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Rackspace Gets Punished for Being Smart

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Shares of Rackspace Hosting (NYSE: RAX  ) were down more than 14% at one point today on what some Big Money investors appear to believe were disappointing first-quarter results.

Revenue, up 31% to $301 million, beat estimates by $1 million, but earnings were a different story. A 71% gain on the bottom line resulted in $0.17 in adjusted profits, a penny short of what Wall Street had hoped for. Whoops.

Could a single missing Lincoln really be the source of so much trouble? That's tougher to say, but margin seems to be the bigger issue. Rackspace converted just 33.4% of revenue as earnings before interest, taxes, depreciation, and amortization -- or EBITDA -- down from 36.1% in the fourth quarter.

In an interview, Chief Financial Officer Karl Pichler said hiring new staff has increased costs over the past two quarters. Rackspace has also added new space in the Midwest as it transitions its own cloud computing infrastructure to run on the OpenStack platform that it has long touted in concert with NASA.

Opening up with OpenStack
Think of it as a toolbox. OpenStack provides a series of software components any company can use to create and run "clouds" for virtual storage or computing at a basic level, and much more for those willing to experiment with the available code. As the name suggests, OpenStack is 100% open source.

Why adopt OpenStack? Two reasons. Rackspace isn't exactly youthful, having opened for business in 1998. Updating the Rackspace Cloud to take advantage of newer cloud technologies makes sense. Second, Pichler said OpenStack should allow Rackspace to offer more sophisticated features and, as a result, should help the company deliver EBITDA margin on par with its late 2011 performance.

CEO Lanham Napier expanded on this idea during yesterday's conference call with analysts: "Our belief here is that [the] new platform has greater capability to run larger and more complex apps on it than our current platform does. So we like our chances in terms of being able to serve bigger customers better, to increase their royalty rates and correspondingly, grow faster."

OpenStack remains in testing for now, available to only a select few Rackspace customers. Pichler said general availability should come in the third or fourth quarter, at which point customers will be simply moved over to the new platform. Earnings volatility is likely to continue until then.

Why OpenStack matters
Napier is right to focus on features and scale in his comments about OpenStack. A better, more durable infrastructure increases the chances of Rackspace taking on big clients with big needs. But having it be open source matters, too.

Why? Anyone can use the tools, which means -- unlike's (Nasdaq: AMZN  ) Amazon Web Services (AWS) platform, which is custom designed -- there's no special sauce required to design software for Rackspace's OpenStack infrastructure. The universe of potential customers gets bigger.

Think of it this way: When it comes to delivering infrastructure on demand, Amazon and AWS is to Rackspace and OpenStack, as Microsoft and Windows is to Red Hat (NYSE: RHT  ) and Red Hat Linux.

Does that mean AWS could lose customers who crave openness to Rackspace and OpenStack? Not necessarily, since these are two very different businesses. AWS is a host-on-the-cheap alternative; Rackspace is a high-touch, service-when-you-need-it premium operator.

Meanwhile, Amazon works with an OpenStack alternative in Eucalyptus Systems, and Citrix Systems (Nasdaq: CTXS  ) has its own take on cloud infrastructure, a project called CloudStack. There's no guarantee customers will embrace OpenStack and the new Rackspace Cloud. But with more than 150 companies already working with the platform in some form, the odds appear to be in Rackspace's favor.

So even if the first quarter's miss didn't please investors, today's margin-thinning investments in technical staff and a newer, smarter Rackspace Cloud should pay off over the long term in the form of bigger, more profitable hosting deals. Of course, Rackspace isn't the only one profiting from the rising tide of data in the cloud. This company has just as much runway, thanks to big clients such as PayPal and 3M.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team and the Motley Fool Supernova Odyssey I mission. 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 and Microsoft. Motley Fool newsletter services have recommended buying shares of Rackspace Hosting, Microsoft, 3M, and, as well as creating a diagonal call position in 3M and a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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  • Report this Comment On May 10, 2012, at 11:18 PM, kavier wrote:

    Thanks for your take on RAX. I have it on my watch list for now.


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