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Why Is Rackspace So Jumpy?

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Rackspace Hosting (NYSE: RAX  ) is a perfect poster boy for the indecisions of Mr. Market.

The hosting leader and cloud-computing upstart reported third-quarter results on Monday night, pretty much in line with analyst expectations: Sales grew 6.6% compared with the previous quarter and 23% year over year to $200 million, while earnings jumped to $0.09 per share from $0.06 per share a year ago. Free cash flows kept pace with earnings, the company signed up a record 11,000 new customers to grow its customer list by 10% in just three months, and the cloud-computing segment remains smaller than the hosting business but on a much faster growth trajectory.

The stock did what you'd expect it to do under these circumstances. First, it fell by more than 7% on a quick knee-jerk response to the merely satisfactory performance, then it opened 5.6% above the closing price on heavy volume as investors refocused on the positives. In short, the market didn't know what to do with the information.

That continues a long-lived trend in the general vicinity of next-generation IT infrastructure businesses. Rackspace has given shareholders a 47% return on their investment over the past year, behind market darlings Terremark (Nasdaq: TMRK  ) and SAVVIS (Nasdaq: SVVS  ) but comfortably ahead of IBM (NYSE: IBM  ) and (Nasdaq: AMZN  ) , both of which are closer to direct competition in Rackspace's industry.

Uncertainty begets volatility
The thing to consider here is, Rackspace is transforming before your very eyes. Rackspace was once a pure play on hosting services and colocation, but the cloud-computing division now represents about 12% of sales and is on track to become the majority of the company's business within the next couple of years.

Cloud services are a higher-margin business than hardware hosting, because you can simply cram more accounts in a single server to juice your returns on the hardware investment. Now, Rackspace does, in fact, run virtual servers on some of its traditional hosting boxes, too. Chief Financial Officer Bruce Knooihuizen tells me that the private hosting accounts are managed through the VMware (NYSE: VMW  ) toolkit to make more effective use of the available servers while Citrix Systems (Nasdaq: CTXS  ) provides the underlying virtual machine software for the cloud-computing business.

Most server-hosting providers are not as forward-thinking in their asset management as Rackspace, and this advanced management model translates into both low-cost services for end users and strong margins.

What makes Rackspace so darn special?
The barriers to entry are rather low in the space where Rackspace competes -- all you really need is some seed funding to buy or lease some servers with high-speed networking attached, and then you hire a few system administrators to keep the good ship afloat. But Rackspace never claimed or aimed to compete on the basis of having the best technology on the planet. "We differentiate ourselves on the quality of our service," Knooihuizen said. "We've been working on our unique culture of fanatical support for ten years, and you can see in the customer additions that it's paying off."

Indeed, happy customers beget strong word-of-mouth marketing, and that's the engine that drives Rackspace. Operating under this model of simple technology done right for every customer, Rackspace is hitting its long-term growth and margin goals with ease. The company is hiring engineers by the bushel, mostly to take customer support to an even higher level. Somebody like IBM may sell a similar mix of cloud-and-hosting services, but nobody can claim to delight its customers to the same degree -- Knooihuizen was happy to detail his company's industry-low customer churn numbers and numerous customer-service awards.

Buy, sell, or hold?
Rackspace isn't a cheap stock by any stretch of the imagination, but you often get exactly what you paid for. As the company moves further into the cloud-computing sector and continues to build its already-impressive customer-friendly reputation, the bottom line should kick into the next gear before too long. And if you thought a 47% annual return was nice, the next phase in this company's growth history should make that era seem mild by comparison. Rackspace is a Rule Breaker for good reason.

Fool contributor Anders Bylund doesn't hold a position in any of the companies discussed here. Rackspace Hosting and VMware are Motley Fool Rule Breakers recommendations. is a Motley Fool Stock Advisor selection. The Fool owns shares of IBM. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.

Read/Post Comments (2) | Recommend This Article (8)

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 November 10, 2010, at 3:45 PM, jbrt wrote:

    nothing better than POSITIVE FEEDBACK from ones customers , the best " advertizing " there is ! and IT'S FREE !!!

  • Report this Comment On November 11, 2010, at 3:04 PM, bludgeon2000 wrote:

    The argument that there are low barriers to entry in managed hosting is specious. Hosting is as process- and operations-intensive as it gets, and is inherently far more complex than financial analysts are capable of understanding. Of the hundreds of datacenter operators nationwide, all of them would love to generate the revenues RAX generates per square foot with managed offerings, but only a dozen or so are capable of delivering anything close to RAX's level of service. A decade ago, industry titans like Intel, Dell and Sprint all rushed into this space, then got completely annihilated and then got out with their tail between their legs. That's like saying all you need to do to become the next Oracle or Microsoft is "hire a bunch of programmers". The bulk of IT spend is and always has been operations, not hardware or software, and RAX provides a radically novel and cost-effective alternative to traditional IT service delivery. The barriers to entry are there, even if they are hard to understand.

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