Value Play: Rackspace Hosting (NYSE: RAX)

Just as automobiles/airplanes, antibiotics, radio/television, and microprocessors transformed the 20^th century, the Internet is the first great transformational force of the 21^st century. According to a 2011 McKinsey report:

The Internet is changing the way we work, socialize, create and share information, and organize the flow of people, ideas, and things around the globe. Yet the magnitude of this transformation is still underappreciated. The Internet accounted for 21 percent of the GDP growth in mature economies over the past 5 years. If internet consumption and expenditures were a sector, its weight in GDP would be bigger than the energy or agriculture industry

To succeed in this new “Information Age” economy, virtually all businesses, including local businesses, require an online presence. Simply put, customers expect it, and only want to deal with a company that provides instantaneous information and shopping functionality via a website.

My Value Front Runner this month – Rackspace Hosting (RAX) – provides the telecommunications equipment, installation/rental space, and continual servicing and consulting necessary for businesses to offer customers a robust Internet experience. The company was founded in 1998 by three college graduates of Trinity University in San Antonio Texas, along with real-estate venture capitalists Graham Weston and Morris Miller. The company was named Rackspace because its primary function was to rent space in a datacenter to install Internet equipment (e.g., servers, routers, switches, firewalls) and the volume unit of rentable space in the datacenter was called a “rack.” In essence, the company started as a real-estate rental business and provided the back-office “Internet plumbing.” Not sexy, but critical for a website’s proper functioning. In 1998, the Trinity grads thought that the business model should focus on the initial equipment installation (Rackspace 1.0) because that job promised a large, up-front payment. Post-installation customer service was seen as uninteresting because it promised only small, periodic payments. In fact, the Rackspace founders were told that there was “no money in servicing customers” and consciously decided not to answer the phone if customers called with problems.

Everything changed in 1999 with the hiring of David Bryce as vice president of customer care. Bryce had previously owned a janitorial service and his company’s success depended on differentiating itself from its competition by offering superior customer service. Bryce convinced the Rackspace founders that the equipment side of the business would soon become commoditized with collapsing profit margins and that the real way to generate a long-term competitive advantage in Internet hosting was through on-going customer service (Rackspace 2.0). There were a growing number of companies that could provide the initial equipment, but there were very few companies that had the technical expertise and trained workforce needed to continually manage the back-office equipment and provide consulting know-how once it was installed. Bryce coined the phrase “fanatical support” to emphasize the company’s new unequaled commitment to customer service and introduced the “fanatical straightjacket” as a symbol of this obsessive, high-quality commitment. Although a straightjacket is usually a symbol of mental illness and considered a bad thing, in the context of obsessive customer service it is a very good thing. Today, fanatical support and the straightjacket symbol is at the very core of what Rackspace represents.

Fanatical support generated intense customer loyalty and attracted many new clients, including YouTube. Rackspace went public on August 8, 2008, an inauspicious time during the global financial crisis, and was a flop – dropping 20% on its first day of trading after pricing below the midpoint of its expected $12-$16 IPO range at only $12.50. The stock continued to drift down as low as $4.00 in February 2009 before beginning a historic rise. In fact, from its IPO date to the present time, Rackspace has outperformed the S&P 500 index by almost triple on a price-only basis (182.5% vs. 62.4%) and by more than double on a total return basis including dividends (182.5% vs. 89.1%):

The reason that the stock has performed so well over the last seven years is that its financial performance has been stellar. Even at the time of its rocky 2008 IPO, analysts noted that it was “the rare tech startup with a track record showing profit growth and financial discipline.” Since its IPO, Rackspace has exhibited consistent profitability, growing revenues each year and earnings every year but 2013:

The one-time decline in earnings that occurred in 2013 was caused by price competition with Amazon Web Services (AWS). Rackspace decided not to match Amazon’s prices, which caused the company to lose market share, but helped preserve profit margins. The fact remains, however, that Rackspace has never fully recovered the profit margins it enjoyed prior to Amazon.com’s aggressive entry into the public cloud market, because Amazon has both tremendous economies of scale and scope, as well as expertise in Application Programming Interfaces (APIs) that enhance the cloud experience by integrating a customer’s website with other websites in a seamless Internet network. Google cloud services and Microsoft Azure also entered the fray, which didn’t help.

