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What to Do With Rackspace Ahead of Earnings

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Rackspace's (NYSE: RAX  ) management has a lot riding on the coming quarter's results. At the Credit Suisse conference, CEO Lanham Napier said two rather significant things: The company has made investments in building out infrastructure to grow the business, although revenue hasn't been realized, yet. Plus, "in no way do we think that our economic model is profoundly different than it was a year ago."

Lanham stuck his neck out and is boldly pronouncing that the selling environment is stable, and that even though the company made a few missteps, it will right itself in 2014. Its possible that he was just trying to ensure a strong finish going into the end of the year, but this is a very bold statement and one that seems to be supported by his personal trading.

The question investors should ask is, how much does he know? Two months after the Credit Suisse conference, (NASDAQ: AMZN  ) dramatically cut prices by 22%-50%, depending on the service. This was followed by Microsoft (NASDAQ: MSFT  ) specifically citing Amazon's price cut as the reason it, too, was cutting prices.

Unreasonable competition is the biggest concern for Rackspace
Although this is not the primary line of business for either company, each has decided that this is a strategic part of the vision. In the case of Microsoft, it is easy to see the ties to its Windows server business. In the case of Amazon, it is selling the IP it generated while building its own architecture. By allowing others to leverage its experience, Amazon gains economies of scale in addition to incremental revenue. These are two scary competitors.

Upcoming earnings call will reveal the size of the moat
Rackspace considers itself to be in the high end of the cloud outsourcing market and may have differentiating intellectual property, but when a war is raging all around, you can't expect to avoid injury. From the tone of those press releases, it appears as if the two technology behemoths are going to the mattresses. We will hear more about the 2014 outlook on the earnings call, scheduled for the afternoon of Feb. 10.

The stock isn't expensive if it can meet or beat estimates
Expectations were dramatically ratcheted down in 2013, as the company's shares lost 50% of their value over the course of the year. Today, the Street is expecting earnings of $0.88 for 2014, which, at a price of $36 results in a forward price-to-earnings ratio of 40. However, if the aggressive pricing significantly crimps growth, there could be far to fall.

Even though the company has little debt, it only has nearly $2 in cash and slightly over $6 in book value per share. Therefore, any acquirers looking at the business would be paying, primarily, for future earnings rather than assets. Over the years, the "close your eyes and buy" price for a tech company has been approximately two times its cash.

Contrary to popular belief, the CEO is not dumping his stock
On the flip side, contrary to popular belief, the CEO is not dumping his holdings, which leads back to the notion that Lanham believes he can bring the company to the next level. A closer look at the Form 4s that started this rumor shows that the number of shares Lanham holds directly did not change significantly. He exercised options and sold the stock, which was sizable, but this was likely driven by grant and vesting dates rather than share price.

At the end of November 2013, Lanham held 886,000 shares directly, 3.6 million through his LLC, and 37,500 in trust for his children. At the end of November 2012, he held 892,000 shares directly, 3.6 million through the LLC and 37,500 in trust for his children. Although nearly 1 million shares were bought through an option purchase and sold the following day, his underlying holdings (and personal exposure) remain the same.

Foolish final thoughts 
Sadly, this is one stock you shouldn't buy ahead of the earnings call, as the reward/risk is skewed to the downside. The EPS estimate for 2014 could drop significantly, and if it doesn't you should have time to buy after the call. That said, this company should be on your watch list. Turnaround candidates can be very profitable while being safe, if you wait to see the turnaround taking hold.

This is The Motley Fool's top stock for 2014
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David Eller

I started contributing to the Motley Fool in 2013. I have held research positions at two investment banks and two hedge funds before trying more entrepreneurial ventures. I'm passionate about helping people find freedom in financial independence. Feel free to add comments and start a discussion. I hope to use these articles as forums to learn from you as well as share my opinion.

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8/28/2015 4:00 PM
RAX $31.26 Up +0.31 +1.00%
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