Why Rackspace Has Farther to Fall

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Too often, investors stay with an investment after the fundamentals have turned. Take Rackspace Hosting (NYSE: RAX  ) for example -- you can admire the company and recognize its strengths, but you must admit that it's not going to change and you probably shouldn't keep it in your portfolio.

Rackspace is the leader in third-party hosting. It founded OpenStack (an open-source operating system for the cloud), it employs over 5,000 people, and it is on Fortune's list of the 100 Best Companies to Work For. The stock reflected this strength, growing from $4 per share to $81 between 2008-2013. These are good reasons to admire the company, but as an investor you cannot ignore changes in fundamentals, and last year they changed. Today, both revenue growth and profitability are dropping because the company has lost pricing power.

It was a good quarter, but Rackspace announced revenue and earnings of $408 million and $0.14, respectively, that were in line with consensus. However, profit was down 33% from the prior year.  Even though guidance was slightly ahead of expectations for the coming year, the announcement that Lanham Napier would be stepping down immediately caused a shock wave, indicating that people don't necessarily trust the numbers. Executive turnover often indicates that something bad is about to happen, and CEOs rarely step down immediately. The board of directors seems to think drastic action is needed.

Rackspace is caught between titans
Rackspace is caught in the middle of a duel between Amazon (NASDAQ: AMZN  ) and Google (NASDAQ: GOOGL  ) where price is being used to attract clients. Amazon and Google are leapfrogging each other with price drops: Amazon in July 2013, Google in December 2013 and Amazon again in January 2014. Rackspace offers a differentiated service, but it hasn't been able to maintain both growth and pricing, and margins have fallen as a result. There doesn't seem to be an end in sight and as contracts are renewed, Rackspace will continue to feel pricing pressure.

Amazon developed its cloud computing initiative in 2006 to leverage its experience building internal datacenters. According to Andy Jassy's keynote at the AWS Invent conference, reduced prices lead to more AWS usage, which leads to economies of scale, which leads back to reduced prices. This is a compelling value proposition, and to get an idea of the scope of the project, in 2012, Amazon added enough server capacity every day to power the "2003 Amazon infrastructure."

Google came into the game later, but according to CNet, it's "now ready for prime time." Customers such as Snapchat and Evite have built complex systems using the service. To manage this new business, Google has recruited some heavy hitters including Ari Balogh, formerly Yahoo!'s CTO, who now manages the storage infrastructure group. Google has been able to use its capital to attract top tier talent in an effort to catch up to Amazon, and if CNet is to be believed, it's succeeding.

What happens to Rackspace?
Even though the company has been meeting expectations, those expectations are being reduced on a daily basis. The war chests at Google and Amazon are being funded by the profits from other businesses and Rackspace cannot compete in a pricing war. Since the company has been reinvesting its profits to gain market share, the balance sheet isn't cash rich and the stock price could fall to single digits before it is supported by asset prices. I respect what the company has been able to achieve, but the market is becoming commoditized and there are better places for people to invest.

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Comments from our Foolish Readers

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 February 13, 2014, at 3:30 PM, chomp20x wrote:

    And yet this stock is a formal recommendation of a Motley Fool service? With this in mind, what might be some good reasons (I'm assuming there are since it is a stock rec.) for investing in the company in the long-term?

  • Report this Comment On February 13, 2014, at 6:24 PM, dpelleratgmail wrote:

    Hi chomp20x, Thank you for the feedback and the reasonable question. I'm a contractor for Motley Fool and just publish my personal opinions independently of any other services the company offers. Over my career, I was both a buyside and sellside analyst and try to point out issues that will protect investors or allow them to capitalize on trends that the professionals see but the public may not. Feel free to follow me on twitter @ronin_ip for followup on articles like this.

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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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