Rackspace has fought back through a partnership with NASA to develop Openstack – an open source API-laden hybrid cloud solution that provides both the security of a private cloud with the connective integration of a public cloud. Open source is attractive because it provides flexibility for customers to build their cloud through different competing vendors rather than get locked into a single technology with one vendor (e.g., Amazon or Google) that is able to charge higher prices. The risk of open source is that it can be used and modified by anybody and may not offer the robust standardization that a single cloud purveyor can guarantee. It is questionable whether Openstack can achieve the market penetration needed to make the open-source venture a success. Then again, Red Hat (RHT) has been very successful servicing the open-source Linux operating system by offering strong customer support and its own standardized version of Linux.

On February 10, 2014, at the same time that Rackspace announced its profit decline in fiscal 2013, CEO Lanham Napier unexpectedly “retired”, which really meant that the board of directors had lost confidence in his ability to compete against Amazon, Google, and Microsoft and therefore dismissed him. Co-founder Graham Weston, who had been CEO from 1999 to 2006, stepped in again as interim CEO. In May 2014, the company hired Morgan Stanley to “evaluate strategic options” including the possible sale of the company. No buyers for the entire company emerged and four months later in September 2014 Rackspace decided to stay independent and appointed the company’s president, Taylor Rhodes, as permanent CEO. Weston remains a founder presence at the company as Chairman of the Board.

Rhodes’ philosophy is if you can’t beat ‘em, join ‘em. In July 2015, Rackspace announced a partnership with Microsoft to resell and provide fanatical support to its Azure cloud service. Three months later in October 2015, Rackspace announced a partnership with Amazon to resell and provide fanatical support to AWS. Analysts view these partnerships as a “win-win scenario” for Rackspace because not only will the servicing agreements bring in much-needed revenue but also “allow the company to lure some AWS and Azure customers to try out its own proprietary services.”

In essence, Rackspace is leveraging its core competency in “fanatical support” to the entire managed cloud market, while maintaining its status as an exclusive, high-end managed cloud provider. According to a March 2015 report by information technology research and advisory company 451 Research, the market for managed cloud services is huge and growing much more rapidly than the installation of cloud infrastructure. Furthermore, the report recognizes Rackspace as “the clear leader in the space”:

Rackspace is the leader of the Managed Hosting Market, in which managed services are wrapped around public cloud and single-tenant infrastructures (e.g., private hosted cloud). Managed Services at Cloud Service Providers are growing from $17B in 2014 to $43B in 2018 with a compound annual growth rate (CAGR) of 25.6 percent.

Managed Services account for 29.1 percent of total cloud market revenue in 2014 and are projected to account for 36.3 percent of the total cloud market revenue in 2018. The report also found that Managed Services revenue (CAGR) is growing 60 percent faster than infrastructure-only revenue.

Rackspace reports its third-quarter financials after the market close on Monday November 9^th. A Wall Street Journal article cautions that the worst may not be over for Rackspace despite its new partnerships with Microsoft and Amazon because competition in the managed service space is intense. Although cautious investors may wish to wait until after the company’s third-quarter earnings are released to jump in, Rackspace is trading at such a low valuation relative to its historical valuations (e.g., less than half its five-year average for PE Ratio, price-to-sales, price-to-book, and price-to-cash flow ), that the worst-case scenario is arguably already fully discounted in the current stock price.

My favorite valuation metric is the enterprise value to EBITDA ratio, and Rackspace is currently trading at only 7.7 times EBITDA, which is well within my threshold of 10 times for inclusion in the Value Portfolio. The corporate balance sheet is strong with debt very reasonable at only 14% of equity. Insider ownership is substantial at 14.1% of outstanding shares (page 58), most of which (13.3%) is owned by co-founder and current Chairman of the Board Graham Weston. Even better, on August 25thWeston purchased 85,500 shares of RAX at an average price of $29.24, which was the first insider purchase in almost a year.

