Is Rackspace a Falling Knife?

With shares of Rackspace Hosting (NYSE:RAX) trading at around $34.77, is RAX an OUTPERFORM, WAIT AND SEE or STAY AWAY? Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

C = Catalyst for the Stock’s Movement

It’s often said that investors should never attempt to catch a falling knife. This means that if a stock is consistently dropping, you shouldn’t attempt to predict a bottom and invest in that stock. If you do, then you will hurt yourself. By this definition, yes, Rackspace is a falling knife.

Even if there is future potential, it doesn’t matter if the market has already made up its mind. Once the sellers pile in, the downward trend compounds on itself. A v-shaped recovery is highly unlikely. The best investors can hope for is for the selling to exhaust itself and for the stock to trade in a range for several months, sometimes even years. This is when a buying opportunity often presents itself. Unfortunately for Rackspace, that time has yet to come.

Rackspace is trading at 45 times earnings whereas the industry average is just 10 times earnings. This makes the stock highly sensitive to market corrections. It’s also part of the reason there is a 10.90 percent short position on the stock.

R&D and depreciation expenses have both increased. This led to a Q1 operating margin decline of 50 bps to 11.8 percent. However, Q1 revenue and earnings still improved year-over-year, and revenue and earnings have consistently improved on an annual basis.

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There doesn’t seem to be much confidence in Rackspace’s near-term potential. However, Rackspace seems to be very confident in its future potential, partially due to wearable technology and what it refers to as the human cloud. Not many people have taken advantage of wearable technology to date, but the majority of those who have admit that it has helped improve their lives. Started improvements have related to:

  • Health and fitness (biggest improvement)
  • Career development
  • Knowledge
  • Self-confidence
  • Control
  • Love life

The chart below takes a look at some basic fundamentals for Rackspace, International Business Machines (NYSE:IBM), and Computer Sciences Corporation (NYSE:CSC).

RAX IBM CSC
Trailing P/E 44.92 13.95 7.28
Forward P/E 40.69 11.02 10.91
Profit Margin 7.99% 16.05% 6.41%
ROE 14.15% 82.86% 17.18%
Operating Cash Flow 438.51M 19.32B 1.12B
Dividend Yield N/A 1.80% 1.80%
Short Position 10.90% 1.60% 1.60%

Let’s take a look at some more important numbers prior to forming an opinion on this stock.

T = Technicals Are Weak

Rackspace has been a big loser year-to-date. At $34.77, the stock is trading well below its 50-day SMA and 200-day SMA.

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1 Month Year-To-Date 1 Year 3 Year
RAX -30.47% -53.67% -26.82% 106.5%
IBM -0.84% 6.32% 8.57% 69.67%
CSC -4.84% 12.79% 77.14% 0.44%
50-Day SMA 42.82
200-Day SMA 58.65

E = Equity to Debt Ratio Is Strong

The debt-to-equity ratio for Rackspace is stronger than the industry average of 0.40.

Debt-To-Equity Cash Long-Term Debt
RAX 0.12 278.63M 105.81M
IBM 1.74 12.06B 33.40B
CSC 0.86 2.06B 2.73B

E = Earnings Have Been Steady

Earnings and revenue have consistently improved on an annual basis — always a good sign! On a quarterly basis, revenue and earnings both improved year-over-year. This is another good sign.

Fiscal Year 2008 2009 2010 2011 2012
Revenue ($) in millions 532 629 781 1,025 1,309
Diluted EPS ($) 0.19 0.24 0.35 0.55 0.75
Quarter Mar. 31, 2012 Jun. 30, 2012 Sep. 30, 2012 Dec. 31, 2012 Mar. 31, 2013
Revenue ($) in millions 301.36 318.99 335.98 352.91 362.20
Diluted EPS ($) 0.17 0.18 0.19 0.21 0.19

 

Now let’s take a look at the next page for the Trends and Conclusion. Is this stock an OUTPERFORM, a WAIT AND SEE, or a STAY AWAY?

T = Trends Support the Industry                         

According to International Data Corporation, the cloud market is expected to increase 130 percent over the next three years.

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Conclusion

Rackspace is probably being unfairly treated based on the company’s fundamentals, consistent revenue and earnings performance, and future potential. On the other hand, with the stock trading at 45 times earnings and 41 times future earnings, it will be difficult for Rackspace to meet expectations. This also makes the stock more susceptible to market corrections.

It should be noted that with the company’s future potential and now more affordable price tag, it’s possible for Rackspace to draw interest from potential acquirers. An acquisition isn’t likely, but the current situation makes it a slim possibility.

Rackspace still has long-term potential, but there will likely be more pain prior to a recovery in the stock price. For now, Rackspace is a WAIT AND SEE.

Using a solid investing framework such as this can help improve your stock-picking skills. Don’t waste another minute — click here and get our CHEAT SHEET stock picks now.

All content posted should not be considered professional advice. Please do your own research and consult with a professional financial advisor before making any investment decisions. I don’t have any positions in this stock.