Is Rackspace Overpriced?

No investor ever beats the market without knowing how to value companies. The numbers are that important -- and they suggest that Rackspace Hosting (NYSE: RAX  ) is overpriced.

In particular, I mean numbers like these:

  • Negative free cash flow after accounting for the impact of debt and capital needs.
  • A trailing P/E ratio of 82.

"Unlike many other internet companies, Rackspace Hosting is somewhat capital-intensive," CAPS All-Star mrindependent recently wrote. "It needs to reuse its capital to build more and more computer capacity. I like the company's market niche and growth opportunities, but I think it is significantly overvalued at 5.5 times book value and 56 times estimated 2009 earnings. Insiders are heavy sellers around $15."

Dozens of mrindependent's peers agree:

Metric

Rackspace Hosting

Recent price

$16.77

CAPS stars (out of 5)

***

Total ratings

227

Percent bulls

91.2%

Percent bears

8.8%

Price-to-book

6.56

ROE

12.0%

% Above 52-week low

319.3%

Sources: CAPS, Capital IQ. Data current as of Oct. 28.

Numbers do lie, sometimes
So a lot of smart people think Rackspace is overpriced. And by the numbers, they're right. But every time I come across a company like Rackspace, I'm reminded of something I heard from professor Aswath Damodaran during a speech he gave at Fool HQ some years back. To paraphrase:

The more you know about the business, the less valuation matters. Conversely, the less you know about the business, the more valuation matters.

It makes sense, doesn't it? Valuation is an imperfect science that we use to reduce risk as investors. Mostly, it fills gaps -- gaps created by a lack of industry knowledge. We rely on low P/E ratios, rich cash flows, and big asset balances to fill the void. Numbers are comfort food for investors hungry for safety, which is why tech is so unnerving.

Growth is the problem. Growth is the key driver for all valuation equations, and for techies, it's frequently unpredictable and underappreciated. Think of Apple (Nasdaq: AAPL  ) , whose $1.82 in fourth-quarter per-share earnings beat the consensus estimate by a whopping 28%.

This is a frequent problem among disruptive techies. Ask anyone who follows salesforce.com (NYSE: CRM  ) , Netflix (Nasdaq: NFLX  ) , or Amazon.com (Nasdaq: AMZN  ) . Wall Street has a history of swinging and missing in its attempts to predict earnings and pin a value on these businesses and their rebellious peers.

If not numbers, then what?
Analysts would have done better to look at the underlying qualities of these companies and ask why they were growing so quickly. They would have found:

  1. Leading positions in massive growth markets.
  2. Excellent management.
  3. An underappreciated ability to invest for above-average returns.

Rackspace has all three. Its market opportunity is the same one driving growth for salesforce.com, NetSuite (NYSE: N  ) , VMware (NYSE: VMW  ) , and many others: cloud computing. It's a multibillion-dollar business today, and researcher Gartner predicts it will become a $150 billion global market by 2013.

What's more, two of Rackspace's three co-founders retain an active role in the business, and their passion for customer service has become a corporate obsession. Customers have become fans, and more of them are coming through the door:  8,700 more in the last quarter alone, a 14% increase.

Skeptics will note how much debt Rackspace carries. What they miss is that debt is down $90 million from January, and that management has produced a 7.5% return on capital over the past 12 months, higher than the 6% maximum interest rate the company was paying as of the end of fiscal 2008.

The Foolish bottom line
Finally, I'll admit to a bias here. Rackspace Hosting is one of my outperforming picks for Motley Fool Rule Breakers. I still like it at these levels for all the reasons you just read, and because history tells me that even 100 P/E stocks outperform when the conditions are right. Rackspace couldn't be better-positioned than it is now.

But that's my take. Now it's your turn. Do you think Rackspace is a buy at these prices? Please vote in our poll and then add your comments in the box below. We'd love to hear from you.

Amazon, Apple, and Netflix are Stock Advisor selections. Rackspace, salesforce.com, and VMware are Rule Breakers recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers had stock and options positions in Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy just won the grand prize!


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