Rackspace Needs to Find Its Rhythm
Kevin Kelleher
08/11/08 - 02:16 PM EDT
Last November, what passes for a freak accident on the information superhighway sideswiped
Rackspace(RAX Quote).
A truck -- an actual, real-life truck composed of a serious mass of molecules -- slammed into a utility transformer, depriving Rackspace of power at a crucial data center.
It was Rackspace's misfortune that a truck showed up again -- metaphorically, this time -- to derail its carefully planned IPO. Rackspace had lined up a strong crew of underwriters -- Goldman, Merrill, Credit Suisse -- who helped compile a clear, informative prospectus. Even in this parsimonious IPO market, it was expected to go well.
It didn't. Rackspace closed its first trading day at $10.01, a far cry from its pricing at $12.50, which was near the bottom of the $12-$16 range initially proposed. It's never very felicitous when a newly listed stock closes below $10 a share -- let alone on its first day. Rackspace managed to avoid this fate by two cents.
On Monday, the stock joined the broader market's continuing rally, jumping nearly 9% in recent trading to $10.90.
But what happened to this once mouth-watering offering? Can it all be blamed on that dastardly truck? Or is the market simply hostile to tech IPOs, regardless of quality?
Rackspace was heralded as the end of a drought in venture-backed technology IPOs. It had a brand image for good customer service --"Fanatical Support," to borrow the marketing department term (their caps, not mine). It has shown growing revenue and profit. And best of all, it had a feel-good buzz phrase -- "cloud computing" -- peppered throughout its prospectus: "Cloud" appears 23 times in the document.
However, a closer look at Rackspace reveals some vulnerabilities, starting with a nagging persistence of deteriorating margins, and continuing with a history of outages that have plagued Rackspace in the past year.
Rackspace's path to the public markets hasn't been a smooth one. It's gone through four CFOs in five years, according to the
San Antonio Express-News, and disclosed a "material weakness" in its 2007 accounting. It also withdrew its IPO proposal during torrid markets last March.
Investors who can stomach those warning signs may want to take a hard look at profit margins. The company has seen its profit growing more slowly than revenue. The company's top line grew 62% last year from 2006, while operating profit grew 20% and net profit declined 10% (mostly because of a surge in interest expenses and revenue lost due to outages).
That trend hasn't changed much this year: In the six months through June 30, Rackspace's revenue grew 57%, compared to operating profit growth of 23% and net profit growth of 7%.
This graph shows how the slower profit growth is eating away at margins over the past couple of years. Net margins have been below 5% for the last three quarters, and operating margins below 10% for five of the past six quarters.
The overall margin trend is clearly downward. In the June quarter, operating margin fell to 6.4% from 9.3% in the year-ago quarter, and net margin fell to 3.2% from 5.7%.
Where are the costs coming from? Primarily, it's due to new hires. Cost of revenue grew 64% in the second quarter, outpacing the 55% rise in revenue. Putting those capital letters on "Fanatical Support," it seems, costs money. Staff in support and data-center operations grew to 1,173 as of June 2008 from 799 a year earlier. The marketing team cheering them on grew to 419 workers from 275.
More workers may be requiring more compensation, but they aren't bringing in much more revenue. Revenue per employee was $54,000 in the June quarter, down from $50,000 in the same quarter of 2007.
Of course, profit margins were up from the fourth quarter of 2007, but that was the one with the big outage. Rackspace did the stand-up thing: Offering $3.4 million in credits to customers affected by the outage, money which would otherwise have been counted as revenue. It hurt 2007 financials, but it probably won some long-term good faith from key clients.
The problem is that the November 2007 outage wasn't a one-time occurrence. The tech Web site GigaOm
noted that it suffered power issues only a week earlier. And tech blog Valleywag pointed to
further problems in January. That's at least three incidents in the nine months before the company went public.
Outages strike every hosting company eventually, but investors may want to see a cleaner track record before plunging into its stock.
(Interestingly, Rackspace's discussion of the November 2007 outage is no longer on its site, but it lives on in an
archived version. And a
mention of it in the Wikipedia entry on Rackspace was also scrubbed on Friday.)
Finally, there is the question of valuation. Rackspace has 115.4 million shares outstanding, which gave it a valuation of $1.16 billion at Friday's close, or 3.2 times last year's revenue. That's not bad, but it's also 64.8 times 2007 net profit.
Remember, Rackspace's net profit is up only 7% so far this year. Unless profit grows much faster in the last half of the year, it's hard imagining Rackspace with a forward P/E below 60, a rich valuation given we're seeing the harshest climate for tech IPOs in several years.
Rackspace shows a lot of promise, setting a strong foothold in a growing niche. But there are a number of questions hanging over it: Were the accounting mishaps a one-time incident? Can it leverage all the new hires into stronger profit growth? Can it overcome recent outages and strengthen client loyalty?
Until these issues become clearer, Rackspace will have a hard time justifying its high valuation. Which means another recent IPO of a well-run company could be poised for further declines.
