Data Center Stocks: Rackspace Pivot to Cloud Support Fails to Impress Investors

From an investor's point of view, Rackspace Hosting is now operating in uncharted territory, and Mr. Market hates uncertainty.

Fanatical belief in "fanatical support" and anecdotes about the potential of managed services for Amazon Web Services and Microsoft's Azure, Private Cloud, and Office 365 simply didn't excite analysts on the Q4 2015 earnings call.

Rackspace (RAX) investors bid the stock up 3 percent to close at $18.17 prior to the release of Q4 earnings and full-year 2015 results after the bell Tuesday.

The company reported record revenues of just over $2 billion for full 2015, with fourth-quarter revenue of $523 million coming in $1.4 million higher than consensus estimates. Its CEO Taylor Rhodes's prepared remarks were upbeat regarding the new direction, key new hires, and new initiatives, which the cloud hosting company has undertaken.

But none of this helped its stock. RAX fell 8.6 percent in after-hours trading to $16.70 per share that day on what was widely perceived as soft guidance for 2016. One analyst on the Rackspace earnings call referred to the company's 6 to 10 percent revenue growth in 2016, or 8 percent at the midpoint, as essentially being flat.

The company's management also shared that a "seasonal slowdown" expected in Q1 2016 would become a headwind for Rackspace full-year 2016 results. The global macroeconomic environment was another factor mentioned for the relatively flat revenue expectations for 2016.

Little Color on New Initiatives' Progress

Rhodes seemed pleased to be able to report that the company had signed 100 customers since the October 2015 launch of Rackspace Fanatical Support for Amazon Web Services. One of these enterprise customers signed up for a "six-figure" monthly services contract, he said. Seattle-based Razorfish, a digital advertising firm, was singled out on the call as a featured customer win. However, to put those numbers in perspective, Rackspace has an existing customer base of 300,000 customers located in over 120 countries.

It became clear as the call progressed that the new business plan for supporting Amazon and Microsoft public cloud offerings had many moving parts, with minimal visibility regarding sales, revenues, or margins.

While Rackspace has made substantial investment in its public OpenStack cloud business, it was also clear on the call that company management is no longer expecting to see a lot of growth from that business. They were candid in sharing that its existing customers were deploying new workloads on AWS and Azure.

Rackspace is now spinning AWS pricing in a positive light, with Rhodes saying that both Rackspace installed base and new customers will use its services to migrate into the big public clouds and to manage hybrid cloud solutions. He also expects this migration to boost sales of Rackspace Managed Security services.

Management believes that engineering hybrid solutions for customers should lead to more private cloud hosting opportunities for Rackspace. In turn, this will drive CapEx spending for new equipment to build those IT stacks. This helps to explain why the company's initial 2016 guidance of 20 to 22 percent of CapEx did not markedly decrease from the 23.3 percent expenditure in 2015.

My concern is that Rackspace is not truly in a growth mode, while the transition over to this new strategy precludes any real hope for steady-state results in 2016.

A slide like this one, from the Q3 earnings presentation by Rackspace, was not included in the Q4 deck. In fact, many slides were omitted from last quarter, highlighting the uncharted nature of its current initiatives.

CFO Karl Pichler clarified toward the end of the call that as long as Rackspace remains in the hosting business, that 10 percent of revenues required for Maintenance CapEx would be the absolute spending floor.

Low Data Center Utilization

Another factor that may weigh on results moving forward is server decommissioning from customer migration resulting in lower data center utilization. Rackspace revealed that it is only utilizing 32.2MW of the 62.7MW of data center capacity currently under contract.

It was required to take down space in London in 2MW increments, which mitigated savings from two sites outside of London, which were decommissioned. The management indicated that there is still a long-term expectation of growth but made no mention of any anticipated data center capacity reduction.

Investor Takeaway

Rackspace has been forced to pivot away from its former bread and butter of managed hosting in order to survive.

Clearly, the elephant in the room during the earnings call was how fast the Fanatical Support managed cloud services will take to ramp up as its cloud hosting business slowly deteriorates.

Meanwhile, Rackspace spent $327 million buying back shares during Q3 and Q4 2015 and expects to complete this $500 million repurchase by May 2016. Additionally, the board has approved another $500 million share repurchase authorization which will run through mid-2017.

This certainly shows that management is confident in its ability to grow free cash flow as it transitions into a less capital-intensive managed services provider.

It remains to be seen whether Rhodes and his Rackers will be able to pull a rabbit out of the proverbial Red Hat for investors.