More Trouble for Rackspace

Life just got a bit harder for cloud computing services company Rackspace Hosting. Google  aggressively reduced prices across its range of cloud services recently, while deep-pocketed competitors like Amazon, Microsoft, and Oracle are committed to offering infrastructure as a service, or IaaS, at highly competitive rates. In addition, Cisco Systems is planning to invest heavily in offering IaaS. While much of this is known to investors, it's sometimes easy to lose site of the fundamental reasons why these companies are doing this and why competition is only going to get more intense.

Why companies are investing in IaaSSimply put, it works. The companies that have transitioned to offering their services and applications on a software as a service, or SaaS, basis have seen a transformational improvement in their prospects. The three leading examples of this change are Adobe, Autodesk, and Intuit. Investing Fools already know how and why these companies are outperforming the markets.

 

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Rackspace's Challenges in 2014

Shareholders in cloud provider Rackspace (NYSE: RAX  ) endured a rough time after the stock fell 15% on the week of its results. While the numbers were slightly better than analyst estimates, investors reacted badly to the announcement that CEO Lanham Napier was leaving the company. Has the market overreacted and made the stock a good value?

Rackspace racks up uncertainty
Napier's announcement certainly shocked the market, and negative surprises are the last thing that a company clouded in uncertainty like Rackspace needs right now. Essentially, there are two fears hanging over the stock. The first is well-known, but the second might prove even more problematic in the long term.

 

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Rackspace's Business Model is Being Challenged

There is a difference between saying that a company is good, and saying that it is a good investment. In the case of Rackspace , its current business trajectory is suggesting that it's not a good investment even though that doesn't mean it’s not a great company. Unfortunately, increasing competition within the cloud computing provision market from the likes of Amazon Web Services  and Microsoft's   Azure is threatening Rackspace, even as the company improves its already high level of service.

Rackspace's margin
It's difficult competing with Microsoft and Amazon in the best of times, but it's a lot harder when they are both cutting prices in order to win market share in a fast-growing business. Throw Google into the mix and its almost unfair. The fact is that those three tech giants can easily subsidize lowering prices (and therefore margins) because they have add-on advantages to winning new business.

Indeed, AWS is reported to have recently cut prices by 10% across all its regions, and it's hard not to think that its response to Microsoft's aggressive discounting actions. The two companies have seemingly been locked in a price battle, the effects of which are starting to show in Rackspace's margins.

While its revenue was up 15.6% in the third quarter, Rackspace's operating income margins fell to 9.4% for the first nine months compared to 12.9% last year. Moreover, the third quarter saw operating income margins come in at just 7.1%.

Rackspace invests in order to grow
In defense of the company, it's currently investing to support growth created by customers adopting its OpenStack public cloud options. In addition, its management has long claimed that its "Fanatical Support" is its unique selling point within a competitive industry. Unfortunately, a high level of support usually implies a high level of investment, and Rackspace appears to be running hard in order to stand still on that front.

At the start of the year, Rackspace had forecast full-year capital expenditures of $375 million--$445 million and customer gear expenditures of $235 million-$275 million. Fast forward to the latest results and capital expenditures are now forecast to come at $460 million--$510 million. While "north of $10 million" of the increase is due to buying land for a datacenter, the rest is because it is investing in its cloud infrastructure and customer gear. In fact, customer gear expenditures have already hit $233 million this year. It's safe to assume that they will come in higher than the forecast at the start of the year.

These facts play to the heart of the questions with Rackspace. Can it leverage up its investments and start to generate meaningful cash flow in future? Alternatively, is it forced to invest in continually buying customer gear so that its customers can benefit from outsourcing IT expenditures in order to generate growth?

The following chart shows operating cash flow, capital expenditures, and customer gear expenditures as a share of income over its last four quarters. The hope is that Rackspace will be able to generate free cash flow (operating cash flow minus capital expenditures) over time.

Source: company presentations, author's analysis.

Unfortunately, it looks like Rackspace is finding it difficult to generate meaningful cash flows. As 2013 has gone on, its customer gear requirements have gone up. Consequently, customer gear now makes up nearly 67% of capital expenditures. Its one thing to provide fanatical support to generate revenue growth, but it's another thing to generate cash to be returned to shareholders.

Rackspace's bottom line
All told, conditions look like they are getting tougher for Rackspace. Competition from Microsoft and Amazon appears to be pressuring prices, while it's having to increase expenditures in order to service clients.

Rackspace has generated just $18.7 million generated in adjusted free-cash flow (its own figures) so far in 2013, but sits on a current market cap of $5.9 billion. Meanwhile, it still hasn't demonstrated that its business model can generate the kind of cash flows that could justify its valuation in future. It doesn't look like a good value to me.

Oracle's Results Reveal Tech Weakness

The last thing the tech market needed right now was a disappointing set of earnings from Oracle (NASDAQ: ORCL), but unfortunately that is exactly what it got. It would be an understatement to say that it has been a difficult 2013 so far for the tech industry and these numbers will do little to assuage many fears. But what do they mean for Oracle and how do they relate to the rest of the tech world?

