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Amazon Rival Rackspace Evokes Dot-Com Era Deal: Real M&A

June 20, 2012

Rackspace Rivaling Amazon in Cloud Evokes Dot-Com Era

Rackspace lets its more than 180,000 business customers store their websites and applications on its servers. The fleet of data centers it runs competes with Amazon Web Services in the public-cloud market, where customers rent computing power, storage and other services. Photographer: Noah Berger/Bloomberg

Rackspace Hosting Inc. (RAX:US) is tempting buyers that covet a foothold in the cloud to tackle the largest U.S. Internet takeover since the dot-com bubble.

Rackspace has more than tripled since its 2008 initial public offering as it evolved into Amazon.com Inc. (AMZN:US)’s biggest competitor in cloud computing, which allows businesses to save money on data centers by storing information on remote servers and accessing it via the Web. While the $6.1 billion company has a higher valuation relative to earnings than almost two-thirds of Internet software and e-commerce firms, it’s less than half as expensive as Amazon, according to data compiled by Bloomberg.

Even after profit failed to top analysts’ estimates for the first time (RAX:US) in four quarters, the company is still projected to almost triple net income (RAX:US) by 2014 as the market for cloud- computing infrastructure services expands to $10.5 billion from $3.7 billion last year, according to Gartner Inc. Benchmark Co. says that may lure AT&T Inc. (T:US), International Business Machines Corp. or Dell Inc. (DELL:US) An acquisition may fetch as much as 13 times estimated 2013 earnings, said Dougherty & Co., valuing the San Antonio-based company at $7.9 billion for the biggest takeover of a U.S. Internet company in 12 years, the data show.

“There truly isn’t anyone else out there that’s independent and as big as Rackspace in cloud infrastructure,” Clayton Moran, a Delray Beach, Florida-based analyst at Benchmark, said in a telephone interview. “There’s good value here given the strong growth. Potential acquirers are pretty deep-pocketed so they certainly could pay a healthy multiple.”

‘Fiduciary Duties’

“We think this is a paradigm shift in computing and the future is huge for the winners in this space,” Lew Moorman, president of Rackspace, said in an interview yesterday. “We want to build something great. Our board has fiduciary duties, but we’re not for sale.”

Rackspace lets its more than 180,000 business customers store their websites and applications on its servers. The fleet of data centers it runs competes with Amazon Web Services in the public-cloud market, where customers rent computing power, storage and other services.

Rackspace is moving its cloud services to OpenStack, an open-source project that it created as an alternative to Seattle-based Amazon’s product. OpenStack lets companies build their own clouds using Rackspace’s code. The effort has the backing of the U.S. space agency NASA, and it’s being used by companies such as Dell and AT&T, whose offerings compete with Rackspace’s.

Amazon’s Cloud

Competition in the market is still heating up. Amazon’s cloud business may have reaped $800 million in revenue last year, Heather Bellini, a New York-based analyst at Goldman Sachs Group Inc., estimated in a February report. Microsoft Corp. (MSFT:US) is promoting its Azure services, while traditional technology providers IBM and Hewlett-Packard Co. (HPQ:US) are also in the market.

Rackspace increased revenue at its cloud unit by 88 percent last year to $189.2 million (RAX:US). The company has gained share with its early entry into the market and has maintained it by charging a premium for service, said Mark Kelleher, a Boston- based analyst at Dougherty.

“There’s going to be such a competitive fight going on for cloud customers,” Kelleher said in a phone interview. “Pricing is going to come down and the service capabilities of other competitors are going to come up. Amazon has put some new service components on top of their cloud to try to close the service gap with Rackspace.”

Revenue in the first quarter climbed 31 percent to $301.4 million, while analysts on average predicted sales of $300.2 million. Rackspace still reported earnings of 17 cents a share, failing to exceed the average of analysts’ estimates (RAX:US) compiled by Bloomberg.

Stock Decline

“As the founders of OpenStack they sit at the center of this open-source movement,” James Staten, an analyst at Cambridge, Massachusetts-based Forrester Research Inc., said in an e-mail. “However, they haven’t moved as aggressively as others in expanding their cloud services or geographic reach.”

The market for cloud infrastructure as a service “is growing rapidly and so market share today is fleeting,” he said. The move to OpenStack should free up internal resources to help build new cloud services, which could help the company secure its market position, Staten said.

Since Rackspace reported earnings May 7, the shares declined 22 percent (RAX:US) through yesterday, reducing its market value by $1.5 billion.

“As the stock pulled back, obviously it looks even more attractive,” Mark Demos, a portfolio manager who helps oversee $15 billion including Rackspace shares at Fifth Third Asset Management in Minneapolis, said in a phone interview. “There’s going to be a lot more chatter about a takeout. It’s been a big growth business.”

