Buy This Digital Real Estate Stock Now

Skeptics have really good reasons for avoiding Rackspace Hosting (NYSE: RAX  ) . Just ask my Foolish colleague, Eric Jhonsa. He's laid out as good a bear case as you'll find.

Mostly, the bears don't believe Rackspace will earn more per server, and in the process logarithmically improve cash flow. I think they're wrong. Here's why:

Metric

Q3 2009

Q2 2009

Q1 2009

Q4 2008

New revenue

$10,404,000

$6,918,000

$1,940,000

$4,783,000

Additional servers

2,386

2,231

2,520

2,287

New revenue per server

$4,360.44

$3,100.85

$769.84

$2,091.39

Cloud computing as a % of revenue

9.4%

8.6%

7.5%

6.2%

Data current as of Nov. 21.

Notice how a tight embrace of cloud computing is already helping Rackspace to be more efficient. I'll get into the nuts and bolts of why this is happening shortly. First, have a look at the numbers from the prior 12 months:

Metric

Q3 2008

Q2 2008

Q1 2008

Q4 2007

New revenue

$7,525,000

$11,216,000

$12,930,000

$10,586,000

Additional servers

2,807

2,669

3,063

2,770

New revenue per server

$2,680.79

$4,202.32

$4,221.35

$3,821.66

Data current as of Nov. 21.

Not so good, are they? From this year to last, revenue fell in three of four quarters, and revenue per server suffered a sharp downturn beginning in last year's Q3.

What's gone unnoticed in the months since is how cloud-computing services have created more efficient growth. For example, in December 2007, Rackspace was getting just 3% of its revenue from the cloud. Today, the cloud accounts for more than 9% of revenue, and Rackspace is earning more per deployed server.

A better Trump than Trump
Why is the cloud so helpful to Rackspace's business? It helps to think about real estate.

Rackspace offers two types of hosting services. The first is like renting a house. Known as managed hosting, this is when one "tenant" pays for a plot of defined "property" consisting of servers, storage, software, and processing power. The tenant doesn't own any of this infrastructure, of course -- heck, he doesn't even maintain it -- but he does control it, typically via Web-based tools. AT&T (NYSE: T  ) , IBM (NYSE: IBM  ) , SAVVIS (Nasdaq: SVVS  ) , and Equinix (Nasdaq: EQIX  ) offer similar services.

But Rackspace does more than rent houses; it also manages one of the Web's largest hotel chains. That's cloud computing at work -- servers that act as fully furnished, extended-stay hotel rooms that the maids clean up each morning. 

Which is the better business? The extended stay hotel, of course! Instead of renting to just one tenant, the landlord books thousands of rooms nightly. Fixed costs such as land, buildings, fixtures, and so on are covered by a constant influx of cash. And best of all, prices rise during peak season, or when these (ahem) "hotels" are operating near capacity. Revenue improves with demand.

The beauty of the burst
Let's be more specific. Cloud computing servers earn more because they host more "tenants," and because Rackspace decides how to dole out its available rooms. There's also little need to customize cloud servers -- again, think about how hotels have "standard" rooms -- which makes them cheaper to maintain.

Peak season is when cloud hosting gets interesting. By "peak," I mean when heavy digital traffic threatens to overwhelm a client's prescribed resources. At those moments, Rackspace creates a spillover room in the cloud -- and charges extra for the emergency space. Known as "bursting," this is an industry-standard practice that Akamai (Nasdaq: AKAM  ) has used for years. E-commerce firms, in particular, tend to pay for bursting during the busy holiday shopping season.

A real estate rebel in the making
I've said it before: Rackspace isn't cheap. Fortunately, there's a lot more to this business than a high P/E ratio and heavy capital expenditures.

What differentiates Rackspace from, say, Amazon.com (Nasdaq: AMZN  ) and its EC2 cloud hosting service is its emphasis on "fanatical" customer support. Clients will pay a modest premium for high-touch service. That's what Rackspace offers.

And it can offer these services efficiently and therefore profitably, earning progressively more from every server it deploys. That's a recipe for truly massive growth, the kind you'd expect only from a true Rule Breaker.

Akamai and Rackspace Hosting are Rule Breakers recommendations. Amazon is a Stock Advisor selection. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the market-beating Rule Breakers stock picking team. He owned shares of Akamai and IBM 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 was last seen heading for that dive bar on the other side of Avenue A. Somebody call a cab.


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