Rackspace Is Losing Altitude

 | Nov 12, 2013 | 12:30 PM EST  | Comments
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Late Monday, Rackspace (RAX) reported its third straight disappointing quarter.

Rackspace has really come down from the clouds. In February, the company missed Street consensus expectations by a penny. Things only got worse by mid-April, when pricing pressure took a toll on second-quarter expectations. The stock lost altitude when Microsoft (MSFT) decided to slash the price of its Azure cloud service in an effort to better compete with Amazon's (AMZN) Web Services (AWS). When all was said and done, depending on the service, cloud pricing fell between 21% and 33%.

Judging by last night's report, the pressure is still on. While revenue was about in-line with consensus, net income was a disaster. For the third quarter, revenue was $389 million, up 3.4% sequentially and 16% from the year-ago quarter. Net income, however, was $16 million, down 27.1% from the second quarter and down 40% year over year. Yikes!

Expenses are out of control. Total expenses rose 24% year over year. Because of the higher-than-expected expenses and lower margins, income from operations was trashed, down 36% year over year. Adjusted cash flow was just $8 million and return on capital was only 8%.

Rackspace is spending heavily on memory and disk space. The company's cloud now offers disk speeds 132 times more powerful than its existing servers do. Rackspace has begun to offer customers 120 gigabytes of storage, or more than four times their standard offering. Unfortunately, Rackspace can't get paid for it.

While the new technology offerings are great for customers, they're terrible for shareholders. All this investment in a more powerful cloud hasn't translated to faster revenue growth. In fiscal 2012, revenue was growing at 31.3%. For fiscal 2013, Rackspace will be hard-pressed to end the year with 16% revenue growth. The company used to be able to deliver gross margins over 71%. But that's history. Gross margins were 68%, down from 71.7% last year.

The stock is down nearly a third so far this year. After hours, the stock lost even more altitude. I see no reason to catch a falling knife. Until Rackspace can get ahead of the pricing curve and grow revenue with stable (or higher) margins, the stock will continue to decline. It's clear that Rackspace offers a commodity product that is subject to extreme pricing pressure. I would keep my head out of this cloud.

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