The Good Host: Rackspace

Rackspace US Inc. (NYSE: RAX), a provider of managed- and cloud-hosting services, prides itself on superior customer service, calling it “fanatical support.”

But traders weren’t big fans this week, sending the stock down by as much as 14% after the company reported first-quarter earnings of 17 cents a share, one cent shy of the consensus estimate. Revenue of $301.4 million did manage to beat the consensus of $300.5 million, growing 30.9% year over year and 6.4% sequentially. Those with a myopic view might consider Rackspace’s longer-term growth prospects.

I first started following Rackspace back in September 2009, when the stock was trading around $14. At the time, I saw Rackspace benefiting from the developing trend of more companies (particularly smaller ones) outsourcing their datacenter and cloud computing requirements to outside providers. It’s simply a lot easier and less expensive than buying infrastructure hardware and software. Plus, customers can dial up or down their computing capacity, paying only for what they need.

Rackspace’s laser focus on customer support is paying off: it has nearly 181,000 customers (up from 90,925 at the end of 2009) and has seen its revenue growth accelerate in each of the past two years. After rising 24% in 2010 (up from 18% growth in 2009), revenue last year advanced 31%, topping $1 billion for the first time.

With cloud computing now all the rage, Rackspace shares, which traded below $31 as recently as early October, hit a new high of $60.55 at the start of this month. No surprise that expectations were elevated going into the latest earnings report. Even with the recent pullback in the stock, the company still sports a market cap of slightly more than $7 billion, or 5.3 times the 2012 consensus revenue estimate of $1.32 billion.

In the first quarter, revenue from dedicated hosting rose 23% year over year to $237 million, while public cloud revenue jumped 75% to $65 million. EBITDA margin of 33.4% was up 40 basis points from the year-ago quarter but fell 270 basis points sequentially, partly because of a big jump in hiring costs (headcount rose 7.3% sequentially).

Rackspace added more than 8,300 customers in the March quarter, and its average monthly revenue per server rose to $1,238 from $1,191 in the fourth quarter (the 11th quarterly increase in a row), signaling acceleration in the enterprise customer base.

While monthly average customer churn in the first quarter was below the overall churn rate for last year, monthly average installed base growth of 0.7% fell short of the 2011 average of 1% because net upgrades took a hit on a sequential basis as “a handful” of enterprise customers saw some special projects come to an end, causing workloads to be ratcheted back.

Rackspace primarily serves smaller and midsized businesses. However, the company now counts 47 of the Fortune 100 companies as customers because larger enterprises are increasingly realizing the cost benefits of switching to hosted solutions. The way it usually works is: Rackspace gains a foothold in a large account by hosting one application and then builds business with the customer after proving its services are reliable, secure, and quickly scalable.

Going forward, Rackspace will offer more hybrid hosting, which combines dedicated and cloud platforms via its RackConnect solution. This gives customers, especially larger ones, the flexibility to place workloads where they perform best (bursting into the public cloud on spikes in computing demand) and add the security of a dedicated firewall to the cloud configuration. Enterprises can move workloads between their own datacenters and Rackspace over an encrypted VPN tunnel or private link.

Rackspace is in the middle of a platform transition to OpenStack, an open-source cloud operating system the company developed along with NASA to serve as an alternative to proprietary operating systems from VMware Inc. (NYSE: VMW) in the private cloud and Amazon.com Inc. (Nasdaq: AMZN) in the public cloud. Amazon is a formidable competitor in the public cloud, with its Amazon Web Services business estimated to hit $1.6 billion in revenue this year. By September, Rackspace plans to roll out various OpenStack-based solutions, which will enable it to handle more large-scale applications, including big software-as-a-service (SaaS) workloads.

In February, Rackspace teamed up with Redapt to deliver Rackspace Cloud: Private Edition, a complete infrastructure hardware and support solution for customers who want the consumption model of the cloud, along with the control afforded by private hardware. As part of the offering, Redapt, which has worked with customers ranging from Zynga Inc. (Nasdaq: ZNGA) to Red Hat Inc. (Nasdaq: RHAT), delivers fully configured OpenStack hardware (within 14 days of order placement) that easily plugs into a customer’s datacenter of choice. Rackspace then provides the 24/7 support and operations assistance.