Not Just An Appliance in a $RAX

by Dan May 9, 2016 2:24 pm • Commentary• Trade Ideas

Event: Tonight after the close, Rackspace Hosting (RAX) reports their Q1 results. The options market is implying about a 14% one day move tomorrow, which is rich to their one day average moving following their last 4 quarterly reports, which is also the average move dating back to 2009. 

Price Action / Technicals: RAX is down 11% ytd, down nearly 60% from its 52 week highs, and up 50% from its 52 week intra-day lows that occurred the morning of their Q4 results in mid February.

On the morning after their Q4 results, RAX opened down 16%, but reversed hard to close up 3% on the day.  While the company met Q4 expectations, they guided Q1 and full year 2016 lower.

[caption id="attachment_63500" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

In hindsight, the reversal after a massive gap lower, amidst a few brokerage downgrades was a classic short covering rally. It was hard for the stock to find many incremental sellers after all that.

My View into the Print: Since going public in 2009 the company has demonstrated revenue growth of at about 20%, 2016 is expected to be its first year of single digit rev growth.  The stock currently trades 1.5x expected 2016 sales, and 24x expected eps growth of only 4%.  The issue here is that while RAX is partnered with Amazon’s AWS and Microsoft’s Azure to offer valued-added services for their public cloud offerings, they are actually losing business to these larger platforms for their private cloud offerings, per BarronsOnline:

Also downgrading the stock is Pacific Crest’s Michael Bowen, who cuts his rating to Sector Weight from Overweight, as he’s skeptical the company can offset the leak of workloads to the public cloud providers:

While Rackspace continues to attempt to win value-added contracts associated with other cloud platforms, the contracts are not material enough to offset softness in Rackspace’s public cloud revenue. Management states it is shifting resources from OpenStack private cloud to AWS and Azure as well, but this will likely take substantial time to accelerate […] Rackspace reported that it now has 100 customers signed up on fanatical support for AWS and has its first estimated six-figure deal. The majority of these customers are new to Rackspace. While this may be a strong start for the company, it is not going to be enough to offset the weakness in the public cloud business, in our view. Rackspace cited macro pressures, 1Q16 softness, resources shifting to AWS and Azure, and its increasing reliance on cloud partners to drive value-added revenue. Rackspace decommissioned 2,400 servers during the quarter due to legacy public cloud migration to OpenStack public cloud and data center consolidation in London, and we believe decommissions could continue throughout 2016

Potential Outcomes: After last quarter’s guidance reset, a miss of the already lowered guidance, and another reset lower would easily have the stock back in the high teens in line with the implied move.  An inline quarter (again, in line with expectations that were higher 3 months ago) and in line guidance would likely result in a stable stock massively under-performing the implied move.  While a beat and raise, implying a re-acceleration in business conditions would have the stock above its 200 day moving average for the first time since last May:

[caption id="attachment_63502" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

My Take:  RAX put themselves up for sale back in 2014 when earnings growth was 26% and sales growth was 17%, to no avail.  I am hard pressed a buyer would emerge out of know where now that growth has decelerated massively and their competition is only getting stronger.  While sentiment is not particularity bullish (8 Buy ratings, 12 Holds and 1 Sell) and short interest is high at 12%, I suspect a flush like what just seen in stocks like GoPro, Fitbit, Square and Twitter could be in the cards as investors have little appetite for repeated guide downs.

I have no conviction on direction, but the reversal on last earnings caught my eye and thought worth taking a look prior to the print.