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War for the Cloud: Realism about Rackspace



Wall’s Street’s love affair with Rackspace Hosting appears to have come to an end, or at least taken a big hit.

Several days before Saint Valentine’s, the company announced mixed 4th quarter results, light revenue guidance and the "retirement" of Lanham Napier its young CEO. In the earnings call, management also sketched out a new, "services intensive” hybrid cloud strategy aimed at corporate customers.

The company has long been a darling of the Street, with valuation ratios that suggested that investors saw it as a serious challenger in the public cloud to Amazon Web Services (AWS) and even the likes of Microsoft, Google and IBM. The company has indeed grown rapidly and even achieved some level of differentiation, mainly based on its well deserved reputation for outstanding – or as the company like to say “fanatical” - customer support.

This time investors didn’t like what they heard, and shares promptly plunged more than 20% over the following two days.

THE FACTS

On February10, 2014, Rackspace announced financial results for the quarter ended December 31, 2013. Net revenue for the fourth quarter of 2013 was up 16% from the 4Q 2012 while full year 2013 revenue was around $1.5 billion, up 17% from 2012. Operating income margin, however, declined from 13.2% in 2012 to 8.7% in 2013. Forward guidance was light, with the company predicting 2014 revenues between $1.77 billion to $1.8 billion, somewhat below analyst estimates.

In the strategic public cloud market, however, net revenue in 2013 was around $415 million, up 36% from the previous year, while dedicated cloud revenue grew at around 10%.

In an unexpected move, after 14 years with Rackspace, CEO and co-founder Lanham Napier announced that, after overseeing the transition to OpenStack, he had decided to step away from public company executive leadership.

Finally, Graham Weston, a co-founder coming back as interim CEO, laid out a new strategy. According to Weston, Rackspace intends to establish itself as “the leading service specialist in the hybrid cloud with clear differentiation from the do-it-yourself approach of the industry giants.”

ANALYSIS

The forensic analysis of abrupt market swings is an irresistible exercise for financial analysts. Their general consensus seems to be that the detonator of the Rackspace sell-off was the unexpected retirement of the well respected CEO, the sort of thing that is immediately interpreted by traders as bad news to come. As early sellers head for the door and the share price drops, the herd instinct of traders and the algorithms of computer driven trading can rapidly change a dip into a plunge. The new price may or may not bear much relation to the fundamentals, but as everyone knows, markets are always rational…except when they aren’t.

A case could certainly be made, however, that Rackspace was significantly overvalued and that a correction was in order. The company has reported several quarters of uninspiring results and the stock price has steadily moved down throughout 2013. One explanation making the rounds of the industry is that outgoing CEO Lanham Napier spent most of 2013 on the technology transition of existing customers to OpenStack to the detriment of business development.

Be that as it may, investors may well have become simply more realistic about the company’s medium term prospects. Rackspace is facing increasingly fierce competition, not only from AWS, the public cloud market leader, but also from giants like Microsoft, Google and IBM. Lacking the economies of scale of its rivals, competitive pressure can only get worse and financial performance may well continue to suffer.

A more realistic strategy for a changing market

It is clear that Rackspace will have a very tough time if it continues to play the same game as its biggest competitors. In that light, the most interesting thing about the earnings call was the announcement of a strategic inflexion, away from pure “infrastructure provisioning” and towards a “services intensive” approach focused on hybrid clouds.

Management was quite explicit in targeting mainstream corporate customers who are only now adopting the cloud as a platform for technical and business solutions. They believe that these mainstream customers – unlike the “do it yourself” early adopters - want top notch support and services, in order to focus development resources on their core businesses rather than on the operation of cloud infrastructure.

There is a lot to be said for this analysis of where the market may be going. Most markets, including Tech, do in fact have room for both high volume and high value players, assuming of course that the perception of higher value by the target customers is sufficiently compelling that they are willing to pay more. In technology markets, in particular, “disruptive” technologies like the cloud do tend to follow a well-known “adoption curve” in which the early market is opened by “do it yourself” technophiles, later followed by mainstream customers with very different expectations.

In this context, Rackspace’s new strategic direction makes sense, which is not to say that execution will be easy or that the company has, as of yet, figured out how to do it.

In the earnings call, Graham Weston, the incoming interim CEO, affirmed that achieving differentiation as a service specialist would be based on “three core pillars”: “fanatical” customer support, hybrid cloud (leveraging OpenStack) and specialist capabilities in running open and standard technologies.

Overall, in a pure “public cloud” market, these points may well be differentiators, but for a company that aims to be a high value services specialist for hybrid clouds, they are “check the box” requirements. “Hybrid” is hot in the IT industry and Rackspace will still be facing serious competition from players like IBM and even VMware with deep roots in existing enterprise IT infrastructures. Even so, as a cloud services specialist, the company will be playing in a game where factors such as customer intimacy and top notch skills are more important than pure economies of scale.

Execution issues

However sound the strategy, execution will make the difference, and Rackspace has some important issues to address.

First, it needs to build a catalogue of industrialized services that those mainstream customers it wants to target are willing to pay for. Given its roots in dedicated hosting, this should be within Rackspace’s capabilities, although it is surprising to see the apparent confusion in the company’s narrative between “customer support” and a true services offering. The catalogue should include both “upstream” services such as architecture and cloud application enablement as well as “downstream” operational services, from OS and middleware management up to 24x7 application supervision.

Second, it has to ensure that its basic infrastructure pricing remains, if not the cheapest, at least reasonably competitive. If the first cost item is “out of the market”, the discussion will stop before it gets started and potential customers will look to other possibilities, for example, a volume cloud player in partnership with a third party services provider.

Finally, Rackspace needs to devote a major effort to developing a solutions and services ecosystem. Attracting developers and ISV applications will be key, but it will also need specialized services partners to complement its own offering. The success of AWS owes as much to its flourishing ecosystem as to its massive economies of scale and demonstrated willingness to undercut competitors on pricing. This is a particularly urgent issue, because most of the players are already competing furiously for ecosystem mindshare.

CONCLUSION

Rackspace’s strategic inflexion from volume to value can be seen as symptomatic of the rapidly changing dynamics and structure of the cloud marketplace. In pure infrastructure provisioning, the company is up against very big competitors with very deep pockets and needs to find a new space in the market.

In this context, the ambition to become a hybrid cloud services specialist does make sense, if the company intends to remain independent, as it presumably does. Even so, while Rackspace has recognized technological strengths, loyal customers and a well respected brand, successful execution on the new strategy will be challenging.

Monday, February 24th 2014
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Duquesne Advisory is a European firm, dedicated to researching, understanding and advising clients worldwide on opportunities and trends in Information and Communications technology.

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Duquesne Advisory delivers in-depth analyses of Information and Communications Technologies, their implementations and their markets. Research is based on critical observation of the market by the analysts and their on-going contacts with the vendor community, together with hands-on, practical experience in consulting engagements.

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The analysts of Duquesne Advisory leverage the Firm’s ongoing market and technology research to undertake high added value consulting engagements for both ICT users and ICT providers. Focused on client service, their approach is rigorous and methodical, and at the same time pragmatic and operational.