Successful investing demands a careful balance between confidence in your own subjective analysis and a willingness to acknowledge that you may be wrong. When I last wrote on Rackspace (NYSE:RAX) back in February of 2012, I thought the stock looked overpriced and was trading far more on the mania over all things “cloud” than on credible projected cash flow streams.

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What I didn't mention at the time was that my fair value was less than half of the current stock price. Such a dramatic difference of opinion with the market led me to revisit the numbers repeatedly, and things didn't look so good for that call as the stock climbed into the high $50s, came back down into the $40s, and then rocketed up to the high $70s earlier this year. Then the worries about growth, competition and margins started to take hold – leading to a nearly 50% drop to today's price just below $40 (as of this writing).

As it sits today, my concerns about Raxspace really haven't changed. While I believe gross demand for managed hosting and cloud platform services will be strong, I believe Rackspace will be hard-pressed to create any sort of economic moat in this market or produce the sort of free cash flow necessary to validate even today's lower share price. I continue to appreciate why investors like Rackspace as a play on cloud and outsourced services, but I fear Rackspace will be laid low by commodity-like profitless prosperity.

First Quarter Results Weren't *THAT* Bad
I do think the apparently outsized reaction to Rackspace's first quarter earnings report highlights just how the valuation ups the risk and volatility for this stock.

Revenue rose 20%, missing the average sell-side guess by only 1%. Managed hosting saw 15% year-on-year growth, with 2% sequential growth. Cloud was a much stronger grower, rising 40% (and 4%) to about one-quarter of revenue, with very strong growth in OpenCloud.

Margin performance continues to be tricky, though, as competition from Google (Nasdaq:GOOG) and Amazon (Nasdaq:AMZN) impacts pricing. GAAP gross margin fell almost two points from the year-ago level, and slightly more on a sequential basis. GAAP operating income fell 13% and 25%, while adjusted EBITDA rose 11% and fell 16%.

While the margin erosion certainly plays into part of the bear thesis, other non-financial metrics caused some consternation as well. The monthly installed base increased just 0.1%, while the net upgrade rate declined again to 0.9% (from 1.2% in the fourth quarter and 1.6% in the third). While the company's server count increased 4% sequentially, the revenue per server declined very slightly.

SEE: Understanding The Income Statement 

Still Looking For Leverage
When you hear executives from Amazon's Amazon Web Services talk about over 30 price cuts, and more to come in the future, it doesn't seem unreasonable to ask about the long-term profitability of this sector's business model. Hardware companies like IBM (NYSE:IBM), EMC (NYSE:EMC), and Fusion-io (NYSE:FIO) may be constantly at work providing more power for less cost, but I have real concerns that Rackspace's rivals will cut prices more or less in sync with the change in hardware prices.

To Rackspace's credit, management realizes that they have to distinguish themselves with high levels of service and support. Regrettably, Amazon and Google are just as aware of the importance of high levels of service and support. Moreover, I worry about the Red Hat (NYSE:RHT) example – Red Hat tries to set itself apart by focusing on service and support, but so far that model has shown no real operating leverage. Said differently, I'm not confident that Rackspace will be able to offer a level or menu of services that will allow it to differentiate itself from its rivals and achieve any meaningful price or margin leverage.

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The Bottom Line
I have little doubt that Rackspace, Google, and Amazon will succeed in reducing the cost of hosting and cloud services to a point where cost isn't much of a factor. Where I have my doubts is whether anybody will make real money off of this business – every player talks about absorbing the relentless price competition and trying to stand apart with high levels of service, but it's increasingly reminding me of the infamous South Park Underpants Gnome episode, where the actual catalyst to profitability was just a large question mark.

I'm not that troubled by the lower guidance Rackspace gave for the second quarter, though the lower EBITDA margins (around 30% instead of 33% to 35%) bring the margin/leverage worries into focus. What troubles me is the long-run profitability. The combination of better than 10% long-term revenue growth and 15% free cash flow margin doesn't generate a fair value above the mid-$20s. Even a decade of compound free cash flow growth of over 20% only gets you to about $40, and I frankly find it hard to believe that this sort of business will produce sustainably strong free cash flow margins. Consequently, even after the big post-earnings decline, I still struggle to see the value in Rackspace shares.

At the time of writing, Stephen D. Simpson owned shares of EMC.