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Intense Competition and Lack of Cash Flow Haunt Rackspace

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Free cash flow is a concern

With a market capitalization of ~$4.5 billion, Rackspace (RAX) was considered a pioneer in the cloud space. However, with the increasing competition ensuing in the pricing war, the company is finding it difficult to post growth. Previously in the series, we saw that Rackspace posted a negative free cash flow of $0.7 million. Free cash flow indicates the profitability and possibility of stock appreciations. Free cash flow allows us to see the cash left over after capital expenditures are accounted for. This money is most likely to reach the shareholders, which is why it’s of special significance to investors and shareholders.

The above chart shows that Amazon’s AWS (Amazon Web Services) dominates the public cloud computing usage. The percentages show the number of organizations running cloud applications.

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Intense competition and price wars pose threats

Amazon (AMZN) is a leader in the cloud space. As the above chart shows, Amazon Web Services dominates the public cloud usage. Amazon is notorious for price cuts. AWS has lowered its prices more than 30 times since its launch in 2006, and is known for its extremely low prices, scalability, and efficiency.

Increased interest from technology leaders like Microsoft (MSFT), IBM (IBM), and HP (HPQ) has contributed to the increased competition in the cloud space, thus providing companies with various options to shift to private and hybrid cloud. IBM leads the hybrid cloud space. Rackspace performance has thus suffered due to the rising competition and pricing wars, as its OpenStack is based on the private and hybrid cloud.

Regular price cuts by Amazon forces other players to do the same. For players like IBM and Microsoft, it is still manageable. However, for Rackspace, which is reeling under low revenue growth with barely any free cash flow left, it leads to blockage of new capital, consequently impacting its growth.

3Q15 expectations

For fiscal 3Q15, Rackspace expects revenue to grow in the range of 2% to 3.5% on a constant currency basis. It expects adjusted EBITDA margins to be between 33% and 34%.

You could consider investing in the iShares US Technology ETF (IYW) to gain exposure to Rackspace. IYW invests about 0.11% of its holdings in Rackspace.

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