Breaking Down Morgan Stanley's $40 Bull And $12 Bear Case Scenarios

Rackspace Hosting, Inc. RAX reported softer revenues, but better margins for 1Q16. Morgan Stanley's Simon Flannery maintained an Equal-weight rating for the company, with a price target of $26. The analyst mentioned that IT application spending and hybrid cloud adoption were key to the company’s future growth.

1Q Results

Rackspace reported revenues of $518M, representing 7.9 percent y/y growth, which was a significant deceleration from the 10.7 percent y/y growth achieved in the prior quarter. “While public cloud was historically Rackspace's growth driver, it has now turned into a headwind, as customers choose to deploy incremental workloads to larger public cloud competitors like AWS,” analyst Simon Flannery wrote.

Rackspace reported adjusted EBITDA margins of 34.5 percent, meeting the higher-end of the guidance range, backed by a G&A decline. The company has a higher number of large recurring revenue deals [more than $100k] in the pipeline than its historical trends, Flannery mentioned.

Guidance Implies Growth Slowdown

Rackspace reiterated its 2016 guidance. The analyst expects 4Q16 revenue growth to decelerate to 3.7 percent y/y, significantly short of the 10.7 percent y/y growth achieved in 4Q15.

Bull Case Scenario: $40

In the bull case scenario, Rackspace becomes the leader in service-only-cloud, and “is able to leverage its Fanatical Support base and service clouds based on third party infrastructure,” Flannery commented. He added that this, along with an embedded dedicated cloud base, would allow the company to improve FCF.

Base Case Scenario: $26

Slowdown in revenue growth, although with “reasonable traction” in the service-only offering. “The service-only growth cannot offset the slower revenues from the legacy cloud. However, the legacy dedicated cloud provides a constant base for positive FCF,” the Morgan Stanley report stated.

Bear Case Scenario: $12

In the bear case scenario, competition could begin to pressure the company’s growth. Amazon.com, Inc. AMZN and others could gain market share with increased scale benefits, forcing Rackspace to lower prices.

“New bookings from incremental customers trail off, while persistent IT spending weakness suppresses installed base growth. The cloud offering cannibalizes managed hosting customers,” Flannery wrote.