“The 3 Kings of Cloud Computing: Version 2.0”

By Travis Johnson, Stock Gumshoe, December 13, 2010

The Motley Fool folks have been using the “3 Kings of Cloud Computing” special report to pitch David Gardner’s Rule Breakers newsletter for a couple years now, and have occasionally even given away all three of those stock picks for free as part of their “give us your email” list building exercises — but I noticed today that the ad campaign is back and in full strength, both teasing the “3 Kings” again and teasing us that they have a “Version 2.0” with two other companies in the cloud computing space that you should buy.

For review, the original “3 Kings” from the Rule Breakers pitch were Google (GOOG), Akamai (AKAM) and VMWare (VMW), and by all accounts those are still being teased — Akamai is the company that “makes the internet fly” and VMWare is the one with the “stranglehold on a niche market that’s absolutely essential to the future of cloud computing.” The business case for these companies hasn’t changed much in the two+ years since the ad campaign started and I wrote about them, and though megacap Google’s shares are a bit more stable than the others, the prices of all three have moved in some sympathy with each other through the market crash and recovery — Google and VMWare are priced pretty similarly to where they were in August of 2008 when the ads started, though Akamai has done substantially better (for full disclosure, I own GOOG shares personally and have profiled AKAM as an “Idea of the Month” investment for the Irregulars).

But whether or not you think those stocks are worthy of your attention now (all three trade at a premium to the market, though they have also almost always done so — and they’re growing faster than the market, too), they’re pretty well known by most investors and you and I (old pals, us — right?) have chatted about them any number of times.

So who’s on their list for the “version 2.0” — the sequel in the Motley Fool Rule Breakers “Kings of Cloud Computing” franchise? Version 2.0, appropriately enough, touts two stocks — here’s the headline for the first one:

“The Rule Breaker that’s eating Microsoft, SAP, and Oracle’s lunch — and handing investors monster returns in the process”

Sounds pretty good, right? And in the next few paragraphs we get a few hints and clues … here are the excerpts to whet your appetite:

“This company started out as a top dog and first mover in another emerging area of technology, it has quietly transformed into a budding cloud computing powerhouse that’s positioned to host all of the corporate data on the Web.

“But it wasn’t its robust developer network (literally tens of thousands of developers are now invested in the success of this company) nor its 50,000-plus corporate client list that initially caught David’s eye…

“It was the fact that, like many of the other companies I’ve told you about today, all the “pros” on Wall Street claimed it was drastically overvalued — while overlooking the fact that it’d more than doubled its customer base in just over two years and more than doubled its free cash flow in just over one.

“Not to mention, it outperforms nearly every other company out there (even Google) in turning research and development investments into returns for shareholders…

“Today they sell for around $136 — meaning investors who followed David’s advice have quadrupled their money in just over a year.

“Despite an extremely tough economy, this company managed to grow sales by an impressive 25% in the most recent quarter — while adding 5,100 new customers.”

So this one, you will probably be unsurprised to hear, must be Salesforce.com (CRM) — the pioneer of business-class cloud computing, and one of the first companies to make a mint on the idea that companies would stop hosting their own software and would hire someone else to handle it. Before “cloud computing” entered the parlance, Salesforce got attention for this as pioneering the concept of “Software as a Service (SaaS).

And this is perfect for Dave Gardner’s “Rule Breakers” concepts, because he loves first-movers in a space, which I think fits CRM … but he also loves stocks that are written off as overvalued because Wall Street is a little bit afraid of the nosebleed valuations that hyper-growth stocks get. CRM trades at a FORWARD estimated PE of almost 100 (the trailing — or “actual”) PE is a mammoth 270 with the shares now at $147 (they were at $136 a few weeks back, as teased, but their good earnings and optimistic forecast last quarter moved them up further, as did their announcement that they’re launching a more direct challenge at Oracle with a new “database.com” service).

Given that valuation, with the dramatically slower growth (20-25% annually in the next few years, which gives them a PEG ratio of about 5, among the highest I’ve seen) … it’s probably no surprise that this is both a favorite of many of the momentum jockey traders and a fairly heavily shorted stock (about 12% of the float is sold short). And though I own Google and have owned Akamai and other rapid growers like Intuitive Surgical in the past, I also can’t get over my fuddy-duddy “holy crap that’s expensive” position and get excited about CRM at this valuation, not when it’s already quite large with a market cap of about $20 billion. Still, just because I get sweaty when I start looking at the numbers doesn’t mean it’s a bad pick — that’s up to you, of course, it being your money.

So what’s the second “Cloud Computing 2.0” stock? Some clues:

“Unlike any other company in this niche of cloud computing, this one guarantees that its clients’ cloud computing applications (think Facebook or YouTube) won’t go down for any reason — making it the most trusted company in the industry.

“… now boasting more than 88,000 customers in its latest quarterly report.

“Thanks to a new ultra-efficient business model, new revenue grew 23% year over year and earnings leaped 33%.

“As I mentioned earlier, this company has already gone up some 181% since it was recommended in Rule Breakers — and I imagine you’re beginning to understand why.

“But don’t worry… as with all the companies I’ve told you about today, David Gardner and his team are convinced that this one is just getting started and that the big money is yet to be made.”

So we toss that into the ol’ Thinkolator — and quick as a bunny, we get our answer: Rackspace (RAX)

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Yes, they do guarantee 100% uptime for their network (Rackspace has been primarily a managed hosting provider, though they’re rolling out what seem like higher-touch “cloud” services on top of that — and from what I read, the 88,000 customers is the number for the cloud division). I don’t know if a 100% guarantee is typical, I think my hosting provider guarantees 99% uptime but I’m not positive.

With all the cloud computing-connected stocks getting rumored as takeover targets after the bidding war for 3PAR a while back, it should come as no surprise that the rapidly growing and still quite small (market cap about $4 billion) Rackspace is also expensive as heck — the trailing PE for RAX is about 100, and the forward PE is 60 … which looks affordable compared to CRM, but pretty pricey compared to almost anyone else. Analysts expect them to grow roughly as fast as CRM over the next several years, in the low-20% range, so that’s nice growth but with that high valuation it still means you’re paying a price/earnings/growth (PEG) number of almost 4 for these shares.

I can’t say that I know a lot about either of these companies, so it may well be that you can make a strong case for that premium valuation for these or any of the other cloud computing companies, especially given the scalable nature of the business and the possibility for continued high (or growing) margins. I still like Akamai more than most of these, though not as much as Google (which I own), but even with Akamai I noted for the Irregulars a few months ago that there was plenty of reason to take profits as it neared $50… and if it’s any indication of my thinking about growth stock valuations, I wrote about cloud computing plays for the Irregulars last month but focused on the high-dividend REIT plays in the space (though as I said, I may be a bit of a fuddy duddy these days).

But it’s not my money you’re trying to manage — it’s yours. What do you think about the Fool’s new Kings of Cloud Computing? Is version 2.0 better than the orig