Rich Valuation

Even after the recent stock drop, the company still had an enterprise value (RAX:US) of $6.1 billion yesterday, which was almost 18 times its earnings before interest, taxes, depreciation and amortization in the last 12 months, data compiled by Bloomberg show. That’s more expensive than about two out of every three Internet software makers and Web retailers globally with market values of at least $100 million, the data show. The group trades at a median of 13 times Ebitda.

Among the nine publicly traded companies that Rackspace lists as cloud-computing competitors in its annual filing, its Ebitda multiple trails only Amazon, which at 47 times is the sixth highest in the Standard & Poor’s 500 Index, data compiled by Bloomberg show.

“Given the multiple Rackspace is trading at, even with the recent drop, there would have to be a fabulous premium to provide any upside,” Barry McCarver, an analyst with Stephens Inc. in Little Rock, Arkansas, said in a phone interview. “It’s already trading so high.”

Growing Cloud

Today, shares of Rackspace fell 1 percent to $44.67.

The growing market for cloud services, where companies can pay pennies an hour to have their apps and websites hosted rather than buying and managing their own servers, may still attract takeover interest from buyers including AT&T, IBM (IBM:US), Dell and Microsoft, Benchmark’s Moran said in the interview.

“It would be a buy or build decision and it would just be a lot quicker and more efficient to buy,” Moran said. “Not only are you buying the operating capability, but also the brand which has a good reputation.”

AT&T, the largest U.S. phone company, may be an interested buyer because it has already adopted the OpenStack software for its cloud services, said Dougherty’s Kelleher. AT&T is ramping up competition with Amazon as it tries to convince developers and small businesses to switch to using its infrastructure, called AT&T Cloud Architect, which was introduced in January to provide hosting services via the Internet.

Dell’s Interest

Kelleher said that Dell, the world’s third-largest maker of personal computers, may be the most likely acquirer because it also uses OpenStack, Rackspace’s servers and storage are based on Dell products and the company has been pursuing deals. Dell bought closely held Wyse Technology Inc. last month to gain desktop devices used by cloud-computing customers.

“Dell has been sort of behind in their cloud efforts, so I’d probably have to put them at the top of the stack,” Kelleher said. “Dell’s been on an acquisition binge lately.”

Mark Siegel, a spokesman for Dallas-based AT&T; David Frink, a spokesman for Round Rock, Texas-based Dell; Frank Shaw, a spokesman for Redmond, Washington-based Microsoft; and Ed Barbini, a spokesman for Armonk, New York-based IBM, all declined to comment on speculation.

Unwilling Seller

While Rackspace would be an attractive acquisition target for access to an expanding market, management may be resistant to a sale, said Christopher Larsen, a New York-based analyst at Piper Jaffray Cos. Chairman Graham Weston, 48, owns about 19.4 million shares of Rackspace, making him the company’s biggest stockholder with more than 14 percent of the shares outstanding, according to a March regulatory filing.

“The seller may not be all that willing,” Larsen said. “Frankly, anyone interested in cloud storage would be interested in it if they thought they were selling. They have access to great technology. They have a great reputation. They’re in a very fast-growing industry.”

Dougherty’s Kelleher said Rackspace management would demand a price tag that’s at least 13 times his estimate for Ebitda next year of $606 million, including stock-based compensation. That would amount to $7.9 billion and rank as the largest U.S. Internet takeover since 2000, according to data compiled by Bloomberg that includes net debt.

Globally, it would be the second-biggest Internet deal since then, trailing Microsoft’s $8.5 billion takeover last year of Luxembourg-based Skype Technologies SA.

Price Tag

“You’d really have to make a compelling offer to get them to go do something else,” Kelleher said. “They believe they’re on a very strong path, and I think would require a nice premium to sell.”

He said Dell may be the only acquirer able to justify such a price, while other buyers may only be able to pay 10 times Ebitda, on par with the company’s current enterprise value.

A bid for Rackspace would have to be at least $60 a share, said Fifth Third’s Demos, which would top the stock’s all-time high (RAX:US) closing price of $59.04 on April 27. Moran of Benchmark pegs a potential price tag at $63 a share, a 40 percent premium to yesterday’s closing price.

“Amazon’s number one and you can’t buy it,” Pat Walravens, an analyst at JMP Securities in San Francisco, said in a phone interview. “Rackspace is number two. Sure, you could buy it. You’d just have to be willing to pay a lot of money.”

To contact the reporter on this story: Will Robinson in New York at wrobinson11@bloomberg.net; Danielle Kucera in San Francisco at dkucera6@bloomberg.net.

To contact the editors responsible for this story: Daniel Hauck at dhauck1@bloomberg.net; Katherine Snyder at ksnyder@bloomberg.net.


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Companies Mentioned

  • RAX
    (Rackspace Hosting Inc)
    • $31.19 USD
    • -0.29
    • -0.93%
  • AMZN
    (Amazon.com Inc)
    • $323.63 USD
    • -0.87
    • -0.27%
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