Oracle disappoints, again

Looking back at an analysis of the previous quarter’s earnings Oracle missed its own guidance and this quarter saw some key numbers coming in at the low end. For example Oracle had forecast 1-4% overall revenue growth (they came in at 2% in constant currency), new software license and cloud subscription growth was forecast to come in with 1-11% growth (the result was 2% growth). The one ‘bright’ spot was that hardware systems product growth was forecast to be negative 12-22% and came in at the high end with a negative 12%.

Clearly the numbers came in towards the bottom of the guidance ranges. All of which is somewhat disappointing given that many investors have been hoping for a second quarter (2Q)  bounce back. Last time around Oracle blamed some sales execution issues and the timing of the sequester. However it calmed investors by describing its pipeline as being up and, claimed that the issue was really about the timing and execution of deal closure.

Well it was a different story this time around with sales execution quoted as improving ‘significantly’ and economic weakness cited in a few areas like Brazil, China and Australia. Moreover, transaction sizes were described as being smaller (a sign of economic pressure).

The good news from a geographic perspective was that its US and EMEA performance were as expected with 4% and 5% new license growth respectively. The problem was with Asia-Pacific down 7%. This is a worrying sign for the industry because many technology companies are relying on Asia for growth.

What the industry is saying

As a bellwether Oracle’s results will be closely watched and those of us hoping for some sort of confirmation of a return to better days would have been disappointed. In a sense it is a mere continuation of what we have been seeing elsewhere. For example, Palo Alto Networks (NYSE: PANW) recently reported results. It missed estimates and guided lower than the market consensus for the next quarter. Although Palo Alto is in a different area (IT security), I found its results interesting because other companies in the sector had previously reported weakness in April. Unfortunately Palo Alto came out and confirmed that conditions in May were only ‘in line’ with the reduced expectations created by a weak April. Another indication of weakness and it appears to be linear.

One interesting aspect of Palo Alto is that its telco service provider revenues do not make up a significant part of its revenues. This is in contrast with other tech companies like say F5 Networks and Fortinet. These companies missed estimates and disappointed with guidance. Both cited weakness in their service provider verticals and this may well continue into the current quarter. On the other hand Palo Alto's results are more indicative of the wider tech spending environment and investors will need to hear some more positive noises from bellwethers like IBM and Oracle before feeling very confident with Palo Alto.

Moreover Oracle is facing some operational challenges as it shifts revenues towards cloud-based solutions. It described its SaaS (software as a service) based revenues as having a $1 billion run rate. This is fine but to put it into context its full year revenues are closer to $37 billion. In addition some cloud-based companies like Rackspace Hosting (NYSE: RAX) have reported some weakness as enterprises still seem keen to use any excuse to withhold IT spending. In fact in its last quarter it declared that its revenue per server declined to $1,308 from $1,310 last year. This is not a good sign for a company supposed to be in a high growth phase. In Rackspace’s case it was partly due to customers delaying purchases of legacy systems while they appraised its new OpenStack public cloud offering. Rackspace also has increasing competition from the likes of Amazon Web Services (who has been cutting prices) and I take this to be another sign that conditions have weakened in technology in 2013.

With regards to Oracle’s direct competitors like IBM (NYSE: IBM) and SAP (NYSE: SAP), these results are obviously not great news and they got marked down in sympathy. Moreover Larry Ellison was quite candid on his view that SAP’s Hana database was ‘virtually never’ seen in the market and even referenced some large German industrial companies that had bought Oracle’s rival Exadata database machine in order to run SAP’s applications. He also suggested that Hana could never successfully compete with Exadata. Frankly there is no love lost between SAP and Oracle, even when it comes to yachting, and this sort of comment has been heard before. Moreover I think SAP’s investors can take some heart from the fact that EMEA (its core market) was a bit stronger than expected for Oracle.

As for IBM, Oracle’s report was a bit worrying. It pretty much reported a similar story to Oracle last time around by blaming things like sales execution, the sequester, the weather and even the change in the Chinese Government. Will it do the same this time? It’s hard to tell but IBM didn’t lower its full-year forecast last time around and announced it would take some workflow rebalancing in Q2. All of which will put some pressure on it to deliver in the current quarter. As for the issue with the Chinese Government, did we see signs of this in the weak results that Oracle just reported?

Where next for Oracle?

The positives in this report were that the transition to new hardware product systems is going a bit better than expected and the US and Europe are doing okay. In a sense it is another story of current macro weakness amidst ongoing change in Oracle’s business as it shifts to cloud based solutions and new hardware products.

In the last quarter it made sense to pick up some Oracle stock after disappointing results and I wouldn’t be surprised if the same applies this time too. The stock trades on an enterprise value to EBITDA multiple of just 7.4 and generates huge amounts of cash flow that currently represent over 10% of its enterprise value. On a value basis the stock looks cheap and I wouldn't be surprised to see Oracle increasing its returns to shareholders in future. It looks a good long term hold but be prepared for volatility as the tech spending environment still looks a little weak this year.

Why I'm Still Not in Love with Rackspace

It’s been a difficult year so far for investors in Rackspace Hosting (NYSE: RAX). While it is not alone in having delivered disappointing results in the tech world the latest earnings raise more questions than answers as to how to best evaluate this company.

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 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 (NASDAQ: AMZN) is offering a public cloud approach and VMware (NYSE: VMW) has a private cloud focus while Rackspace 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 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, 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’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 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 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 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 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.