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Stock Strategist

Market Is Ignoring Competitive Risks for Rackspace

Absent a potential takeout, prolonged price competition and low returns on capital will depress investment returns.

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We are perplexed by  Rackspace Hosting's (RAX) recent stock market run and have been encouraging investors to avoid investing in this cloud company, preferring to err on the side of caution. Although we remain bullish about the demand for cloud services, including infrastructure as a service, providers like Rackspace and Amazon (AMZN) and the profitability and economic moats across subsectors and companies vary greatly. We do not believe that Rackspace has built durable competitive advantages, and excess returns on capital aren't likely to persist beyond our forecast period. In our view, the stock is overvalued and is likely to deliver subpar investment returns.

Rackspace Lacks an Economic Moat
We can't identify a potential source of moat that would underpin a durable competitive advantage for Rackspace. In our cloud computing framework, we view the shift from the client/server era to the cloud/device era as shifting the economics toward cloud computing vendors, but heavily favoring applications vendors (for example, Oracle (ORCL) and Salesforce.com (CRM)) and operating system vendors, particularly those that are building development platforms (for example, Microsoft's (MSFT) Azure). We place vendors of infrastructure as a service, such as Rackspace, in the hardware bucket, but we expect very few firms in the IaaS segment to build economic moats. Rackspace is not likely to be one of those firms.

Rick Summer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.