Can IBM Save OpenStack?

| About: International Business (IBM)

This has been a hard few months for OpenStack, the open source cloud infrastructure first pioneered at NASA and later offered, as an open source project, through Rackspace (NYSE:RAX) and, now, the OpenStack Foundation.

This spells trouble for IBM.

What's evident from financial results is that OpenStack is losing the public cloud market battle to (NASDAQ:AMZN) and that, in the end, there may be little or no private cloud market at all.

No company has as much at stake in this as IBM. IBM formally endorsed OpenStack as its cloud standard last year, but that was a foregone conclusion, as their chief operating system ally is Red Hat (NYSE:RHT), which had endorsed OpenStack the year before.

It's clear from the numbers that this is the chief crisis facing CEO Virginia Rometty. Not only did IBM fall 10% last month due to a worse-than-expected quarter, but Rackspace itself has suffered two consecutive bad quarters, and now Dell (NASDAQ:DELL) has publicly abandoned the software, choosing to re-sell services from other cloud companies rather than build its own OpenStack cloud.

The problem is partly driven by price - Amazon.Com consistently drops its prices, abandoning all hope of short-term profit, in order to maintain its share of the market. But there's an urgency, too - Amazon has succeeded in making its Application Program Interface, or API, a defacto standard. This makes it harder-and-harder for companies to switch to another system - like OpenStack.

Let me be clear about this. I expect IBM to address this problem. I'm just looking for opportunities in that effort, and here's my conclusion.

Buy Rackspace.

Rackspace is key to the OpenStack public cloud. If it fails, so does IBM. In order to succeed in the public cloud, Rackspace needs capital in order to expand into multiple data centers (most of its operations are centered in one San Antonio center) and to take quarters of losses and meet, even beat, Amazon's pricing.

The easiest way to make that happen is for IBM itself to buy Rackspace. IBM has not made a really big acquisition since buying Cognos in 2008 for $5 billion. Rackspace is currently on a market valuation of $5.3 billion, but IBM could probably make this deal happen for $6 billion, accounting for inflation, without breaking any internal rules.

Does it have $6 billion in cash? Yes, it does. And if Rometty is afraid of spending half her corporate cash at once, she can do a cash-and-stock deal that would represent minimal dilution for existing shareholders - her market cap is $231 billion.

There are other things she can do, like engineering a Dell or HP (NYSE:HPQ) purchase of Rackspace, engineering a merger-of-equals between Red Hat - market cap $9.9 billion - and Rackspace. Even a formal alliance with IBM's own cloud operations could probably do a lot.

But she needs to act. So investors should be bullish on Rackspace, much more bullish than the present situation would suggest.

Disclosure: I am long IBM, RHT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.