Rackspace Stock Trades In The Clouds But Analysts Warn The Party Could Slow

May 13 2014, 4:40pm CDT | by

IT-hosting and cloud-computing company Rackspace is trading in the clouds — up nearly 10% after Tuesday’s market action — on the heels of better-than-expected first quarter earnings results. But as the company celebrates its earnings beat and stock rally, more than a few analysts have issued words of caution about the company’s growth potential and future market performance in light of increased competition from technology giants Amazon, Google and Microsoft.

Rackspace reported $421 million in first quarter revenue after the closing bell Monday afternoon, beating the Street consensus of $419 million and marking a 16% increase over sales recorded during the same time in 2013. Net income for the quarter came in at $25 million, resulting in earnings of 18 cents per share, a penny below earnings from the year-ago quarter but six cents above the 12-cent per-share analyst estimate. Investors cheered the earnings beat, sending shares of Rackspace surging in after-hours trading Monday; the stock sustained those gains in early Tuesday trading, going on to open to a 14% pop and trade at or near a 10% gain throughout the day.

However, several different analysts issued lower price targets for Rackspace on Tuesday, issuing words of caution that highlighted everything from the competitive cloud computing landscape to lower selling, general and administrative expenses that slow growth in the future.

“The company will be challenged to differentiate itself from competitors and achieve sufficient pricing to deliver excess returns on capital,” wrote Morningstar analyst Rick Summer in a note on Tuesday, adding that Rackspace competes with Amazon, Google and Microsoft and could be hard-pressed to keep up, especially in light of the giants cutting the price to access their cloud infrastructure services.

“In the ‘unmanaged’ cloud segment, we aren’t convinced Rackspace can avoid the competition and believe it is likely to experience slowing growth or limited profitability for its public cloud offerings,” Summer said. “Either way, we remain concerned that Rackspace will not be able to earn returns above its cost of capital over any meaningful period.”

Morningstar has a $19 per share fair value estimate for Rackspace; the research agency has one of the lower price targets for the cloud-focused company. Other investment firms have higher price targets, even after Tuesday’s revisions: Canaccord Genuity, for instance, lowered its price target from $39 to $35.

“Without a permanent CEO and with increasing levels of competition from competent competitors, we remain concerned for this subsector in the second half of the year and remain cautious on the stock,” wrote Canaccord’s Greg Miller, referencing the departure of Lanham Napier, who retired as Rackspace CEO in February. Graham Weston, Rackspace co-founder, is serving as interim chairman.

Miller added that it is due to the aforementioned competition as well as the company’s lower SG&A spending that resulted in the lower price target.

Stephens’ analyst Barry McCarver, too, cited competition from Amazon, Google and Microsoft in his note about Rackspace but said it had little to do with lowering the Stephens Rackspace price target from $59 to $41. “Rackspace has suffered from headline risk and confusion about the exact service that it offers,” McCarver wrote on Tuesday, but going on to note that Rackpace management made sure to explain the difference between its services and Amazon Web Services/Google Cloud/Microsoft Azure, and in so doing got off to a “strong start” in re-branding. “While we lowered our price target, that was mainly due to trading patterns and the volatility that Rackspace’s stock has experienced and not our belief in the company.”

Analysts from Nomura, Wells Fargo and UBS issued similar sentiments, lowering Rackspace’s price target but attributing the revision less to a significant problem with a company than to a new EBITDA calculation. Nomura analyst Adam Ilkowitz lowered his price target from $42 to $39; Wells Fargo analyst Gray Powell lowered the stock’s target range from $48 to $51 per share to a target range of $38 to $41 per share, based on 7.5 to 8 times Rackspace’s 2015 EBITDA; and UBS analyst Steven Milunovich lowered his price target from $38 to $34, noting, “the stock got deeply oversold and this solid report should calm some fears, but we think the competitive dynamics will make the long term model difficult to achieve.”

Shares of Rackspace traded for gains around 10% throughout the day on Tuesday and eventually closed for an 8.5% gain despite all the price target revisions. Year-to-date, however, the picture still isn’t pretty: the IT provider is down a whopping 26.9% since the first day of 2014 trading. Shares of Amazon, Google and Microsoft, meanwhile, finished Tuesday with modest gains ranging from 0.6% to 1.1%.

 
 

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