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Forget Amazon -- Buy This Stock Instead

Karen Canella

It might be pie-in-the-sky thinking that Rackspace Hosting (NYSE: RAX) could overtake Amazon Web Services as king of cloud hosting -- at least not in the near future.

That’s not necessarily a bad thing for investors. While’s (Nasdaq: AMZN) enormous profile has cast a shadow over Rackspace for some time now, being No. 2 in this arena is nothing to sneeze at.

Back in March 2012, my StreetAuthority colleague David Sterman named RAX one of the most overvalued stocks in the market -- but these days, Rackspace is getting some rather special attention at current prices. When Dave's article was published last year, RAX sold for about $54. It subsequently grew even more expensive, to nearly $78 a share this January, but it has since fallen nearly 50% from that high.

Last Monday, RAX's share price of $49.31prompted investors to acquire 21,687 call options on the company, about 815% more than usual. That same day, Rackspace reported third-quarter earnings, showing higher than expected revenue ($389 million, up15.7% from a year ago) but lower than expected earnings per share (EPS), which came in at $0.11 compared with the $0.16 expected.

So, you had some investors selling shares -- price fell by 12% mid-day -- and others betting that the stock would go up. Here a few possible reasons for the dichotomy.

Rackspace's earnings miss was due in part to the company's bigger than expected investments on new Performance Cloud Servers, a move being applauded by its critics and one that differentiates itself from Amazon. Without getting too technical, the servers use Intel's (Nasdaq: INTC) Xeon E5 processors with 120 GB of RAM, meaning they’re faster, more reliable and less prone to failure.

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According to IT research firm IDC, “Everyone is gunning for (Amazon Web Services) right now, and performance is one area where competing public clouds feel they can differentiate from them.”

Another factor in Rackspace's miss on earnings might be the nearly 4,800 physical servers it added in the second quarter, which marked a significant increased from the previous two quarters and brought its total number to just shy of 99,000.

After being criticized for the slow pace of growth in its cloud computing business, this was welcome news for investors. The reason for all the new servers: a deployment of new cloud infrastructure in Virginia, Australia and Hong Kong that required added capacity -- which, by the way, is all due to be upgraded soon with Xeon E5 processors.

Unfortunately, Rackspace has been caught between a rock and a hard place. On one hand, as new business churns out revenue, the $5.9 billion company also requires more servers and additional capital expenditures. As a result, second-quarter investments totaled $119.8 million, compared with $188 million for the previous two quarters combined.

“We’ve increased our investment levels to play for a bigger long-term outcome," CEO Lanham Napier says. "This is how we see things right now. We think now is the time to really go for it.”
Some analysts and the financial media think so too.

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• Fortune magazine, citing Warren Buffett's famed advice “to be fearful when others are greedy, and be greedy when others are fearful,” reported that RAX is now considered oversold according to its relative strength index reading.

• JMP Securities concluded Rackspace made a worthwhile investment in the new servers and expects the company to grow 20% in 2014 with a target price of $67.

• Oppenheimer reiterated a buy rating on RAX with a $62 price target.

On the other hand, analysts at Evercore Partners cut their number from $56 to $52.50.

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Risks to Consider: With a 52-week low of $34, RAX may have more room to fall in the short term, especially after an earnings miss. There's also the obvious risk that Rackspace's capital investments might not pan out as expected.

Actions to Take --> Much like Amazon, Rackspace is a great long-term investment. I wouldn’t be actively trading RAX; I would use the 200-day moving average -- which currently stands at just under $45 -- as a buy trigger.

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