Did Rackspace Deserve This Trouncing?

Three of my 15 stock holdings increased by more than 4% on Thursday. Another one jumped 2%. The market was just so full of promise -- some new, some delivering on old vows. And yet, my portfolio barely broke even. Why? One of my newest holdings plunged 25% in one day.

Ouch, dude. That swan dive came from cloud computing specialist Rackspace Hosting (NYSE: RAX  ) , based on a disappointing earnings report with a weak next-quarter outlook. The company is waist-deep in moving old customers over to the new OpenStack platform, leaving less resources for seeking out new contracts. So revenue jumped 20% year-over-year to $362 million, but Wall Street had expected $367 million. Rackspace rarely publishes quarterly guidance, but the second-quarter sales range provided this week sits 3% below analyst targets.

The report sparked at least four analyst downgrades, but also one opportunistic upgrade. I reached out to Stephens analyst Barry McCarver to see why he's swimming against the stream on this call.

McCarver's research note to clients says that the stock is likely hitting "rock bottom" right about now. The upgrade is meant to reap the benefits of an upcoming surge in large enterprise customer signings while the stock is unreasonably cheap.

The way McCarver sees it, Rackspace plays in a slightly different sandbox than archrival Amazon.com and most of its traditional competitors. Both Amazon and Google recently slashed the price tags on their "platform as a service" products, playing a time-honored game of price-sensitive sales. But Rackspace didn't follow suit entirely.

Instead, Rackspace offered discounts on a couple of key products but actually raised prices on the main platform offering. Not directly, you understand, but by keeping a price premium on the new OpenStack virtual servers when compared to older solutions.

Customers are dragging their feet in this transition, which explains why sales came in below expectations. The same trend is also responsible for the weak revenue guidance in the current quarter.

But McCarver believes (and I agree) that Rackspace is actually building the foundation of a strong growth engine here. The payoff may be delayed, but it's coming in the second half of 2013, onward.

The whole OpenStack strategy is aimed at the enterprise space, where large potential contracts roam free. It's a huge weapon in Rackspace's arsenal, second only to the company's vaunted customer-service focus. You might pay a little more for a Rackspace virtual server, but you also get what you pay for. "Pricing is only one of many metrics in play when large enterprises are picking a cloud platform," McCarver said.

And that's why enterprise contracts should provide an upward catalyst in a couple of quarters. "Today, or maybe later this week, ought to be the trough" for Rackspace shares, McCarver said. "The company has tremendous long-term earnings power, and the stock is cheap below $40."

Lost in the revenue shuffle, Rackspace actually delivered earnings just above Street targets. I do agree that the long-term story looks intact here, and would treat this trough as a buy-in opportunity. My personal stake and bullish CAPScall are staying put.

RAX Chart

RAX data by YCharts.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2013, at 6:17 PM, pastabelly wrote:

    Another MF bbn and core stock takes a hit. This reminds me of last year when GMCR tanked and I panic sold it at a loss. In my defense it was "panic taken" out of the core which was 90% of my panic selling decision. I learned an important lesson from GMCR. I've had RAX for a few years now and will continue to hold and see what happens.

  • Report this Comment On May 11, 2013, at 12:12 PM, earlyseller wrote:

    Well Well Well. So one of TMFs picks tanked. So what can you do to minimize the down side impact? How about becoming a Bill O'Neill of IBD follower and keep you stop loss at about 10% or keep up with PUT options as a better entry point to earn income and buy stocks at lower prices when they or the market falls, corrects or tanks. Is Minimizing your losses your only objective or making more profitable picks and holding thru "thick and thin?"

    Set a buy percentage below the current price and stick to it. If you get the bargain, great. If you don't, there are "OTHER" opportunities all the time. You may even Google them for more info to help your decision process, assuming you have one.

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