Rackspace Has Already Racked Up A Demanding Valuation

By Stephen D. Simpson, CFA | February 16, 2012 AAA

Server hoster and cloud computing play Rackspace (NYSE:RAX) is a straightforward play on two of the biggest trends in IT today - cloud computing and big data. Unfortunately, the company has a valuation to match and it's joined the ranks of hot tech stocks. The question, then, is whether the company's service-oriented model can keep fostering the sort of growth it will take to not only stay ahead of rivals like Amazon (Nasdaq:AMZN) and Google (Nasdaq:GOOG), but to maintain those lofty premiums.

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Really Nothing to Disappoint in Q4
To its credit, Rackspace did everything it needed to do in Q4 and then some. Revenue rose 32% when compared to last year and about 7% when compared to the third quarter. The monthly installed base rose a bit more than 1%, while the average per-user revenue rose more than 7%. The company's cloud services revenue rose 86% from last year.

Service-heavy models usually take a bite out of margins, but Rackspace is nevertheless delivering good operating leverage. Gross margin improved almost two points from the prior year and a like amount on a sequential basis. Operating income (on a reported GAAP basis) rose 70%, while adjusted EBITDA climbed almost 42%. With operating and free cash flow both up as well, it would seem that Rackspace is doing better by just about every relevant metric. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

In Place to Exploit Technology
One of the pieces of Peter Lynch's advice that has always stuck with me is that it's better to bet on the companies that can exploit advances in technology rather than those making the advances. To that end, the fratricidal competition between server vendors like Dell (Nasdaq:DELL), Hewlett-Packard (NYSE:HPQ), and IBM (NYSE:IBM) is music to the ears of Rackspace, even while all of these companies would be more than happy to take away Rackspace customers for their own service businesses.

Rackspace does face a never-ending drive to upgrade its technology; the move to solid-state storage being the latest example. If Rackspace doesn't spend the money, Amazon or someone else will and Rackspace will lose the business. But Rackspace has some advantage in buying in larger volumes than most customers and charging premium prices for premium technology (the aforementioned SSDs).

Can a Service-Intensive Model Work?
Rackspace serves a clear need in the IT space. Just as many companies have neither the capital nor the inclination to buy/build their office real estate, furnishings or other capital, so too would many companies prefer to outsource IT needs like servers. Building hulking data centers is all well and good for large airlines, financial firms and major corporations, but the hundreds of thousands of small and medium-sized businesses out there can benefit from this outsourced model.

The question, though, is whether a service-heavy model can work. Companies like Amazon already offer competitive hosting that trades a lower price for lower levels of service, and there's a risk of companies like Verizon (NYSE:VZ) and AT&T (NYSE:T) getting into this market eventually. My suspicion is that there will always be a market for service, but the trick is getting customers to pay for it - look around the world today and it's not hard to find numerous examples where customers have traded service quality for price.

The Bottom Line
I like the services that Rackspace offers and I think it may be harder for companies like Amazon, Microsoft (Nasdaq:MSFT) and Google (Nasdaq:GOOG) to break into the market. That said, price is always an issue with any tech stock and Rackspace is richly valued today.

Maybe a trailing EV/EBTIDA of about 24 times is OK when adjusted EBITDA is growing around 40%, but it's difficult to build any sort of model that makes this stock look cheap. Valuation won't matter so long as the growth stays hot, but this is certainly not an undiscovered or overlooked opportunity at this point. (For related reading, see Relative Valuation Of Stocks Can Be A Trap.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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