Is Rackspace's Cloud Business in Big Trouble?

Apparently, Rackspace (NYSE: RAX  ) is a premium service provider that doesn't feel it necessary to lower the prices of its cloud infrastructure, or laaS, products to match competitors. These competitors include juggernauts Amazon (NASDAQ: AMZN  ) , Google (NASDAQ: GOOG  ) , and Microsoft (NASDAQ: MSFT  ) , just to name a few. Is Rackspace making a mistake, and if so, how will this decision impact its stock?

Rackspace: Cloud products are important
If you're an investor in Rackspace, much of the reason has to do with its cloud infrastructure business, also called its public cloud revenue. In the company's last quarter, it reported revenue of $408 million, which was good for growth of 15.6% year-over-year. However, nearly one-third of that revenue came from its public cloud business, a unit that grew 34%, which includes its cloud infrastructure business.

Albeit, Rackspace's cloud infrastructure business is growing at twice the rate of its total revenue. Still, Rackspace has consistently seen its market share decline, as was the case last quarter. Revenue from cloud is growing slower than the overall industry. Particularly, laaS, combined with cloud app platform, or PaaS, grew 52% in the fourth quarter. However, investors have been satisfied with Rackspace's growth, although it has been noticeably slower than the overall market.

An industrywide trend
Rackspace's cloud business is important to its overall valuation, and the company faces the toughest of competition possible. Google, Amazon, and Microsoft all have a sizable presence in this fast-growing arena, and each have made moves to strengthen their position in the space.

Google's market share of the laaS/PaaS market stood at roughly 5% in the fourth quarter of last year, or $150 million. While this looks fairly insignificant relative to its overall business, this market reached nearly $10 billion last year, with over $3 billion in the fourth quarter alone. Hence, it's a market that Google wants to control, and therefore has cut laaS and PaaS prices by 32% and 30%, respectively, to gain market share.

Microsoft saw its cloud business more than double in the fourth quarter of last year to exceed $200 million, giving it a total market share or more than 7%. In response to Google's price cuts, Microsoft cut prices from 27%-35% across all cloud product offerings, showing its desire to own this space.

However, Amazon is the current kingpin; Amazon Web Services, or AWS, has a market share over 30% and grew a whopping 65% in the fourth quarter. Yet, despite this dominance, Amazon slashed prices following Google's cloud cuts. The majority of its top cloud services saw price cuts of 30% of more, making it the 42nd cut in AWS's history. Clearly, Amazon wants to protect its position, as the business generated $3.7 billion last year and is now worth $50 billion, according to Evercore.

What is Rackspace doing about it?
Rackspace is facing some tough competition, and investors must wonder how the company plans to compete against this arsenal of tech juggernauts. According to chief technology officer John Engates, Rackspace provides premium services and does not base pricing on the actions of competitors. In other words, Rackspace is not going to match its price-cutting peers.

The problem is that Rackspace does not have an edge, nor a premium product. According to The Channel, Rackspace charges $0.68 per hour for a 15GB cloud server with SSD storage. Yet, for an equivalent product, Amazon now charges $0.28, as does Google minus the SSD storage.

Final thoughts
Essentially, Rackspace charges a premium of more than 140% for nearly identical technology offered by peers Google and Amazon. To conclude that price cuts are not necessary is absurd.

With that said, these price cuts are sure to affect Rackspace, and without as much leverage, it appears that Rackspace is willing to try its luck in an attempt to maintain growth and protect margins. However, this ideology will likely falter, and the only logic needed is common sense: A discount of 50% or more for an equal product equals bad news for both Rackspace and investors.

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Read/Post Comments (4) | Recommend This Article (2)

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 April 11, 2014, at 3:02 PM, cruzn59 wrote:

    The stock dropped 70 cents after this report came out despite the news enclosed is simply a rehash of headline summaries from the last 5-10 business days. For being the most intelligent species it never ceases to amaze me that most of our trading decisions come down to the herd mentality. Everyone is running, the sky must be falling. The only other truth that must be considered was when Morgan Stanley analyst Simon Flannery gave RAX a thumbs up that based on his less than stellar record many decided to sell. In hindsight that would have been an amazing and profitable decision. There was a comment found on Ameritrade's site that IBM was courting a RAX buyout at $47 per share. Although this article was only RAX negative and it might not be as "short" biased as desired, I would like to know more about the details of such a purchase.

  • Report this Comment On April 12, 2014, at 1:17 AM, sliderw wrote:

    Rackspace customers and prospective customers easily see its unwillingness to cut prices like its competitors did. Hence, Rackspace can kiss growth goodbye in its cloud business.

  • Report this Comment On April 12, 2014, at 12:27 PM, eyeknonothing wrote:

    I was impressed with the "fanatical support" line at first. Now however, I make the analogy of two restaurants. They both serve the same quality of food, one has regular service. The other has 'fanatical service'. The first one charges half of what the second one charges. It's a no brainer, no?

  • Report this Comment On April 14, 2014, at 9:59 AM, adtFoolish wrote:

    @eyeknonothing.

    No. Why be a burger king when you can be a chipolte? For coffee, why be a mcdonalds when you can be a starbucks?

    Most analysts don't get that there are varying product/service offerings in the cloudspace and RAX realizes chase the low margin market is a mistake for them. Rackspace has been there with web hosting and learned that lesson before.

    FD; Im long RAX

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