Rackspace San Antonio As Cloud City

Mauli Agrawal, professor of biomedical engineering at the Unviersity of Texas-San Antonio, speaks at a Rackspace event. Credit: Rackspace Hosting. 

Rackspace Hosting (NYSE:RAX) produced big gains in third-quarter operating income and earnings per share despite posting its lowest year-over-year revenue growth in at least seven quarters. The company -- which released its quarterly report Nov. 9 -- also announced plans to offer $350 million in senior debt to refinance existing obligations, and it could use any remaining proceeds to help fund share repurchases. Here's a closer look at the company's overall Q3 performance:

MetricQ3 2015 ActualsQ3 2014 ActualsYOY Growth
Revenue  $508.9 million  $459.7 million  10.7%
Operating income  $56.5 million  $40.5 million  39.5%
Earnings per share  $0.26  $0.18  44.4%
Cash from operations   $111.4 million  $125.4 million  (11.2%)

Sources: S&P Capital IQ and Rackspace Hosting press release. 

Commenting on the results, CEO Taylor Rhodes said in a press release:

We're proud of the financial results that we delivered in the third quarter. And we're excited about the new products and partnerships that we've launched in recent months, with Amazon Web Services, Intel, and Microsoft. These initiatives will make us more competitive and will drive our growth for the future.

What went right: Careful capital allocation paid off, with annualized return on capital rising to 15% from 11.8% in last year's third quarter. Average monthly revenue per server improved 2.8% over the same period, to $1,444. Earlier quarters had seen the company struggle to pass $1,420. 

What went wrong: For as much as Rhodes talked up partnerships, the cost of revenue still expanded 19.8% year over year -- nearly twice as fast as revenue. Overall operating expenses grew just 7.9% over the same period, mostly because of no or low spending on R&D, sales and marketing, and administrative expenses. That can't last; Rackspace needs material revenue growth to fund investments back into the business.

What's next: Looking ahead, management forecast 2%-3% sequential revenue growth in Q4 after accounting for currency effects. Rackspace reported $472.42 million in revenue and $0.26 a share of profit in last year's fourth quarter, S&P Capital IQ reports. 

For the full year, the company is planning for 12% to 14% year-over-year revenue growth on a constant-currency basis. Rackspace generated $1,794.36 million in 2014 revenue, up 16.9% annualized. Per-share earnings grew 26.2%, to $0.77, over the same period. 

In the meantime, investors should focus on gross margin and capital expenditures. Benefits from its dealings with Amazon and Microsoft to be the service and support supplier of choice for their cloud platforms should manifest as higher margins. Capex should also moderate now that there's less pressure for Rackspace to assemble an infrastructure that rivals its larger peers.

Tim Beyers just keeps racking up the points. He's also a member of the Motley Fool Rule Breakers stock-picking team and the Motley Fool Supernova Odyssey I mission and owned shares of Rackspace Hosting at the time of publication. Check out Tim's web home and portfolio holdings or connect with him on Google+Tumblr, or Twitter, where he goes by @milehighfool.

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