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.

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

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.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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

Related Articles
  1. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  2. Entrepreneurship

    Top 10 Side Jobs You Could Start Now

    Ways to make extra cash in your spare time.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!