As My Portfolio Wanes, Rackspace Opens Up About OpenStack

Each week, I report the results of the Big Idea Portfolio, a collection of five tech stocks that I believe will crush the market over a three-year period. I've done it before; my last tussle with Mr. Market ended with me beating the index's average return by 13.35%.

Real money was on the line then as it is now, which means any one of the five stocks you see below could cause me a lot of public embarrassment. This week, Rackspace Hosting (NYSE: RAX  ) cost me after reporting revenue and earnings that were in line with Wall Street estimates.

The stock was down nearly 12% through Thursday's close and was off another 2% Friday morning on what appeared to be profit taking. Rackspace's premium valuation -- the stock trades for more than 80 times trailing earnings and 50 times estimates -- may have investors rushing to diversify into cheaper, dividend-paying alternatives.

So be it; Rackspace performed well in Q3. Revenue rose 27% and net income jumped 36%. Returns on capital rose to 16% from 14.8% in last year's Q3 as the company generated more than $40 million in free cash flow. And that's despite heavy investments in transforming its hosting infrastructure to an open-source technology called OpenStack.

The idea, CEO Lanham Napier said in an interview, is to bring the same sorts of dedicated equipment service levels Rackspace provides to top clients such as Southwest Airlines (NYSE: LUV  ) to the public cloud, where "unit economics" are better.

"OpenStack allows us to scale higher. It allows us to use a cheaper server that we can utilize for a longer period of time ... all of which creates compute efficiency, storage efficiency, and network efficiency," Napier said, noting that greater efficiency leads to higher returns on capital, and ultimately profits.

What's the Big Idea this week?
So far he's been right to bet on the public cloud, but we're also in the early days of implementing OpenStack. Investors aren't yet ready to believe Rackspace can deliver on the premium it trades for, resulting in the sell-off that sank my portfolio for the second consecutive week. Mr. Market gained 6 percentage points on me in our battle for stock-picking supremacy.

Not that the indexes have done particularly well this week. They just didn't lose as much as my five stocks. The Dow dropped 2.15% while the small-cap Russell 2000 declined 2.54% and the S&P 500 fell 2.59%. The tech-heavy Nasdaq led the losers with a 2.90% drop, according to data supplied by The Wall Street Journal. Here's a closer look at where I stood through Thursday's close:

Company

Starting Price*

Recent Price

Total Return

Apple (Nasdaq: AAPL  )

$418.68**

$537.75

28.4% 

Google (Nasdaq: GOOG  )

$650.09

$652.29

0.3% 

Rackspace Hosting

$41.65

$61.54

47.8% 

Riverbed Technology (Nasdaq: RVBD  )

$25.95

$17.50

(32.6%) 

Salesforce.com (NYSE: CRM  )

$100.93

$143.28

41.9% 

AVERAGE RETURN

--

--

17.16%

S&P 500 SPDR

$125.83**

$138.04

9.70% 

DIFFERENCE

--

--

7.46%

Source: Yahoo! Finance.
*Tracking began at market close on Jan. 6, 2012.
**Adjusted for dividends and other returns of capital.

Notable newsmakers
None of the other stocks in my portfolio reported major news this week, though all signs point to strong sales of Apple's iPad Mini. More tablets -- and, in particular, more Internet-connected devices -- also bode well for Google, which is quietly building the world's largest Database of Everything.

In other tech news, priceline.com (Nasdaq: PCLN  ) on Thursday night announced plans to acquire recent IPO Kayak Software (Nasdaq: KYAK  ) for $1.8 billion, a 29% premium to the day's close. The price also amounts to $1.63 per search -- Kayak's engine handled 1.1 billion travel queries over the past year -- and takes a potential Rule Breaker out before it can become a threat to industry incumbents.

Groupon (Nasdaq: GRPN  ) didn't fare so well. The group-buying specialist reported still more trouble in Europe as revenue missed analyst targets. Revenue rose 32% to $568.6 million, well short of the $590 million Wall Street was hoping for. European sales grew just 3% versus 80% for North America. The stock fell as much as 29% in Friday morning trading.

The message? Retail is a tough business stuck in the middle of a paradigm shift so massive that it draws parallels to the dawn of mail order last century. Only the most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the "3 Companies Ready to Rule Retail" in a new special report. Uncovering these top picks is free today; just click here to read more.


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