In summary, an investment decision here requires a certain amount of confidence in the future of its OpenStack public cloud project.It also requires an expectation that it is about to demonstrate the kind of scalability in its cash flow generation that it has hitherto not been seen. No one said investing is easy! But I’m saying you don’t have to invest when it isn’t.
Just another tech disappointment or is it?
In a sense the results were the usual story of tech weakness in the first quarter. Okay Rackspace Hosting, Inc. (NYSE:RAX) had the excuse that it is engaging in managing a product cycle transition to its OpenStack public cloud offering. In this kind of environment enterprises are taking any excuse to delay spending decisions. In this case it seems that its customers are holding off investing in Rackspace’s legacy and hybrid solutions while they assess its OpenStack offerings. It does look like a mix of macro and company specific issues but both create uncertainty.
I discussed its strategic move in more detail in an earlier article linked here. Essentially Amazon.com, Inc. (NASDAQ:AMZN) is offering a public cloud approach and VMware, Inc. (NYSE:VMW) has a private cloud focus while Rackspace Hosting, Inc. (NYSE:RAX) wants to do something different by offering its customers the benefit of not being tied to one customer. The benefit being that the the customer will not ultimately be locked into one provider. This makes sense for VMware, Inc. (NYSE:VMW) because it is in line with its unique selling point of offering ‘Fanatical Support’ to its customers.
Unfortunately in a weak environment the competition tends to get tougher. Amazon Web Services (AWS) has cut prices in order to attract market share and customer growth. Of course it can take some potential margin loss because it is part of a highly cash generative e-commerce monolith. Google has also lowered its cloud storage costs and even though AWS reported 21% in its international operations this came in below what some may have hoped. AWS claimed to still be in ‘investment mode’ so we can expect a heightening of competition in the industry.
As for VMware, Inc. (NYSE:VMW), the market was disappointed with the recent results, but the stock has come back strongly since then as investors appreciate its long-term potential.
So will Rackspace Hosting, Inc. (NYSE:RAX)’s share price see a similar bounce back? Frankly I’m not sure and here is why.
Same old Scene
Put quite simply VMware generated $599 million in free cash flow in the quarter while Rackspace Hosting, Inc. (NYSE:RAX) generated adjusted free cash flow of ($1 million). If we look at the reported free cash flow (operating cash flow less capital expenditures) it was ($11 million) in the quarter.
Moreover expenditures on customer gear are being ramped up at a time when revenue is disappointing. In fact Rackspace stated, in the conference call, that revenue per server declined to $1.308 from $1,310 in the quarter, although in mitigation it had opened a new data center in Australia replete with investment in new servers.
Nonetheless the question mark over its long term ability to leverage its capital expenditures will get even more relevant after this report. Here is a graphical depiction of what I am talking about.
It is one thing to laud offering ‘fanatical support’ and argue (positively) that capex only increases with future growth, but the fact is that the gap between operating cash flow and capex isn’t expanding much at present. Where is the scalability?
Moreover I note that –despite revenue disappointing- there was no downward adjustment to the full-year capex forecast of $375-445 million. The bulk of which being focused on customer growth. Rackspace Hosting, Inc. (NYSE:RAX) is going to continue investing because it believes in its strategy. That is fair enough but to follow it you need to share this belief.
Where next for Rackspace?
Clearly the question marks over its business model are not going to be answered definitively anytime soon so investors will have to live with this uncertainty. In addition investors will have to deal with the general macro uncertainty around tech spending. Naturally this also provides some upside potential as well. If enterprise spending picks up then it could appreciate strongly but I would argue that there are better ways to get exposure to it than by buying Rackspace.
Competition is also an issue here with Amazon.com, Inc. (NASDAQ:AMZN) and VMware determined not to cede market share meanwhile investors need to appreciate that VMware is generating huge amounts of cash while Amazon Web Servces can be supported. In other words they can deal with some margin erosion from price cutting. Can Rackspace Hosting, Inc. (NYSE:RAX) do the same while it has significant outlays planned for capital gear this year?
Throw in the overlying uncertainty over the transition to its OpenStack public cloud model and proposition gets even harder. It’s not a stock for widows, orphans or for me.
The article What You Need to Know About This Cloud Play originally appeared on Fool.com and is written by Lee Samaha.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Rackspace Hosting, and VMware. The Motley Fool owns shares of Amazon.com and VMware. Lee is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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