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UBS's Steve Milunovich today initiates coverage of shares of Rackspace Hosting (RAX) with a Neutral rating, and a $38 price target, writing that the company faces increasing competition and has made "some execution errors."

Milunovich models revenue of $1.53 billion and EPS of 59 cents this year, in line with consensus. For next year, he models $1.79 billion and 70 cents, also in line.

Shares of Rackspace today are down 39 cents, or 1%, at $36.76.

Rackspace was early in perceiving the opportunity for the hosting business, writes Milunovich, but now the market is "evolving away from dedicated hosting to public cloud services" provided by Amazon.com's (AMZN) Amazon Web Services (AWS) and Google's (GOOG) Compute Engine, for example.

Milunovich writes that faced with such challenges, the company needs to accomplish what "marketing guru" Jack Trout recommends: differentiation:

(1) make sense in the context of the category; (2) find the differentiating idea; (3) have the credentials; and (4) communicate the difference.

Milunovich writes Rackspace is differentiating by associating itself more deeply with the freely available "OpenStack" software that is sweeping the cloud computing landscape:

Successful repositioning should be about differentiating against the market leader. To Rackspace's credit, it is not attempting to copy Amazon. Unable to compete in engineering resources, the company is making a bet on OpenStack and the support of the open source community to enhance functionality. Rackspace now brands itself "the open cloud company," offering best-fit infrastructure, including public cloud, managed hosting, and private cloud. Furthermore, it is not attempting to compete on price but rather differentiate on superior service. This positioning modification—continuing a high service level while underscoring an open cloud approach (suggesting a contrast to competitors' closed approach) is creative and probably the company's best chance at success.

Milunovich is skeptical Rackspace can withstand the AWS onslaught.

For one thing, he thinks OpenStack will be "like Linux," meaning broadly supported, but offering little differentiation to any one party in tech:

We believe OpenStack could be the next Linux. It is open source and gaining endorsements from mainstream enterprise vendors, including AT&T, Brocade, Citrix, Cisco, Red Hat, Juniper, NEC, Facebook, Huawei, NetApp, EMC, Yahoo, Intel, Huawei, Seagate, VMware, Dell, HP, and IBM. However, OpenStack is neither an open standard nor interoperable and portable today.

For another thing, AWS has much greater breadth and scale than Rackspace's infrastructure:

Rackspace has nine data centers on four continents and more than 100,000 servers. For comparison, AWS also has nine data centers but on five continents and virtual machines in the millions. We believe AWS has more than 5x the IaaS capacity of the next 14 vendors combined.

And Rackspace has to catch up with AWS and others in terms of features it lacks:

Rackspace's strengths are its ease-of-use, support, and broad offerings across IaaS, internal IaaS, and managed hosting. According to Gartner, its weaknesses are SLAs that do not kick in until one hour of downtime has passed, no ability to import a customer's VM image, and lack of automatic scaling. These weaknesses will need to be addressed, which should require significant effort.

Based on a Gartner analysis from this summer, Milunovich thinks Rackspace ranks low among major cloud providers:

We combined the cautions (-1 point each) and capabilities (+1 point each) into a broad score to enable a comparison. Rackspace came in 12th out of 15 companies (Figure 7). Since then IBM has purchased fourth-ranked SoftLayer, so now Rackspace is 12th out of 14. Although capabilities and cautions may be of varying importance for a specific customer and workload, Rackspace is lagging.

Here's Milunovich's chart of how the various providers stack up, using the Gartner criteria (click for larger image):

Milunovich is not happy about the company's self-inflicted wounds this year:

Self-inflicted wounds included firing the head of sales and changing sales incentives to favor the new public cloud. CEO Lanham Napier recently said that the sales force was distracted and did not focus on dedicated cloud while it tried to ramp up the new public cloud business. Some of the former mistakes have been reversed and new managers hired, including Todd Cione from Microsoft to head US sales and Rick Jackson from VMware to run marketing.

Milunovich advises investors to pay attention to Rackspace's R&D burden, and possible threats to pricing from the public cloud:

The critical elements of this model to watch are the $1,000 per server in software development cost, the $358 monthly charge, and the 50-month hardware life. Software development costs are likely to increase as R&D rises to keep pace with the competition. The 50-month life may not hold up as customers demand more processing power and I/O performance. Most worrisome is the $358 per server assumption in that competition could force pricing lower.