Bottom line: Rackspace may have ceded a leadership role in managed hosting to the big-tech behemoths of Amazon, Google, and Microsoft, but its new role as service partner and technological consultant continues to provide it with a large and long runway of growth given the tremendous market opportunity that the Internet generally and managed hosting specifically offers over the next decade and beyond. With co-founder Graham Weston still firmly committed to Rackspace management and maintaining a sizeable ownership stake, the company has the strategic vision, strong balance sheet, consistent profitability, and low valuation that make an investment low risk and high reward.

Rackspace Hosting is a buy up to $34; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for DSW Inc., Roadrunner is selling:

• Harte-Hanks (HHS)

I have concluded that this very small former newspaper company has no competitive advantage in digital marketing and is likely to cut its dividend. The firing of CEO Robert Philpott in July 2015 and the hiring of former CenturyLink executive Karen Puckett as CEO in September 2015 was collectively not inspiring. Philpott had argued back in May when the company released lackluster first-quarter financials that the poor results were merely an accounting “timing” issue and not indicative of poor fundamental performance. In fact, Philpott had asserted that business was stronger than ever. Based on subsequent events, however, Philpott was hiding the truth because the board of directors let him go two months after making this assertion. Similarly, the reason for Puckett’s departure from CenturyLink is murky. She was CenturyLink’s chief operating officer for 14 years, but then transferred (demoted?) to president of global sales in 2014, only to “retire” in August 2015 based on a “mutually-arrived conclusion” with CenturyLink CEO Glen Post. Her reason for leaving was that she wanted to spend more time with her family (sadly, a red-flag reason) and consider new leadership opportunities. In other words, she wasn’t really retiring from work but was either forced out or told that she would never be CEO of CenturyLink.  

Harte-Hanks stock has rebounded on the news of Puckett’s hiring as permanent CEO and there is some historical precedent of stocks outperforming for a short while after new CEOs are appointed. Nevertheless, this honeymoon is likely to be short-lived given that Puckett was COO of CenturyLink in 2013 when the company blindsided investors by cutting the company’s dividend. Puckett may choose to the same plan of action with Harte-Hanks given that the annual dividend of $0.34 is greater than the trailing-12-month earnings per share of $0.22. A dividend cut would likely cause Harte-Hanks stock to plunge just like CenturyLink plunged more than 22% on news of its surprise dividend cut. I’d rather exit Harte-Hanks during the new-CEO honeymoon period and before the dividend gets cut.

Harte-Hanks is being sold from the Value Portfolio.

Momentum Buy:

Globant S.A. (NYSE: GLOB)

Globant S.A. is a Luxembourg-based pure play on emerging technologies  (e.g., big data, cloud computing, internet of things, wearable computing, gaming) that creates innovative next-generation software products to attract millions of consumers. 

• Price gain between 12 months ago and two months ago = 155.36% (100th percentile)
• Price gain over the past two months = 4.29%
• Price gain over the past month = 1.70%
• Roadrunner Momentum Rating: 155.36 – (4.29) – (3*1.70) = 145.96

Global S.A. is a buy up to $41; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• Platform Specialty Products (PAH)

This company, which started out as a London-listed special purpose acquisition vehicle (SPAC) until the company acquired specialty chemical producer MacDermid for $1.8 billion in October 2014, has gotten crushed thanks to weak foreign exchange rates hurting revenues and lower specialty chemical consumption in some agricultural market segments. Management is in chaos as Platform CEO Dan Leever (formerly MacDermid’s CEO) suddenly announced his “retirement” on October 23rd not long after head of the agricultural chemicals division Wayne Hewett (formerly Arysta LifeScience CEO) left in August to pursue other interests. When the leaders of two of the major companies acquired by Platform leave, a lot of expertise goes with them.

PAH is backed by a number of financial heavyweights including Chairman Martin Franklin and Pershing Square hedge-fund manager Bill Ackman, so the company should be able to work out its problems over time, but the fact remains that the stock has lost almost half of its value in 2015 and is not exhibiting the positive price momentum necessary to remain in the Momentum Portfolio. 

Platform Specialty Products is being sold from the Momentum Portfolio.