Cloud computing is a very competitive market with the main competition coming from AT&T, Verizon, CenturyLink (via acquisition of Qwest in 2010), Softlayer and British Telecom.

Key success factors for a provider of cloud computing services

a)    Niche market

b)   Installed customer base

c)    Price parity

d)   Quality of Service

e)    Technological edge

Source: http://tinyurl.com/cozlk9j

RAX capabilities to deal with key success factors and risks in this industry

a)    Niche market – Weak, because RAX provides services to any and all market segments that have “demand”. They have not selected any vertical market, or Software-as-a-Service or Infrastructure-as-a-Service application to excel in. Instead, Rackspace is riding its business on “the segment of the market that demands, and is willing to pay for, strong support and management services on top of raw computing services”.

b)   Installed customer base – Weak, because RAX does not have the customer base or geographical co-location advantages AT&T, Equinix and CenturyLink have and who also happen to acquire and retain these customers through other non-cloud computing related value-added services- telecommunication for example.

c)    Price parity – Strong.  RAX cannot increase prices because that would lead to ceding the market to other global players who are eager to enter. The global competitors in the cloud computing space state that differentiation on cost is virtually impossible to achieve because hosting costs are almost at parity for all service providers in the cloud computing industry, as noted here http://tinyurl.com/blchqme. Until 12/2012, RAX had taken a price leader strategy but this was bound to backfire because most customers in this market are highly price sensitive. Rackspace would end up getting most of their sales revenues from fewer and fewer customers if they continued to keep prices high, albeit for more peripheral services. In 2013 they announced price decreases amounting to 33%, http://tinyurl.com/bccd3ua. This pricing decision indicates Rackspace has warmed up to the fact that pricing parity is critical for survival, after all.

d)   Quality of Service – Strong, because RAX pride themselves on customer service. They use the net promoter score extensively to gauge customer sentiment and constantly improve their offerings to increase the score.

e)    Technological edge – Neutral Strong. I am revising this parameter based on IBM’s stated intent of increasing adoption for OpenStack and the fact IBM has included it as the platform of choice for its initial SmartCloud offerings. By promoting an open-source cloud computing platform called OpenStack that HP also supports, RAX is hoping for an ecosystem of partners that will generate long term cost efficiencies resulting from not having to pay for proprietary platform upgrade and maintenance services. However, it remains to be seen if this strategy will entice enough enterprise customers who value the availability of pre-integrated, pre-tested, and validated integration with other enterprise-class systems, something that OpenStack will need continued support over the next half a decade to achieve. RAX also does not have an answer to Amazon’s capabilities such as performance estimates/guarantees and backup from-and-to cloud services and auto-scaling features as noted here, http://bit.ly/YBHJH3. From a storage standpoint, RAX only recently became a player when it reduced prices to compete with AWS (Amazon Web Services).

Drivers of Rackspace future sales

Customer awareness (installed customer base plus new customers), quality of service and technology edge are the main drivers of future sales. Clearly, Rackspace needs to develop strengths in retaining existing customers and also acquiring newer customers. They may be able to do this using their current strategic focus on the following (Rackspace competitive strategy):

1) provide excellent service,

2) maintain a singular focus on delivering-IT-services-over-the-internet,

3) use a portfolio approach to offering flexible cloud computing services- dedicated as well as public hosting- to customers,

4) use and promote OpenStack, an open-source cloud computing  platform.

Rackspace claims to have created several sustainable competitive advantages by following a “differentiation” strategy based on providing above-average customer support as opposed to Amazon that uses a low-cost strategy and rely on automated support. The list of claimed sustainable competitive advantages include:

1. Fanatical Support– a comprehensive system of customer support services that drive customer retention. Use NPS extensively to keep finger on the pulse of customer wants/desires
2. Singular focus– Rackspace only operates in the cloud hosting space and claims that competitors don’t do that but instead dabble with other lines of business which prevents them from focusing on the end-customer as much as Rackspace can with its singular focus
3. Hybrid Hosting– a flexible hosting solution that creates selective “dedicated cloud” and “public cloud” offerings for a single customer
4. OpenStack is the open-source computing platform that has garnered strong support- 100 sponsors including HP- and is the backbone of Rackspace offerings

