3 Reasons This Cloud-Computing Stock Is a Winner

Fools are all too familiar with Rackspace Hosting (NYS: RAX) , and rightfully so. Shares of the cloud-computing specialist are up more than 27% year to date -- triple the return of the S&P 500 over the same period. And that's despite a recent broad-market sell-off that's taken an especially large toll on tech.

By the end of this article I'll have listed three reasons that I believe investors should expect more gains. There's more than pride at stake here. In February I made an outperform CAPScall that I'm sticking by today. I also own shares via the real-money Big Idea portfolio, the performance of which you can track here.

Fanaticism as advantage
Rackspace has a deceptively simple business: Host websites, email systems, and other software for clients on the Web and collect a fee for the effort. Amazon.com (NAS: AMZN) also plays in this sector of the market, serving big names such as Foursquare, Qlik Technologies, and Twitter's TweetDeck. Verizon (NYS: VZ) bought its way in with a $1.4 billion purchase of Terremark Worldwide in January 2011.


Yet Rackspace stands out for a service pledge it calls "Fanatical Support." No, that's not a typo. Rackspace not only coined the term -- it trademarked it. Employees, known internally as "Rackers," vie each month to be the "Top Fanatic" when it comes to serving client needs. The winner gets the rare honor of wearing a sweater made to look like a straitjacket.

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Storming the "Castle"
Only those who go well beyond the call of duty win the right to wear it. And only one person in the history of the company, founded in 1998, has ever won the "jacket" three times. Competition to be the Top Fanatic is that fierce. No wonder churn has gone negative in each of the past two years. Why would customers leave Rackspace, knowing that the next provider will love them so much less?

I know, I'm buying into the hype. So much for dispassionate reporting. Here's the problem: Once you visit Rackspace HQ, as I did last month, it's easy to catch the fever. Rackers are every bit as serious about support as the marketing material claims they are. You can hear it in the halls. A bell rings proudly with each customer problem solved. The clanging, and the cheering that accompanies it, occur almost hourly as Rackers compete to be crowned chief of the crazies.

But they aren't too serious, either. They call the abandoned mall that serves as headquarters "The Castle." Only this is no fortress. CEO Lanham Napier sits in a cubicle. So do all the executives. They and others use a second-floor slide to get to the highly sensitive network operations center, where teams monitor customer accounts and Rackspace servers 24/7. A nearby "Food Court" sign -- a holdover from the old mall -- looms over an in-house coffee bar.

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My half-day at the Castle included a tour, detailed discussions about strategy, and an explanation for how Rackspace uses the Net Promoter metric to improve performance. All of it was interesting. But none of it was nearly as important to me as an investor as history.

Starting out by giving customers the stiff-arm
Co-founders Pat Condon and Dirk Elmendorf sat with me for an hour. (The third founder, Richard Yoo, has since moved on to other entrepreneurial endeavors.) Here are three things I learned from them that you may, as I was, be surprised to discover.

1. Rackspace was a real estate business from the beginning. Rackspace was born out of a desire to give customers control over hardware. Rent the system, give access, and collect fees. Or so the principals thought. The problem? Elmendorf said it cost $3,000 to set up a new customer on a server, and after 30 days the company had 30 customers, or roughly $90,000 in capital commitments. An initial $100,000 infusion would run out before Rackspace had a chance to profit. A scramble for consulting work led to a pitch for wiring a downtown building for Internet. The project fell through, but the building's owner, Graham Weston, understood the importance of the Internet. In Rackspace, he saw an opportunity to build what amounted to Internet apartments for rent (a model that exists to this day). He invested, and he remains involved to this day as company chairman.

2. Customers started out hating Rackspace. Though Weston's investment helped firm up Rackspace's rent-computing-power-as-you-need-it model, Fanatical Support wasn't originally part of the equation. Condon and Elmendorf said that they never intended to talk with customers. Instead, their strategy was to "reboot and reinstall and tell you to go somewhere else," Elmendorf said. Surprised? He and Condon explained that analysts covering the industry argued that customers were a "necessary evil" and that keeping contact to a minimum was key to preserving quarterly profits. Transactions mattered; relationships didn't. And as a result, monthly churn soared to 10%. Rackspace was turning over its entire customer base every year.

3. How a janitorial model transformed the company. If Weston was one change agent, David Bryce was the other. He had previously run a janitorial services company, a cutthroat business in which service was the only real differentiator. After handling one particularly awful call from a customer Rackspace had let down repeatedly, Condon said Bryce stood up and said they had to do better. Shortly afterward, he acquired and designed the first straitjacket, deeming it the top award for those who served customers well. They had to become fanatical, Bryce warned at the time. Elmendorf admitted to being nervous, saying, "Fanatic isn't a business word." But with churn rising, the strategy was worth trying.

The team began by making a list of all things they hated about customer service. Waiting on hold was a top choice. Today, if you call Rackspace, you get a live person. Another was dealing with different agents for the same problem. Today, if you have an account with Rackspace you are assigned a team so that if one person is out, another knows all there is to know about your account, history, and current problem. On and on it goes. In every way that Rackspace could transform the customer experience, it did.

Finding its rebel yell
Growth has followed, and as investors we've profited from Rackspace's finding its niche. The stock has tripled in the two-and-a-half years since joining the Motley Fool Rule Breakers scorecard. Revenue and profit growth have accelerated over the same period. Margins are up and still rising.

The takeaway? Rackspace has already made and learned from the mistakes that could have killed it. Yet somehow the company survived. Today, with a culture that attracts uncommon talent and a customer service commitment that attracts uncommon loyalty, I'm not sure there's anything it can't survive. Think I'm right? Wrong? Please weigh in using the comments box below.

Rackspace isn't the only company profiting from the cloud-computing revolution. For more ideas, I suggest this Motley Fool video special report: "The Two Words Bill Gates Doesn't Want You to Hear." The research is free, but only for a limited time. Click here to watch now.

At the time this article was published Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Qlik Technologies and Rackspace Hosting at the time of publication. Check out Tim's web home, portfolio holdings, and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.Fool contributor Tim Beyers owns shares of Qlik Technologies and Rackspace Hosting, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. Motley Fool newsletter services have recommended buying shares of Rackspace Hosting, Qlik Technologies, and Amazon.com. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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Richard Yoo

Your recount of RAX's history is not 100% accurate and could be more complete - feel free to contact me for more detail... :)

April 12 2012 at 1:52 PM Report abuse rate up rate down Reply
1 reply to Richard Yoo's comment
Tim Beyers

Richard,

Thanks for the response. I'd love to talk further? How do I reach you? Alternatively, you can try me at tbeyers@gmail.com.

Thanks mich,

Tim
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Tim Beyers
Writer and Analyst, Motley Fool Rule Breakers and Motley Fool Supernova
http://timbeyers.me

April 13 2012 at 4:05 PM Report abuse rate up rate down Reply