAX AMZN MSFT
Trailing P/E 52.48 N/A 16.85
Forward P/E 30.51 79.80 10.64
Profit Margin 8.05% -0.14% 21.58%
ROE 14.61% -1.11% 22.58%
Operating Cash Flow 399.50M 4.25B 30.61B
Dividend Yield N/A N/A 2.70%
Short Position 12.30% 1.80% 1.60%

 

Let’s take a look at some more important numbers prior to forming an opinion on this stock.

T = Technicals Are Weak

Rackspace has performed well over a three-year time frame, but year-to-date has been disappointing.

1 Month Year-To-Date 1 Year 3 Year
RAX -15.61% -47.02% -25.25% 139.1%
AMZN 0.42% 3.66% 16.14% 108.1%
MSFT 14.24% 23.29% 10.30% 25.20%

At $39.36, Rackspace is trading below its averages.

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50-Day SMA 48.40
200-Day SMA 62.08

 

E = Equity to Debt Ratio Is Strong

The debt-to-equity ratio for Rackspace is stronger than the industry average of 0.40. Rackspace has shown quality debt management.

Debt-To-Equity Cash Long-Term Debt
RAX 0.15 292.06M 125.37M
AMZN 0.36 7.90B 3.04B
MSFT 0.19 73.79B 14.76B

E = Earnings Have Been Steady

Earnings and revenue have steadily increased on an annual basis. Looking at the big picture, it looks like May 9 had the potential to be an overreaction.

Fiscal Year 2008 2009 2010 2011 2012
Revenue ($) in billions 0.532 0.629 0.781 1.03 1.31
Diluted EPS ($) 0.19 0.24 0.35 0.55 0.75

When we look at the last quarter on a year-over-year basis, we see an increase in revenue and earnings. This is yet another indication that May 9th’s big drop might have been an overreaction. If you strip out Wall Street expectations, the company is doing well.

Quarter Mar. 31, 2012 Jun. 30, 2012 Sep. 30, 2012 Dec. 31, 2012 Mar.31, 2013
Revenue ($) in billions 0.301 0.319 0.336 0.353 0.362
Diluted EPS ($) 0.17 0.18 0.19 0.2096 0.19

Now let’s take a look at the next page for the Trends and Conclusion. Is this stock an OUTPERFORM, a WAIT AND SEE, or a STAY AWAY?

T = Trends Might Support the Industry

Infrastructure-as-a-service, or IaaS, has been performing well. However, when an industry or innovation performs well and the barriers to entry aren’t too high, other players want to get involved. And you never want those players to go by the names of Microsoft and Amazon.

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Conclusion

Rackspace has fewer OpenStack contracts that they expected to have by this time, but it’s still early in the game. The stock is also trading at 52 times earnings, which is a negative, and it’s not likely to be resilient if the stock market falters.

On the other hand, there is plenty of internal and external confidence about Rackspace’s potential. Rackspace Software Developer Felix Sargent stated, “The Internet is taking a little bit of time to allow for its next growth spurt, and I think that’s going to come from us.” As far as analysts go, they like the stock: 8 Buy, 13 Hold, and 1 Sell. In addition to that, the company culture is one of the best around. According to Glassdoor.com, Rackspace employees have given their employer a 3.9 of 5 rating, which is extremely high. It should also be noted that 83 percent of employees would recommend the company to a friend, and an outstanding 89 percent of employees approve of CEO A. Lanham Napier. The importance of company culture shouldn’t be underestimated. If the atmosphere is positive, then employees are much more likely to be productive as well as innovative.

One factor that hasn’t been covered yet is expectations. In a matter of one day, Rackspace has gone from lofty expectations to low expectations. That might favor the stock’s potential going forward.

All factors considered, Rackspace is a WAIT AND SEE.

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All content posted should not be considered professional advice. Please do your own research and consult with a professional financial advisor before making any investment decisions.

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