2 Reasons I'm Buying This Overpriced Tech Stock

Say you found a stock that's grown incremental revenue six quarters running. Say that also, in that time, management and the board, which own more than 19% of the business, had found a way to steadily increase returns on invested capital.

The trade-off is you have to pay roughly 100 times earnings to buy shares. Oh, and the list of competitors is long, growing, and dominated by some of the biggest names on the planet. Would you buy? I would. Here's why:

Metric	Q3 2011	Q2 2011	Q1 2011	Q4 2010
New revenue (in millions)	$17,343.0	$17,227.0	$15,276.0	$15,016.0
Additional servers	4,689	3,555	4,458	2,019
New revenue per server	$3,698.7	$4,845.9	$3,426.6	$7,437.3
Cloud computing as a % of revenue	19.2%	17.4%	16.1%	14.6% !

Sources: press releases and TMF estimates.?

Metric	Q3 2010	Q2 2010	Q1 2010	Q4 2009
New revenue (in millions)	$12,396.0	$8,509.0	$9,289.0	$7,117.0
Additional servers	2,122	1,998	3,205	2,016
New revenue per server	$5,841.7	$4,258.8	$2,898.3	$3,530.3
Cloud computing as a % of revenue	13.4%	12.4%	10.8%	10.1%

Sources: press releases and TMF estimates.

This, Fool, is what the growth trajectory at Rackspace Hosting (NYSE: RAX  ) looks like. I'll review the two reasons why these numbers are so important in a moment. First, let's cover what happened in the recently comple! ted thir d quarter.

Strong growth, increasing leverage
Revenue improved 32.5% year over year to $264.6 million while earnings grew 56% to $0.14 a share. Analysts surveyed by S&P Capital IQ had been expecting a similar profit but on just $261.6 million in revenue. The beat reflects continued appreciation for Rackspace's cloud computing offerings.

Customers are flocking to the platform. More than 161,000 use Rackspace now, up almost 9,000 from the prior quarter and 43,000 from last year's Q3. Monthly churn, meanwhile, continues to be under 1%, a remarkably low number for a business that competes with Amazon.com (Nasdaq: AMZN  ) , AT&T (NYSE: T  ) , Verizon (NYSE: VZ  ) , and even upstart 8x8 (Nasdaq: EGHT  ) in supplying services for hosting websites and Web-connected services and business operations.

Two metrics, two reasons I'm buying
Investors should be especially pleased with the customer data. Why? Look back at the table above. Revenue has grown progressively faster in each of the past six quarters despite relatively stable customer growth.

Last quarter, Rackspace added $17.343 million in new revenue while adding 8,844 customers. That's $1,961 in new revenue per customer. Now contrast that with last year at this time. In Q3 of 2010, Rackspace added $12.396 million sales and 10,709 new customers. That's an average of $1,158 in new revenue per customer. Rackspace is 69% more efficient at generating revenue than it was a year ago.

The data speak to the leverage built into Rackspace's model. Buy or finance extremely cheap servers from Dell (Nasdaq: DELL  ) and white box vendors, own little land, and spend abundant resources on people with the skill to build dif! ferentia ting software and support customer environments fanatically.

Indeed, it's the leverage that leads to the second reason I'm buying Rackspace. Underlying efficiency has led to strong and increasing returns on invested capital. On an annualized basis, return on capital improved from 12.5% in last year's Q3 to 14.8% last quarter. The implication? Management's expansion efforts are paying off and creating excess value for the business, and thereby, shareholders.

More proof that the cloud isn't just hot air
Skeptics should note that the efficiency gains and attendant rise in ROC charts with a similar rise in the amount of revenue Rackspace gets from services such as managed cloud hosting.

In these high-touch situations, Rackspace guarantees the same sort of service and support it always has to customers using dedicated hardware -- and then strips away the hardware. Not that it disappears, per se. Instead, Rackspace sets the parameters for the type of infrastructure required and then loads the customer's online software into a network some 78,000 servers strong.

Eliminating the need for dedicated servers and disks in this manner lowers costs for both customers and Rackspace. The net effect for shareholders, spokesman Bryan McGrath said in an interview, is that these situations tend to provide three times the average revenue per server.

There's growth, there's smart growth, and then there's really smart growth. I submit that, at Rackspace, we're seeing the latter. That's why I believe this stock story is far from over, and why I'll be adding it to a new real-money tech portfolio I'll be rolling out soon.

Of course, you don't need to wait if you're in the market for more Internet stock ideas. This free video digs into the details of the cloud computing revolution that's lifting the fortunes of Rackspace Hosting and so many others. Watch now and you'll come away smarter and with a winning stock idea from our Motley Fool Rule Breakers scorec ard. Click here to get started -- it's 100% free to watch.