Rackspace Hosting Loves You, Investors

We're suffering mixed feelings at Motley Fool Rule Breakers today. On one hand, Zipcar is off more than 10% on a weaker-than-expected outlook. But on the other, Rackspace Hosting (NYSE: RAX  ) is rallying almost as much on a very strong fourth quarter report.

My Foolish colleague and Rule Breakers teammate Rick Munarriz has the details on Zipcar's fourth quarter, which allows us to dig into all the juicy goodness found in Rackspace's delicious report.

Let's start with the basics. Revenue zoomed 32% year over year and 7.1% sequentially in Q4. Net income improved 85% over last year's fourth quarter and 25.3% over Q3. Adjusted earnings per share came in at $0.18, two pennies ahead of estimates, according to S&P Capital IQ.

Still cloudy, with a chance of billions
Great as those numbers are, they don't fully express the leverage built into Rackspace's business model. For that you need to look deeper:

Metric

Q4 2011

Q3 2011

Q2 2011

Q1 2011

New revenue* $18,689.0 $17,343.0 $17,227.0 $15,276.0
Additional servers 1,088 4,689 3,555 4,458
New revenue per server $17,177.4 $3,698.7 $4,845.9 $3,426.6
Cloud computing as a % of revenue 20.6% 19.2% 17.4% 16.1%

Sources: press releases, TMF estimates.
*Numbers in millions.

Notice how sequential revenue gains aren't necessarily bound to increases in server count? That's leverage at work. Nor is it an accident that the gains coincide with cloud computing sales that comprise an ever-larger slice of the revenue pie.

"Cloud" sales refer to general agreements in which Rackspace supplies certain levels of hosting service while determining which servers and what software to use in order to make good. Customers have zero control over how infrastructure gets deployed. These engagements produce lower revenue but higher margins, CEO Lanham Napier said in an interview.

By contrast, "managed" hosting agreements specify both the types of services Rackspace will provide and guarantees at least some measure of customer control over the equipment and software used. Think of it as renting a snowblower, whereas cloud hosting is more like paying someone to shovel your driveway after a storm.

Both models work for boosting revenue, but when you compare the numbers year over year, you can see that cloud hosting is much more efficient:

Metric

Q4 2010

Q3 2010

Q2 2010

Q1 2010

New revenue* $15,016.0 $12,396.0 $8,509.0 $9,289.0
Additional servers 2,019 2,122 1,998 3,205
New revenue per server $7,437.3 $5,841.7 $4,258.8 $2,898.3
Cloud computing as a % of revenue 14.6% 13.4% 12.4% 10.8%

Sources: press releases, TMF estimates.
*Numbers in millions.

Cloud engagements are also easier to sell, judging by the numbers. Rackspace has added at least 9,000 new customers in each of the past four quarters. More than 172,000 were using its hosted platform as of Dec. 31, up from 130,000 the year prior. Gross margins are up 180 basis points over that period.

Moving up the value chain
What's interesting is how customers are viewing the cloud today versus how they did a few years ago. Today, they're more inclined to believe that a Web-based infrastructure can deliver as reliably as one built and hosted in-house. Rackspace is selling into this belief with what it calls a "Managed Cloud" offering that guarantees certain levels of service that, not long ago, would have required customers to create their own data center.

In our interview, Napier admitted there's a challenge to scale up Rackspace's own infrastructure to deliver at such a high level. But he also believes it's the best way to differentiate against Amazon.com's (Nasdaq: AMZN  ) cheaper Web Services offerings while producing the profits shareholders expect.

So far, the strategy is paying off. Rackspace is doing more to squeeze revenue and profit from its deployed assets. Gains in Q4 were overstated some because of excess server capacity built up in the second and third quarters, but normalizing for the full year shows monthly revenue per server improved 9.8% over 2010's average. Returns on capital improved 301 basis points over the same period.

Making the call: buy
As a member of my Big Idea Portfolio, Rackspace is a stock worth buying. I still believe that. Not only is the company making strides in every metric that matters, but there's also the fact that only a small portion -- perhaps less than 20% -- of customers that have scaled up their commitment to the Rackspace Cloud. As that ratio increases, so will profits, returns on capital, and, ultimately, shareholder returns.

Do you agree? Disagree? Either way, it makes sense to study how the Internet has changed computing. The Motley Fool recently dug into this trend in a video research brief titled "The Two Words Bill Gates Doesn't Want You to Hear." The report is free, but only for a limited time, so watch it now!

Add Rackspace Hosting to My Watchlist for up-to-the-minute Foolish coverage of the stock and your entire portfolio.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Rackspace Hosting at the time of publication. Check out Tim's Web home, portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Zipcar and Amazon.com. Motley Fool newsletter services have recommended buying shares of Rackspace Hosting, Zipcar, and Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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