The Simplest Way to Profit From Cloud Computing

Fools can't make up their minds about Rackspace Hosting (NYSE: RAX  ) , a Motley Fool Rule Breakers pick that specializes in hosting websites, digital applications, and data for customers. Here's a snapshot:

Metric

Rackspace Hosting

CAPS stars (out of 5)

***

Total ratings

284

Percent Bulls

90.5%

Percent Bears

9.5%

Bullish pitches

45 out of 48

Data current as of Feb. 17.

Why so many fence sitters? The major concern, apparently, is that Rackspace is locked in a capex spending death spiral that will ultimately torpedo the business. Bearish investors don't differentiate between Rackspace's data center operations and those of co-locators such as Switch & Data (Nasdaq: SDXC  ) , Equinix (Nasdaq: EQIX  ) , and SAVVIS (Nasdaq: SVVS  ) .

That's a mistake. Rackspace is the simplest way to get started with investing in cloud computing.

Get a rag, we're going under the hood
Take a look at the latest earnings report. Rackspace added just under 10,000 new customers in the fourth quarter, almost all of which were for its cloud computing services. New customers included new Comcast (Nasdaq: CMCSA  ) unit NBC, which is using Rackspace's servers to handle overcapacity in delivering Web coverage of the 2010 Vancouver Winter Olympics.

Presently, cloud computing services account for just 10% of Rackspace's total revenue. The other 90% comes from managed hosting whereby customers rent and control specified servers within the company's network of more than 50,000.

By contrast, customers see none of the infrastructure their software touches when using cloud computing services. All they know is that they're consuming resources inside an amorphous "cloud" of storage and processing horsepower.

Customers like the model. Cloud-computing revenue rose 11.7% sequentially in Q4 and 93.2% over last year. Meanwhile, on-demand computing power is accounting for an increasing portion of Rackspace's overall business:

Metric

Q4 2009

Q3 2009

Q2 2009

Q1 2009

New revenue

$7,117,000

$10,404,000

$6,918,000

$1,940,000

Additional servers

2,016

2,386

2,231

2,520

New revenue per server

$3,530.26

$4,360.44

$3,100.85

$769.84

Cloud computing as a % of revenue

10.1%

9.4%

8.6%

7.5%

Data current as of Feb. 17.

Notice the pattern? Rackspace, which in October of 2008 acquired JungleDisk and Slicehost to remake itself into a cloud hosting business, appears to be successfully navigating the transition. High returns per server are once again the norm:

Metric

Q4 2008

Q3 2008

Q2 2008

Q1 2008

New revenue

$4,783,000

$7,525,000

$11,216,000

$12,930,000

Additional servers

2,287

2,807

2,669

3,063

New revenue per server

$2,091.39

$2,680.79

$4,202.32

$4,221.35

Data current as of Feb. 17.

At the same time, the inherent efficiency of its cloud hosting business has allowed the company to earn higher returns on capital. ROC soared from 8.6% in Q3 to 10% in Q4, Rackspace said in its earnings release. Not bad for a company stuck in a bare-knuckles fight with tough competitors such as Amazon.com's (Nasdaq: AMZN  ) EC2 and AT&T's (NYSE: T  ) Synaptic Hosting service.

Poised to rack up gains
For its part, management expects further gains. "We are in the first inning of many, probably a double-header," explained Rackspace Chief Financial Officer Bruce Knooihuizen in an interview. "We believe every customer has a need that fits the cloud."

Color me unsurprised. Rackspace has good reason to make its cloud offering as appealing as possible; it controls the boxes. Thus, each cloud server can be stuffed to its revenue-generating capacity. (Think of an apartment building with no vacancies.) This also explains the company's increasing returns on capital.

"We think there will be huge opportunity for us, given the way the cloud works," Knooihuizen said. I think he's right, and it's why I'll be buying shares of this rebel when disclosure rules permit.

Would you buy shares of Rackspace at current prices? Make your voice heard using the comments box below.

Rackspace Hosting is a Rule Breakers recommendation. Amazon is a Motley Fool 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 didn't own shares in any of the companies mentioned in this article 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 is still recovering from the last time it appeared in this column. Anyone have an aspirin?


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