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Price cuts, OpenStack transition make Rackspace miss in Q1

Revenues and profits up, but Wall Street will freak out

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Rackspace Hosting did not turn in the kind of first quarter it wanted for the period ending in March, so expect knee-jerk reactions and hyperventilating from investors who think it can't stay in the cloud game against the likes of Amazon, Google, and Microsoft.

Its results did not meet Wall Street's expectations, with only 20.2 per cent revenue growth, to $362.2m, and net income up 17.6 per cent, to $27.3m. That was about $5m shy on the revenue and a penny per share shy on the net income.

Sequential growth in the public cloud, which is comprised of the new OpenStack-based service in addition to the legacy Rackspace Cloud platform that it is replacing, slowed more than expected, according to CEO Lanham Napier.

Rackspace had $90.9m in public cloud revenues in the period, which was up a whopping 40.4 per cent year-on-year. So what is the problem? Sequential growth in the public cloud biz was only 4.1 per cent and lower than Rackspace anticipated.

Moreover, even as the company added 9,800 new customers in the first quarter, the hosting business, which is now called dedicated cloud, only grew 14.7 per cent to $271.3m from last year's first quarter, and only saw a 2.2 per cent bump sequentially from Q4 2012.

As Napier put it, Rackspace is focused on its transition to the OpenStack control freak for its cloud. It's been putting its energies and resources into that business and has not focused as much on its still much larger hosting business. And Napier wants to make sure Wall Street understands that Rackspace is into the cloud for the long haul and that it is tough to predict how such a major transition is going to work out, quarter after quarter.

"It looks to us like OpenStack has reached a tipping point in the market," Napier explained. "Clearly OpenStack has reached a level of acceptance that is appealing to enterprise customers."

And while Napier conceded that Rackspace "was not happy" with the growth in Q1, he did remind Wall Street that the company is much stronger, in terms of technology, than it was even a year ago.

Rackspace doesn't normally do revenue projections. But Jason Luce, the company's VP of finance, said it would provide revenue guidance for the second quarter because of the difficulty of projecting sales, given the transition that is underway and the network bandwidth and storage price cuts that were announced at the end of February, which will continue to impact the second quarter.

Luce, who was sitting in for CFO Karl Pichler, said to expect Q2 sales at Rackspace to be in the range of $369m to $375m. That works out to year-on-year revenue growth of between 15.7 and 17.6 per cent, which is a reasonably tight range.

Luce added that for the full year, Rackspace would spend between $375m to $445m on capital expenditures, and most of this would be to acquire the equipment that customers needed to have their apps hosted on dedicated or cloudy infrastructure.

Rackspace had 94,122 servers under management as the March quarter ended, an increase of 14.2 per cent. Average monthly revenue per server was $1,308, up only 5.7 per cent. Rackspace spent $85.7m on servers, storage, and switching in Q1 and another $13.2m on data center build-outs, up 61.7 and 39.7 per cent, respectively.

As part of its new financial presentation, Rackspace has stopped talking about its customer count, which is a bit odd. None of the other IT players in the cloud market that this systems hack watches provides that data, but still, you hate to lose data.

And Luce was perfectly clear, even though he is not the CFO, that Rackspace would be cutting prices to compete.

"Don't be surprised if we are continually lowering prices on certain products," he warned Wall Street. "We are a cost-plus shop."

Rackspace, like Amazon Web Services, is going to have to make it up in volume. That was why it created OpenStack with NASA in the first place, back in July 2010, and why it is moving to homemade servers inspired by the Open Compute Project started by Facebook. Both give Rackspace access to open source technologies that would cost it money to develop internally, or would have to pay a server maker a premium to come up with.

The question is this: Will OpenStack plus Open Compute servers be cheaper than what AWS can build or buy at the volumes both companies have? No one knows the answer to that question. Yet. The market will decide.

In the meantime, Rackspace says it is going to focus on restoring its growth trajectory. How it will do that is not clear, but it no doubt will mean accelerating the transition to OpenStack-based clouds and leveraging the enthusiasm for OpenStack to attract new customers to its public, private, and hybrid offerings. ®

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