There are some weaknesses in these claimed sustainable competitive advantages:

1. Fanatical Support is a subjective criterion that can be diluted using various strategies by competitors including but not limited to improving their own version of customer support services, or even offering better “peripheral services” such as free support extensions for repeat customers. There is also the question of scale because Fanatical Support will be expensive to scale, and will tend to drive profit margins lower
2. Hybrid hosting, although attractive to customers who “want everything” is actually operationally detrimental to Rackspace because it “fragments” their hosting platform thereby increasing the maintenance, upgrades and monitoring required to ensure 99.999% availability.
3. Singular focus on cloud computing will work for Rackspace assuming the market is difficult to enter. However, barriers to entry in the cloud computing market are low, despite some consolidation of the players in the last few years (for ex. when CenturyLink acquired Qwest). The heavily competitive nature and downward pressure on prices in the market prove this beyond doubt.

Key drivers for forecasting RAX financial statements

In order to forecast financials for Rackspace we want to focus on the key sources of competitive advantage- Fanatical Support and Hybrid Hosting. These are the primary differentiators across multiple services offerings that will drive organic growth in installed base and create pricing power for Rackspace. Rackspace should be able to charge premiums for their dedicated cloud (or “managed hosting”) and “hybrid hosting” solutions keeping their profit margins high, as they increase investments in long term assets – servers in existing and new data centers. Amazon for example relies on higher asset turnover since it does not premium price its cloud services. What they lose in premium pricing, they make up for in sales volume.

Method to forecast sales for Rackspace

Rackspace has reported revenue history for each segment in its MD&A that provides information relating to breakdown of revenue increases for the current year into the portion relating to increases in server deployments and increase in customer base. Information for dedicated cloud (or “managed hosting”) and public cloud is provided, however, hybrid hosting is a new segment that Rackspace has not provided much insight into yet. We feel it will be necessary to forecast margins per customer for this new segment primarily because Rackspace will able to charge a premium for it. One way we could do this is to use public cloud pricing and add an arbitrary 10% margin necessary to cover costs emanating from providing the “flexibility” customers in this segment desire. We would then perform sensitivity analysis on the margin and base price to check if our assumptions lead to reasonable sales forecasts.

Starting out we can work with the data provided for dedicated and public cloud. At 172510 customers with 79805 servers deployed as of 12/31/11, we can estimate approximately 2.16 customers/server-deployed. This includes servers in both segments- dedicated cloud and public cloud. The average monthly revenue per server in 2010 was $11,824/servers-deployed- about $5474/customer and in 2011 it was $12,844/servers-deployed- which is about $5946/customer, an increase of 8.6%. This $sales/customer number needs to be disaggregated per segment to produce the $sales/customer-per-segment forecast.

These numbers are slightly inflated (greater by 8.6M or 0.8% of net revenue in 2011) because the US$ weakened in comparison to the British Pound. Before forecasting sales in future periods we would want to eliminate the foreign exchange effects as also the effects of any acquisitions that Rackspace were to make since these are one-time occurrences and do not reflect the “organic growth” portion of future sales. Adjusting for foreign exchange rate fluctuations, a more realistic historical growth of sales/customer is 7.8%.

We know that dedicated cloud sales grew 21% on average and public cloud grew 83% on average in 2010 and 2011. Since dedicated cloud is the higher margin offering for Rackspace it would be pertinent to determine the sales per customer in this segment.

We also know that growth in installed user base was .5% and 1% during the same period, or 0.75% on average that we could use as a crude forecasted growth in installed base. Of course, it would be far better to get the growth in installed base per segment – “dedicated cloud” and “public cloud” – separately. We could then multiply forecasted $/customer-per-segment by the forecasted growth in installed base-per-segment to get a projection for Sales. We would then add these projections to the projected sales of the new “hybrid hosting” segment to give us a total sales forecast.

We will also want to forecast expenses because Rackspace happens to be playing in a high fixed cost industry. Rackspace is enjoying economies of scale as demonstrated by the increasing sales per servers-deployed, however, there might be a limit the firm is approaching here and we would want to explore that.