Is Rackspace Hosting Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Rackspace Hosting (NYSE: RAX  ) fit the bill? Let's look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Rackspace's story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's look at Rackspace's key statistics:

RAX Total Return Price Chart

RAX Total Return Price data by YCharts

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

101.2%

Pass

Improving profit margin

13.8%

Pass

Free cash flow growth > Net income growth

(54.9%) vs. 129%

Fail

Improving EPS

117.1%

Pass

Stock growth (+ 15%) < EPS growth

42.7% vs. 117.1%

Pass

Source: YCharts.
*Period begins at end of Q3 2010.

RAX Return on Equity (TTM) Chart

RAX Return on Equity (TTM) data by YCharts

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(3.7%)

Fail

Declining debt to equity

(98.5%)

Pass

Source: YCharts.
*Period begins at end of Q3 2010.

How we got here and where we're going
We first looked at Rackspace last year, and it earned the same score today as it did then: five out of seven possible passing grades. The company was close to earning a sixth passing grade on the return-on-equity analysis, and a strong uptick in free cash flow could put it within striking distance of a perfect score next year, particularly if its share price remains more reasonable relative to its impressive net income growth (which has nevertheless stalled out in recent quarters). How can Rackspace move back up from good to truly great? Let's dig deeper to find out.

Rackspace's shares tumbled as much as 12% after the hosting giant reported disappointing third-quarter results. The company's revenue improved by 16%, but net income fell by a whopping 40% amid cutthroat competition from massive and deep-pocketed rivals such as Amazon.com (NASDAQ: AMZN  ) , Google (NASDAQ: GOOGL  ) , and Microsoft (NASDAQ: MSFT  ) . Fool contributor Lee Samaha points out that these companies have been locked in a price war to capture market share in a fast-growing field -- as a result, Rackspace's operating margin is now a rather tepid 7.1%.

Amazon's Web Services recently cut its prices by nearly 10% across all offerings, while Microsoft's aggressive discounts have made it hard for Rackspace and other rivals to hold the line. Microsoft rolled out a newer version of Hadoop, which allows clients to access a cluster of servers for data analysis using its Windows Azure cloud platform. Amazon's AppSteam, which can stream resource-intensive applications and games from the cloud, appears to extend the reach and functionality of the company's flagship Elastic Compute Cloud, recently bolstered with a deployment of over 1,500 graphics processing cores.

Rackspace's "Fanatical Support" remains its full-service edge in the cloud-computing market, but full service tends to involve higher capital costs: Rackspace now forecasts that its full-year capital expenditures will be in the $460 million to $510 million range. Lee Samaha notes that most of Rackspace's investment will be made in cloud infrastructures and customer gear, and the rest will go toward purchasing land for datacenters.

Fool contributor Tim Beyers notes that Rackspace has been trying to play it safer after dominating the global cloud-computing market for several years. The company recently introduced a new line of Performance Cloud Servers, which claim to perform 2.6 times better when handling large jobs in the cloud. The company also completed the acquisition of ObjectRocket and its MongoDB database management system earlier this year to strengthen its position in the Big Data space. Diversification is good, but over the long run, Rackspace will have to differentiate itself substantially if it hopes to overcome persistent price wars that are sure to plague cloud computing as hundred-billion-dollar tech behemoths pour resources into the sector.

Putting the pieces together
Today, Rackspace Hosting has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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