Bottom-line Troubles in the Competitive Cloud Arena

Competition in cloud services is heating up, and a price war waged by bigger players like Google (GOOG 0.58%), Amazon (AMZN 0.87%), and Microsoft (MSFT 1.57%) could doom smaller players like Rackspace (RAX +0.00%).

Rackspace is an IT services company involved in the provision of public, private, and hybrid cloud services. Along with NASA, it created the OpenStack operating system for cloud services. Rackspace claims differentiation from other players because it offers managed cloud services, rather than just renting out raw hardware. The company generated approximately $1.5 billion in revenue during 2013, and 73% of it was generated from dedicated cloud services and the rest from public cloud services.

Competitive landscape
The cloud services industry is currently dominated by Amazon via its AWS offerings. Microsoft's Azure takes the second position, and Google is slightly behind, as it was late in entering the market.

It's clear that the cloud landscape is held by very large, mature organizations, so a smaller company like Rackspace must have a very competitive product portfolio to remain relevant in the industry. The main reason for this is that larger companies can afford price cuts to capture, or sustain, market share. Therefore, services that are on par with larger organizations will not be enough to ensure the growth of a relatively smaller company.

Price wars
As expected, Google recently slashed its prices drastically, and Amazon and Microsoft followed in its footsteps.

This bodes ill for Rackspace, as it does not command as many resources as Google or Microsoft, so it can't afford such drastic price cuts. The company responded to these price cuts by promoting its managed cloud services, in contrast to the raw compute and storage offered by competitors. Rackspace is not cutting its prices, which are summarized as follows:

Rackspace's future prospects are uncertain. The company risks losing market share if it does not reduce prices. On the other hand, cutting prices may not be viable, as the company is not as financially secure as the other major industry players. The only option Rackspace seems to have left is to offer differentiated services for niche markets and private clouds.

Differentiation
All three camps (AWS, VMware, and OpenStack) have their respective strengths, but there is no differentiation, as OpenStack is considered the same as the others and, hence, price cuts will affect Rackspace's market share. Moreover, Rackspace does not command the same flexibility and breadth as AWS, which has been dominating the public cloud arena. On the storage side of IaaS, a detailed benchmark from Nasuni reveals that Microsoft was the top performer for 2013. More importantly, on the scalability front, Rackspace has shown poor performance.

Source: Lower is better

The above figure shows that Rackspace results in inconsistent write performance upon an increase in the number of objects under management, which can explain the limited public cloud adoption of its services. However, the company's services are suitable for the deployment of private clouds because of low scalability requirements. Overall, Rackspace's offerings are not the worst across different use cases, but they are certainly not the best, either. Therefore, price cuts by major players will affect the company's growth going forward.

Investment value
Rackspace's P/E (TTM) is around 47, while the industry's P/E is around 27, making it more expensive than other industry players. However, this above-average P/E is not justified because Rackspace will face difficulty in the public cloud arena amid strong competition from Amazon, Google, and Microsoft. Even the industry average P/E will result in a $20-$22 price target. The table below illustrates a cash-flow-based value perspective:

The company is valued at $3.26 billion using a forecasted cash-flow valuation while the market cap is above $4 billion. The point is that the business is not going to generate as much value as expected by investors.

Bottom line
The cloud services industry is witnessing explosive growth, with large organizations jumping on the cloud bandwagon. However, these companies are engaging in price wars to capture market share. Smaller organizations like Rackspace must offer differentiated products to succeed, as they are not in a position to afford price cuts. No evidence was found of any distinct competitive advantage, so all players compete on an equal footing. Price will be a major deciding factor for the success of any given company. Hence, Rackspace is not expected to excel in the presence of giants like Amazon, Google, and Microsoft.

Editor's Note: This version has been modified to better reflect the differentiation of the three services and to remove attribution of a quote.