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Rackspace's 1,000 Cuts Spell More Pain but Not Death

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Shares of Rackspace Hosting, (NYSE: RAX  ) had another difficult week as both Amazon and Google cut pricing of cloud services. Shares ended down 5.3% for the week and 20% for the year as investors sold ahead of the first quarter closing on Monday. Looking ahead, it is difficult to see how Rackspace will not be affected by this new round of cuts.

Cost cutting is accelerating, not slowing
Google, (NASDAQ: GOOGL  ) fired its most recent shot at Amazon on March 25, when it cut prices massively in an attempt to bring cloud computing pricing in parity with Moore's Law. The price cuts amounted to a drop in on-demand, pay-as-you-go services by 30%-85%., (NASDAQ: AMZN  ) fired back a day later in a blog posting that begins with the sentence: "It is always fun to write about price reductions." Amazon and Google are competing for the reputation of being the low-cost services player and the award that goes to the winner is the hearts and minds of developers. This price cut by Amazon is the 42nd since 2008, and there is no sign of it stopping anytime soon.

Amazon's blog post, goes on to tell customers that these reductions will be applied to their bills without any action on their behalf. You have to love this. When was the last time that your cable bill dropped because Comcast's equipment prices fell?

Amazon and Google are giving their profits back to the customers and they can afford to do this because the businesses are being funded by other operations. That isn't the case for Rackspace and it's now hitting the financials. In 2013, many of the traditional metrics used to gauge successful growth improved. Revenue of $1.1 billion, grew 11%, the number of employees grew 16.5% to 5,651, and the number of servers deployed grew 14.8% to 103,886. Unfortunately, profits reversed direction as income from operations declined to $133 million, down 22.9% from 2012.

Financial impact will be greater in 2014 than 2013
Looking ahead, it is difficult to know how much of an impact pricing can have on the financials, which is the most direct correlation to share price. However, the company has value to competitors in a host of different ways. Rackspace has consistently been at the cutting edge of cloud infrastructure development -- e.g., its joint project with NASA, Openstack. It is ranked as the 29th best company to work for by Fortune. By being at the cutting edge with a good corporate culture, the company has amassed a team of highly sought-after engineers, making it an interesting acquisition candidate for the likes of IBM, Amazon or Google.

What's a fair price for a great culture and intellectual property?
This leaves the question of price. What price would a competitor be willing to pay for the company? Looking at the issue using traditional metrics is difficult. The shares are trading at a trailing price-to-earnings ratio of 51, but the real forward P/E could be much greater. It's likely that a new CEO will fill the open slot left by its now-retired chief executive and slash costs, but it better happen quickly before the talent goes elsewhere.

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  • Report this Comment On April 01, 2014, at 5:29 PM, 45ACPbullseye wrote:

    David, this is an excellent and timely article! I tend to focus on companies through a real estate "lens." I often write about equity REITs, including the data center and communication tower sectors. I really appreciate your taking the time to include the links in your article. Best, Bill

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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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