Rackspace: Bull and Bear Cases Revisited

Following my Rackspace:  Bull and Bear Cases article, I had the opportunity to speak with Bryan McGrath, Director of Finance, at Rackspace to discuss the bear case, capital efficiencies, customer base and competition.  Herein are the takeaways from that discussion.

If there is one thing Rackspace management wants to avoid, it�s �stranded capital.�  Management adheres to a strict EVA (Economic Value Added) metric, or generating a return on capital invested that exceeds their cost of capital.  Historically, Rackspace return on capital has run in the 30%s although, since the purchase of their new corporate headquarters, the fully-burdened return on capital has been increasing from 9% in 2009 to 14% year to date.

One may question why a �Cloud� company needs to have spent so much on its real estate for corporate headquarters.  Apparently, this is a common question, with a refreshingly long-term answer.  Rackspace made the decision to purchase an abandoned mall, which provides enough space for future growth in exchange for favorable tax treatment (over 14 years), no sales tax on purchase of headquarter equipment, $4.7M in education and training, and up to $18.5M in grants.  The net effect is a cost-effective view toward long-term growth and community development.

Rackspace strives for business model efficiencies by streamlining platforms and standardizing offerings �carefully.�  Not only does Rackspace limit server architecture to a x86 platform, it limits the brand of servers it supports to a few Dell SKU models.  With its narrow focus, it can provide greater support for these models to drive more efficient use per server, and therefore higher revenue per server.  Average revenue per server has increased for the last nine sequential quarters to $1,155/month in the third quarter of 2011 from $990/month in the second quarter of 2009.  Greater support means higher service levels to its customers and contributes to Rackspace�s differentiated strategy on customer service.

The investment in and lead time to build data centers was mentioned as a potential risk in the original article, because data centers are expensive and Rackspace had commented in an earnings call that they must plan two years in advance for buildouts.  Now, Rackspace leases the data center space and invests in the Dell servers to install in the facility.  Rackspace assumes that the servers have a three-year life span.  With revenue per server and absolute demand increasing and the ability to lease the facility, management views the risk of stranded capital for the data center is reduced.  Moreover, while Rackspace customer contracts are generally one year, Rackspace assumes no contract for planning purposes to maintain a conservative approach.  Actual customer life spans 4.5 � 5 years.

Rackspace has experienced increased demand with each increased level of service.  About five years ago, Rackspace introduced a higher level of service, Intensive Proactive Managed Support, with more outsourced IT functionality an alternative to its basic Managed Online Demand hosting service.  Today, half of the revenues are generated from the increased service and administrative levels of Intensive Proactive Managed Support.  Adoption of higher level of services makes sense as Rackspace estimates that approximately 50% of IT expenses are IT staffing, and increasing services, thus, makes the pay-as-you-go model more compelling.  In December 2010, Rackspace introduced a new level of increased service targeting the Enterprise market, called Critical Sites, mission critical website and application monitoring.  In 2008, Small and Medium sized Businesses (SMBs) were 100% of Rackspace business, and now, with increased and targeted product offerings, Enterprise is 10% of the overall business.

Rackspace appeal to SMBs is lower cost of ownership for technology, as IT can be paid for as used, as opposed to the significant upfront investment in building one�s own infrastructure.  Because of the exposure to SMB, many analysts have been concerned that Rackspace will be challenged in a slower economic environment.  That was the case in 2008 when growth slowed (not stopped), but today, Rackspace is benefitting from both the increase in exposure to the Enterprise market and the emergence of startups in the economic downturn.

Competition for Rackspace comes in four flavors:  in-house IT departments, IT outsourcing companies, telecommunications companies and technology companies moving into cloud.  Rackspace�s competitive advantage, to date, has been its customer service and that distinguishes it sharply from its most oft-cited competitor, Amazon.  Amazon provides a less expensive, albeit bare bones, cloud service and is an attractive option for those companies with their own robust IT departments.  Rackspace, on the other hand, offers high levels of service for those companies who do not have robust IT departments and the two, Amazon and Rackspace, are highly differentiated from each other.

Here are a couple interesting facts from Rackspace:  Less than 2% of the top 500,00 websites are hosted in modern cloud architectures, and Forrester estimates that the market for global cloud computing will grow from $41B in 2011 to $241B in 2020.  And, also according to their investor presentation, Rackspace and Amazon are almost dead-even for number of websites in the top 500,000 hosted by each (3,662 vs 3,674).

From a valuation perspective, the story remains the same from the previous article.  Rackspace has traded within the $40-$45 range since mid-October, although earnings estimates for the next fiscal year have increased from $1.09 to $1.13.  Going forward, analysts� estimates for Rackspace are $0.80 (up 51%) for 2012 and $1.13 (up 41%) for 2013.  (Rackspace has historically been within a penny or two of analysts� estimates.)    Should earnings meet expectations, Rackspace is reasonably valued on a PEG basis:  Today at $42.10, it is trading at 37x earnings on growth of 41% for the year out.

So far, Rackspace appears to be in the sweet spot of a real-game changer in the IT world:  cloud computing.  Its strategy is on the other end of the spectrum from Amazon, and both of these companies compete mostly with in-house IT departments.  Rackspace faces challenges with a tough economy but still managed to grow through this most recent rough spot while harvesting a new and more competitive clientele, the Enterprise.  By choosing to lease data centers and simply buy equipment, Rackspace has lessened its capital exposure while itself benefitting from a leasing model.    Although the stock is trading at about parity with growth, Rackspace is a stock to watch for dips as an opportunity to invest in Cloud adoption.