Fanatical or Delusional: Is Rackspace Back?

Rackspace  (NYSE: RAX  ) has been a punching-bag stock for the past nine months as its earnings were getting crushed. The popular refrain was that Amazon.com  (NASDAQ: AMZN  ) and other, larger companies had commoditized the cloud storage business and that Rackspace's "fanatical support" -- and accompanying higher prices -- were getting squeezed out. The result was a so-called growth company with declining margins. This is what happens to growth companies when their margins get crushed:

RAX Chart

RAX data. Source: YCharts.

But the just-announced first-quarter earnings report indicates that the rumors of Rackspace's death were premature, with net income up 22% from a year ago, revenue up 16% from last year, and 3% sequentially. Is this proof that Rackspace's business model of high-level support has a place in cloud computing or a last gasp before the unmanaged cloud kings like Amazon and Google race to the bottom? Let's take a closer look.

Fanatical or delusional?

Source: Rackspace.

For the past year or so, Rackspace has been saying that the company's big investment in the Openstack platform would pay big dividends, but would take time to cement itself into the market. While this was happening, Rackspace competitors in the cloud, especially Google  (NASDAQ: GOOGL  ) (NASDAQ: GOOG  )  and Amazon, have been aggressively lowering prices for unmanaged cloud and computing capacity. Toss in CEO Lanham Napier's somewhat sudden retirement, and the outside view paints a picture of a company in turmoil. 

However, co-founder and executive Chairman Graham Weston's return to the CEO role puts the company in capable hands, and with Taylor Rhodes -- a six-year Rackspace veteran with a focus on customers -- now president, and Will Knight -- a longtime Microsoft executive and industry veteran -- running its channel strategy, Weston has a strong supporting cast around him to keep Rackspace focused on doing what it's best at: managing and supporting customers' cloud needs, versus Amazon's and Google's "Here's your cloud -- now figure it out" model at cut-rate prices. 

OpenStack or OpenStink?
The OpenStack conversion was driven by what Rackspace saw as the future of the cloud: a hybrid approach where companies wanted to leverage the sunk money of their current capabilities and augment that with cloud services, as well as both public and private clouds. According to Rhodes in the recent earnings call:

If you think about, again, this emergence of the cloud era into a new phase, Phase one of it was really early adopter driven, and public cloud only. But for the mainstream market to adopt, they're really going to want a hybrid model, which means, "I want to use some of the capability I have within my own data center, but I'm looking for an alternative to expensive VMware or Microsoft stacks." OpenStack is the leading contender to become the cloud architecture for those companies considering those options. 

If this quarter's results are indicative of what OpenStack means for Rackspace, then the future looks great. 

Amazon and Google are in the market, but it's still different 


Source: Amazon Web Services.

What Rackspace is making very clear is that while Amazon and Google are both selling cloud services, they are in a "very  different segment of the market," as Rhodes put it. For Google and Amazon, these are ancillary businesses built on top of those companies' already incredibly robust computing needs. 


Source: Google.

Take Google, for example. Its core business remains search, and advertising is its key revenue generator and will remain so for potentially forever. It's about getting users to plug into Google in as many ways, and as often, as possible. Google wants to be sure that it's the first name you think of when it comes to data, whether it's storing it, looking it up, or the company that's hosting it for you. 

Amazon is making AWS a serious source of revenue. While not specifically broken out, Amazon's most recent 10-Q shows $1.26 billion sales in the category where AWS resides, a 57% increase versus the same quarter last year. While it's not clear exactly how much of this was from AWS, this is definitely a growing business for Amazon. 

The difference? Amazon and Google's cloud service offerings are largely unmanaged. A company can significantly reduce its infrastructure, but will still require very skilled, and expensive, IT pros to build, implement, and manage a cloud or hybrid infrastructure. And this segment is where Rackspace differentiates itself. 

Someone has to manage it
Gartner predicts that global IT spending could reach $3.8 trillion this year, and that cloud computing could be the majority of IT investments as soon as 2016. The bottom line? Even if Google and Amazon get a large chunk -- which they will -- a lot of those spending money aren't going to want to manage it themselves, and this is where Rackspace wins. From Rhodes:

A cloud infrastructure must be managed. So the question we want to pose to the market is, "Who's going to manage it for you?" Are you going to keep up with the skill requirements, and the proliferation of software and tools that will come with ever-cheaper infrastructure, or are you going to invest in the things that help you run your business better? And we offer the clear alternative in the market. 

If Rhodes is right, Rackspace is a growth stock worth owning. And I think he is.

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