Rackspace Hosting, an Expensive Stock, Looks Cheap if it’s a Takeover Candidate

Rackspace Hosting (RAX) has increased almost six-fold in value since its August 2008 IPO, largely due to impressive growth in subscriber base, revenue and earnings per share. Trading at 65 times 2013 earnings, a stunning PE ratio, investors might want to rethink the appropriate valuation of this cloud hosting service provider – or maybe not.

RAX Total Return Price Chart

RAX Total Return Price data by YCharts

What is cloud computing? With cloud services, companies can lower information technology (IT) costs by outsourcing hardware and software functions to third-party vendors via the Internet. In a public cloud – dominated by rival Amazon's (AMZN) AWS offerings, businesses can lower costs by accessing shared services like storage and server power; private clouds are an alternative option – the customer’s dedicated infrastructure can be managed by an outside vendor on or off-site. Whereas Amazon dominates in the former market, Rackspace has focused on the latter: Rackspace generated $246.4 million, or 77.3% of total sales, in rental fees for its proprietary private cloud services in the second quarter.

The growing demand for non-PC mobile devices and content is driving a seemingly endless demand for data transmission and storage. Cisco Systems (CSCO), for example, estimates that global Internet traffic will jump nearly fourfold during the next five years, hitting 1.3 zettabytes per year by 2016. A zettabyte is equal to about 1,000 trilliard gigabytes!

By 2014, it is estimated that more than 50% of all workloads will be processed in the Cloud. Spending in the global market for cloud computing is forecasted to grow almost six-fold to $241 billion in 2020. Market research firm Forrester estimates, too, that the total size of the public cloud market will grow from $25.5 billion in 2011 to $159.3 billion in 2020.

To date, Rackspace has capitalized on this compelling cloud computing story. Notice the correlation between earnings growth and price gains in the following YChart for the company:

RAX EPS Diluted Quarterly Chart

RAX EPS Diluted Quarterly data by YCharts

Virtualization technologies, which multiply server capacity, are rapidly reducing the number of servers needed to power networks. Though this paradigm shift lowers the cost of Internet cloud-based computing – making cloud services more appealing to potential customers – the lower infrastructure start-up costs also lower the barriers to entry, threatening Rackspace’s dominance.

Attracted to the growth-demand story for cloud hosting services, the competitive landscape is getting more crowded. Notwithstanding the plethora of VC-seeded providers flooding the market, better-capitalized companies are planting their roots in Rackspace’s yard too. Competitors include rival cloud solutions providers Equinix (EQIX) and VMWare (VMW); diversified technology companies like Amazon, Microsoft (MSFT), Google (GOOG), and IBM (IBM); and software companies like salesforce.com (CRM).

RAX Market Cap Chart

RAX Market Cap data by YCharts

Of concern, too, the bandwidth suppliers that Rackspace depends on to carry its subscribers’ data traffic smell potential profits in the air. Looking to become top-tier cloud service providers, telecom providers CenturyLink (CTL) and Verizon (VZ) both made multi-billion acquisitions of cloud computing firms last year. Expect other telecoms to follow suit.

Nonetheless, San-Antonio-based Rackspace is hoping to differentiate itself from the thundering herd by developing product offerings built around OpenStack, an open-source cloud platform. The differentiating benefit, according to chief executive Lanham Napier, is that customers wouldn’t be locked into a “static product” like Amazon’s Web Service.

With growth in the Cloud showing no signs of slowing, premiums being paid to get onboard the fluffy white train are accelerating: In January 2012, software giant Oracle (ORCL) spent $1.5 billion, or 68 times trailing twelve-month EBITDA, to acquire RightNow, a provider of customer-service centers for the Internet; and, in May, global software leader SAP AG (SAP) plunked down $4.3 billion, or 106 times trailing twelve-month EBITDA, to purchase Ariba, a leader in cloud-based collaborative commerce applications. Prior to these two deals, the average ratio of six enterprise software and service deals of more than $1 billion was 17 times EBITDA (since 2006) in the U.S., according to Bloomberg News.

RAX EV / EBITDA TTM Chart

RAX EV / EBITDA TTM data by YCharts

Ergo, with Rackspace priced at a premium of only 26.7 times trailing EBITDA, what appears to be expensive to potential stockholders today could look cheap a year from now, ad could look very cheap to a potential acquirer. In any market transaction, however, the principle of caveat emptor always applies: Should anticipated offerings founded on OpenStack be delayed or power outages disrupt services and average monthly revenue per subscriber – i.e. profitability – “let the buyer beware.”

David J. Phillips is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.

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