Rackspace Running Out of Room

NEW YORK (TheStreet) -- The market's recent decline demonstrates what I've always known to be true; when the going gets tough, investors typically get going. This is despite the constant drumbeats about "having conviction." In that regard, investors in Rackspace (RAX) have become prime examples of how patience, virtuous as it may be, is limited.

Some analysts have cited Amazon's (AMZN) recent weakness in its web services segment as reasons to be suddenly cautious on Rackspace. Although Rackspace did suffer a 2% decline on Amazon's announcement, we must then explain Rackspace's 33% decline since the end of September.

In fact, with shares now trading at around $36 per share, the value of this stock has been cut in half since the stock reached a high of $79.24 twelve months ago. Rackspace's rise and fall underscores the consequence of what has become known as "theme investing" in the stock market, particularly in the tech sector.

The buzz surrounding everything associated with "Big Data" and "The Cloud" was yet another example of "theme investing." The disruption propelled the likes of EMC (EMC) and Salesforce.com (CRM) to new heights. This then created a stir about the potential of Amazon's web services in the IT space, particularly in hardware.

The disruption did come. And as Amazon stock soared higher each quarter on the backs of "old tech" like IBM (IBM) and Microsoft (MSFT), Amazon stock exceeded the comfort zone for some investors. That's when the Street turned to Rackspace as the "next best thing."

Unfortunately, the "theme" now is Amazon suffering in web services, so the outlook for Rackspace must not be good. And investors have picked up on this lesson far too late, because Rackspace management must have had some idea. Rackspace's CEO Napier Lanham has sold over 1.6 million shares since November at around $42 per share. Not to mention the sales executed by other officers of the company.

In the case of Lanham, in fairness, I will note that he still owns a significant amount of stock (about 900,000 shares). Plus, he controls another 3.6 million as general partner for HBSA (Home Business Success Academy), an academy for training and turning aspiring networkers and entrepreneurs into market leaders, according to its website.


So it's not as if the CEO is bailing on his company. I want to make that patently clear. But he timed the stock sales well, given that shares are trading 14% lower today. Have we seen the bottom? Far too often, just when we think that things can't get any worse, they do.

Monday, the company will report fourth-quarter and full-year earnings results. After a disappointing November quarter that revealed eroding profit margins within its cloud services, management must show some signs of life. The Street will be looking for earnings of 14 cents per share on revenue of $404.5 million, a 14% year-over-year revenue increase.

Earnings, meanwhile, are projected to decline 33% from last year, which has been the problem affecting this stock. As with Salesforce.com, Rackspace has compiled a track record of aggressive growth. The dilemma, though, is that growth has come at the expense of margins.

This has been Amazon's strategy, too. But even with Rackspace's 16% revenue growth in November, it just doesn't command that same level of respect. Unlike Amazon, which has consistently "delivered the goods" and then some, Rackspace, despite the solid growth, has only met estimates. This explains why the Street has gotten jittery about its prospects.

When you consider the possibility of Amazon squeezing more life out of Rackspace to shore up its own web services business, you have an answer to whether things can still get worse. I have to remain cautious here until management can put together consecutive quarters of earnings/margin improvements. Although the stock might appear more compelling than it was twelve months ago, the risk/reward ratio is not yet in Rackspace's favor.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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