Is Rackspace Hosting Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Rackspace Hosting's (NYSE: RAX  ) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Rackspace's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much Rackspace's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Rackspace's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Rackspace managing its resources well? A company's return on equity should be improving, and its debt to equity ratio declining, if it's to earn our approval.

By the numbers
Now, let's take a look at Rackspace's key statistics:

RAX Total Return Price data by YCharts.

Criteria

3-Year* Change

Grade

Revenue growth > 30%

105.7%

Pass

Improving profit margin

72.9%

Pass

Free cash flow growth > Net income growth

156.3% vs. 258.8%

Fail

Improving EPS

213%

Pass

Stock growth (+ 15%) < EPS growth

265.5% vs. 213%

Fail

Source: YCharts. *Period begins at end of Q3 2009.

RAX Return on Equity data by YCharts.

Criteria

3-Year* Change

Grade

Improving return on equity

58.1%

Pass

Declining debt to equity

(72.2%)

Pass

Source: YCharts. *Period begins at end of Q3 2009.

How we got here and where we're going
Rackspace's five out of seven possible passing grades looks solid. When you consider the fact that another few strong quarters could easily earn those extra two points by improving free cash flow and bringing EPS gains in line with stock-price gains, Rackspace looks even stronger. Free cash flow and EPS gains at the level Rackspace has sustained since late 2009 are nothing to sneeze at. Can the company continue this strong performance?

Fool analyst Tim Beyers certainly believes so. He's made the company a cornerstone of his Big Idea Portfolio, and it's currently the best performer in that elite group, beating out even fellow high-flying cloud-service company salesforce.com (NYSE: CRM  ) Tim points out that Rackspace's underwhelming third-quarter results shouldn't be interpreted as long-term weakness, since the company's in the middle of a shift toward a more scalable open-source infrastructure. On fundamental terms, Rackspace is clearly already ahead of Salesforce, as I discovered when pitting the two companies against each other in a head-to-head battle earlier this year.

Key to Rackspace's strategy when it comes to cloud hosting domination is a fanatical support -- make that Fanatical Support, trademark and all -- of its clients. In an era of automated support, Rackspace makes sure every customer gets personal, human support for whatever problems they may have. Every little bit of connection matters in the highly commoditized cloud storage industry. Amazon.com and Microsoft offer near-flawless reliability for their customers thanks to the deployment of monstrous server farms, and even Spanish telecom Telefonica (NYSE: TEF  ) is getting in the cloud game with what it claims is the ultimate in uptime and accessibility. With so much competition, the human touch can go a surprisingly long way. Rackspace's reliability in the middle of Hurricane Sandy also earned plaudits -- in a networked world, maintaining connections is vital to getting the news of major destructive events in real time.

Rackspace is hardly cheap today, but one thing you'll notice is that a number of utility-cloud companies sport eyebrow-raising P/Es as well. Foolish favorite VMWare (NYSE: VMW  ) , which is a leader in cloud-based virtualization (where file systems and remote programs replace the hardware in your office), has a 50 P/E despite posting faster revenue growth than Rackspace. Salesforce isn't even profitable at the moment, yet it sports a market cap near $20 billion. However, hosting heavyweight EMC (NYSE: EMC  ) has a more reasonable P/E of 19 today, which may well be Rackspace's fate -- virtually no company can maintain a P/E near triple digits for the long run.

Putting the pieces together
Today, Rackspace has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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