Rackspace's Big Bet Is Already Paying Off

Thanks to intense competition from the likes of Amazon.com (Nasdaq: AMZN  ) and AT&T (NYSE: T  ) , Rackspace Hosting (NYSE: RAX  ) has attracted more than its share of doubters over the years. Skeptics aren't laughing any longer. Shares of Rackspace zoomed 12% on Wednesday and are now up more than 25% year to date, or about double the return of the S&P 500 index over the same period.

Strong earnings fueled the gains. Revenue improved 29% to $319 million as earnings soared 38% to $0.18 per diluted share. Rackspace also continued a long-held string of adding roughly 10,000 new customers while keeping existing clients happy.

Most of the customer gains were small- and medium-sized businesses trying out Rackspace for the first time, but large customers are the ones driving revenue growth. "The reason enterprise customers can grow at a high rate here is they have large IT budgets, and big numbers generate large growth rates," CEO Lanham Napier said in an interview.

Don't discount the power of this truism. Big clients helped Rackspace grow revenue from the installed base by 1% monthly during Q2. Annualizing that comes to 12%, and suggests that roughly 40% of Rackspace's outrageous revenue growth comes just from serving existing customers better. Call it the practical impact of serving customers better than peers can.

But there's more to this stock story than improving revenue and profit. Look closer, and you'll find the business becoming more efficient as it grows:

Metric

Q2 2012

Q1 2012

Q4 2011

Q3 2011

New revenue*

$17,635.0 $18,094.0 $18,689.0 $17,343.0

Additional servers

2,540 2,633 1,088 4,689

New revenue per server

$6,942.9 $6,872.0 $17,177.4 $3,698.7

Cloud computing as a % of revenue

22.8% 21.5% 20.6% 19.2%

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

We know from comments from management that Q4 efficiency gains were an anomaly, the result of capitalizing on excess server capacity. Nevertheless, there's still a clear pattern at work here:

Metric

Q2 2011

Q1 2011

Q4 2010

Q3 2010

New revenue*

$17,227.0 $15,276.0 $15,016.0 $12,396.0

Additional servers

3,555 4,458 2,019 2,122

New revenue per server

$4,845.9 $3,426.6 $7,437.3 $5,841.7

Cloud computing as a % of revenue

17.4% 16.1% 14.6% 13.4%

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

Rackspace is earning higher returns for every server it deploys thanks to rising interest in cloud-based computing. Returns on capital are improving as a result, advancing from 14.4% in last year's second quarter to 15.5% in this year's Q2.

Expect further gains in the quarters ahead. This month, Rackspace began selling its first services based on the more advanced OpenStack software it's been touting for years. Cloud Servers and Cloud Databases are available immediately and come with an improved control panel for activating and managing services as needed.

Source: Rackspace Hosting.

The number and variety of these services aren't as important as how they've been developed. OpenStack is 100% open source, which means customers can take their data from Rackspace and move it anywhere else, at their leisure. Amazon Web Services, by contrast, is a custom-built system with proprietary hooks. Think of it as the difference between Apple's iOS and Google's Android.

"[A hosting platform] is a hotel not a jail," Rackspace President Lew Moorman said in an interview. "We think the idea of this being an open platform really does matter."

As an investor, I'm appreciative of Moorman's enthusiasm. But it's also fair to say that Rackspace remains in the beginning stages of seeing through its big bet on OpenStack. Future quarters will bring more investments in infrastructure and people. In Q2 alone, Rackspace hired 223 "Rackers" to handle the workload that comes with transitioning the business. Hiring well has never been more important.

Napier, for his part, believes Rackspace has an edge over peers in this area: "I do think culture is a competitive advantage, especially when we're talking about the talent war going on inside technology companies today. People want to volunteer their best and join a place that resonates with them, that they identify with. Having a good culture gives us an edge in recruiting."

With big clients comes big data
Rackspace is likely to need as much help as it can find. Tens of thousands of new customers are creating an avalanche of new data to capture and analyze. And Rackspace isn't the only one poised to profit. This company also has a big stake in big data. Grab a copy of this special free report to learn more now.

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 Apple, Google, and 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 Amazon.com, Google, and Apple. Motley Fool newsletter services have recommended buying shares of Google, Apple, Rackspace Hosting, and Amazon.com. 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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