What Will Happen to Rackspace? How About Nothing?
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What is going to happen to the cloud services and Web hosting company Rackspace? Rumors have been numerous since it announced in May it had hired Morgan Stanley to help it explore strategic options. Now there’s a strong case that in the end all the drama will come to nothing.
Wells Fargo analyst Gray Powell argued in a research note yesterday that with the list of potential acquirers dwindling, and a leveraged buyout appearing unlikely, he concludes there’s a 70 percent chance that “nothing will happen.” Rackspace shares fell more than two percent yesterday.
Powell runs through the list of potential buyers — IBM, Cisco Systems and Oracle among them — and rules almost all of them out. (Hewlett-Packard is still on his list, though as Re/code reported Wednesday it’s not interested.) Either they’ve made public statements — Cisco CEO John Chambers dismissed Rackspace as “not fitting our acquisition profile” — or they have other deals taking up their attention.
His list leaves only one potential Rackspace buyer: The telecom provider CenturyLink, and it would have to borrow $6 billion and change to do it. Not impossible, though CenturyLink would probably have to absorb a downgrade on its rating.
So what about going private in a leveraged buyout? That, too, is doable, but also unlikely, Powell writes. Assuming a $6 billion valuation, a hypothetical Rackspace LBO would require leveraging the company up with about $4.1 billion in debt.
And while private equity firms may be comfortable with that much debt, squeezing out a 25 percent internal rate of return would be “no lay up.” In an LBO scenario a private equity firm would own about 20 percent of the company and would have to double the value of its stake within three years, a prospect that would be tricky at best. “We can see the logic of a private equity investment in Rackspace because we think the company’s growth prospects and asset value are under-appreciated by investors today,” Powell writes. The targets required to justify the investment, he says, “could limit interest from private equity investors.”
Having sorted through the possible scenarios, Powell pegs the probability of a Rackspace acquisition or leveraged buyout at 14 percent each. That leaves a 72 percent probability for the “nothing option,” meaning Rackspace continues as it is.
And that, Powell writes, may not be such a bad thing. True, it has come under pressure following price cuts on cloud services by Google, Microsoft and Amazon Web Services. But Rackspace’s dedicated hosting business could continue to grow at an annual rate of about 10 percent. Overall, he says, having fixed some problems with “mis-execution” during the last 18 months, if Rackspace’s current revenue growth trends hold, it could maintain a steady growth rate of 12 percent annually going forward. He writes: “Rackspace may not deserve the lofty valuation it once received, but at the same time, we do think there is real value to the asset.”