Rackspace and the Economics of the Cloud

Rackspace (RAX) has shared details of its cloud computing operations, and the numbers provide some interesting contrasts with the company's traditional power base in managed hosting.

Rich Miller

February 26, 2009

3 Min Read
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Cloud computing is hot. But is it profitable? And if so, does the business model extend beyond Internet titans running giant data centers? Cloud market leader Amazon (AMZN) has yet to break out any customer or revenue data for its Amazon Web Services unit. But another public cloud builder, Rackspace Hosting (RAX) provided details of its cloud computing operations in last week's earnings report, and the numbers provide some interesting contrasts with the company's traditional power base in managed hosting.

Rackspace beefed up its cloud operations with its recent acquisitions of JungleDisk and SliceHost, which is reflected in a huge jump in its cloud customer count. But the revenue from these customers pales in comparison to the managed hosting operation:

  • As of Dec. 31, Rackspace's cloud computing services had 34,820 customers, or 65 percent of the company's total customer base. Those operations generated net revenue of $8.9 million in the fourth quarter, which works out to 6.2 percent of the company's net revenue for that period.

  • Rackspace's managed hosting operation has just 35 percent of the customers, with a total of 18,480. But it generated $134 million in revenue for the quarter - 94 percent of total revenue. 

Let's look at these numbers using average revenue per user (ARPU), a common metric for hosting performance: each cloud computing customer produced an average of $254 in net revenue in the fourth quarter, while the managed hosting business averaged $7,265 per customer.

The math suggests that Rackspace might be better off focusing on its managed hosting business. It's a little more complicated than those numbers might suggest. But even if it Rackspace raises the ARPU for its cloud business, it has a ways to go before it approaches the managed hosting operation. So why is Rackspace so gung ho about cloud computing?

For Rackspace, the cloud represents both a threat and an opportunity. Here's why:

  • The Opportunity: Rackspace sees the cloud operation as the best way to expand aggressively into the small business hosting market, where most companies haven't been able to afford managed hosting services. A cloud offering allows Rackspace to offer a more affordable on-ramp for these small businesses. A vibrant base of growing small business customers creates an internal pipeline of prospects for the managed hosting business.

  • The Threat: Many of Rackspace's enterprise managed hosting customers are watching the evolution of cloud computing and over time may want to shift applications to the cloud model. With its in-house  platform, Rackspace can offer a hybrid managed/cloud bundle, so that customers who move to the cloud will do so at Rackspace rather than a cloud specialist.  

It's important to note that ARPU isn't an effective metric for the relative profitability of the cloud computing and managed hosting operations, as it doesn't include costs for hardware and customer support - areas where cloud hosting and managed hosting have very different profiles. A single managed hosting customer may require many dedicated  servers, while each cloud computing server will be expected to provide resources for multiple customers. 

Benefits for Providers?
The benefits of cloud computing for customers are well understood. But what about the benefits for providers? As we've previously noted, Rackspace is focusing on cloud computing because it believes that over time it will get more revenue out of each server than in managed hosting. 

Rackspace President and CEO Lanham Napier said that the company expects its cloud hosting services to be ”higher growth, higher margin businesses than our managed hosting.”

That extra mileage comes from improved utilization - the ability to pack more customers onto each server in a cloud platform  - as well as an extended lifespan as retired servers from the managed hosting business are incorporated into cloud computing clusters with higher fault tolerance.    

Server Utilization as Differentiator
If server utilization is the key to cloud success, does this tilt the playing field in favor of existing server farm operators with economies of scale? Or can customized service offerings and exceptional support build lucrative niches in the cloud? Rackspace, with about 125,000 square feet of technical space and its emphasis on "Fanatical Support," may be positioned to play on both fronts.   

We'll get better metrics on the per-server revenue and profitability of cloud computing over time. Rackspace should be commended for breaking out its cloud computing operation to provide better insight for investors, and give analysts a means of tracking the company's progress on its foray into the cloud. Let's hope Amazon follows suit very soon.

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