How Rackspace Profits From Cloud Computing

Overpriced. Commodity service. Too much competition.

Among bearish investors, these are the three words most often used to describe Rackspace Hosting (NYSE: RAX  ) . But are they fair? I'm not buying it. With each passing quarter, the company gets better at squeezing revenue and profit out of its burgeoning digital fiefdom.

A brief overview of how cloud computing works
More on how Rackspace's business works in a moment. First, we need to dig into why it exists. The answer's simple: code. The 0s and 1s of software have to live somewhere, and in today's Web-connected world that's usually on a server plugged into a network connected to the Internet.

Programmers who distribute software that operates within a browser -- a process we've come to call "cloud computing" -- need infrastructure to host the code they're selling. They either buy their own servers, storage, security, bandwidth, and everything else that goes into hosting or they rent from Rackspace or a peer such as Terremark Worldwide (Nasdaq: TMRK  ) .

A fiefdom, not a kingdom
As you might have noticed in looking at Rackspace's prodigious growth rates, many coders choose to rent.

What makes Rackspace particularly interesting is that it has built what amounts to a digital real estate empire without owning much real estate. Equinix (Nasdaq: EQIX  ) , Digital Realty (NYSE: DLR  ) , and AT&T (NYSE: T  ) are the big data center operators. Rackspace's specialty is servers.

Each one is for rent. What gets rented is determined contractually and then designed into the network. Some clients demand dedicated servers and storage equipment they can access and control. Others simply want to be able to load their software and have it run reliably. In neither instance is a scrap of land required to deliver service.

Therein lies the irony. Rackspace is both landlord and renter. Equinix has been a real estate partner for years.

The advantages of playing both sides
Skeptics see Rackspace operating in the middle and figure the company will get squeezed out of business. They argue competition is too fierce and that pricing pressure will irreparably harm margins and therefore profits.

"Very competitive market, Amazon.com (Nasdaq: AMZN  ) is doing very well with EC2. Margins in the hosting business are very low," wrote Foolish investor mpapile last April, when the stock was still trading for under $10 per share.

I can't blame this Fool for being skeptical. Amazon.com is a big participant in the hosting business and recently introduced a free entry-level tier of Web services. All signs point to the e-commerce king forcing Rackspace to fight for every dollar it earns.

The good news? Rackspace carries a heckuva left hook:

Metric

Q3 2010

Q2 2010

Q1 2010

Q4 2009

New revenue* $12,396.0 $8,509.0 $9,289.0 $7,117.0
Additional servers 2,122 1,998 3,205 2,016
New revenue per server $5,841.7 $4,258.8 $2,898.3 $3,530.3
Cloud computing as a % of revenue 13.4% 12.4% 10.8% 10.1%

Source: Rackspace press releases, TMF estimates. *Numbers in millions.

Notice how revenue per server is climbing just as cloud computing services are accounting for a greater portion of revenue. Because cloud customers don't control their infrastructure, and don't want to, they afford Rackspace the leeway to push servers to the point of maximum efficiency.

Metric

Q3 2009

Q2 2009

Q1 2009

Q4 2008

New revenue $10,404.0 $6,918.0 $1,940.0 $4,783.0
Additional servers 2,386 2,231 2,520 2,287
New revenue per server $4,360.4 $3,100.9 $769.8 $2,091.4
Cloud computing as a % of revenue 9.4% 8.6% 7.5% 6.2%

Source: Rackspace press releases, TMF estimates. *Numbers in millions.

Year over year, the story gets even better. In the recently completed third quarter, Rackspace took in 33.3% more per server than it did the year prior.

VMware (NYSE: VMW  ) and its virtualization peers helped create the boost. Rackspace uses virtualization software to split servers into "instances" of storage capacity and processing power. More instances means more profit and progressively higher returns on capital deployed. But again, don't take my word for it:

Quarter

Cloud Portion of Revenue

Annualized Return on Capital

Q3 2010 13.4% 12.5%
Q2 2010 12.4% 10.9%
Q1 2010 10.8% 10.6%
Q4 2009 10.1% 10%

Source: Rackspace press releases.

Now it's your turn
Numbers like these are why I'm content to let the skeptics sour on Rackspace. Yes, there's plenty of competition. So what? If competition were really an overriding issue, Rackspace would have died early. Instead, the company is poised to celebrate its 13th year in business in 2011.

Want to learn more about Rackspace? Join us in a live chat with CEO Lanham Napier on Nov. 19 at noon EST. Mr. Napier will be taking questions directly from you, our Fool.com readers, so click below to set an email reminder so you don't miss out on this opportunity!

Amazon.com is a Motley Fool Stock Advisor selection. Rackspace Hosting and VMware are Motley Fool Rule Breakers recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is as brilliant as it can be.


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