Rackspace Hosting: A Falling Knife Or An Acquisition Play?

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 |  About: Rackspace Hosting, Inc. (RAX), Includes: AMZN, GOOG, GOOGL
by: Amal Singh

Summary

Rackspace Hosting is down 18% this year, so investors might be thinking of buying some shares.

But Rackspace is a falling knife, and shares have recently risen as the company is exploring alternatives to the business, which might fail.

Competition from Google and Amazon, and weak fundamentals are the primary reasons to stay away from Rackspace.

Rackspace Hosting (NYSE:RAX) started the year poorly and is still down around 18% this year, but it has made a remarkable comeback after news emerged in May that management has hired investment bank Morgan Stanley (NYSE:MS) to look for strategic alternatives for the business. As a result, Rackspace shorts have been forced to cover their positions. At the end of April, Rackspace had almost 14 million shares short, but by the end of May, the number dropped to around 7.3 million.

Why the shorts are fleeing

The increasing possibility of a sale or a partnership with a bigger company has been a tailwind for Rackspace. The company had filed an 8-K back in May, which stated:

"In recent months, Rackspace has been approached by multiple parties who have expressed interest in exploring a strategic relationship with Rackspace, ranging from partnership to acquisition.

Our board decided to hire Morgan Stanley to evaluate the inbound strategic proposals and to explore other alternatives which could advance Rackspace's long-term strategy.

No decision has been made and there can be no assurance that the Board's review process will result in any partnership or transaction being entered into or consummated. The company has not set a timetable for completion of this process and does not intend to discuss or disclose further developments with respect to this process unless and until the Board approves a specific partnership or transaction."

The company clearly stated that there can be no assurance of a partnership or a sale. However, earlier in July, TechCrunch revealed that Rackspace is exploring another strategic alternative of taking itself private. TechCrunch reported:

"Rackspace - the publicly-listed enterprise cloud services company that competes against the likes of Amazon's AWS, Microsoft and Google - has been in the spotlight after announcing in May that it has hired bankers to help consider offers to partner with or be acquired by another company. However, it could choose a third option: taking itself private.

Following the likes of Dell in turning away from public market accountability while it focuses on developing its business in a fast-changing tech world, we have heard from a source that Rackspace has been negotiating with a private equity firm to borrow capital for the deal, with a plan to make an official announcement as soon as this week (keep in mind that we're hurtling to a public holiday in the U.S.).

"The pressures of being a public company are too much," another source within the company noted."

Hence, Rackspace has opened up various possibilities for itself. But, the problem is that it won't find it easy to go private due to several reasons.

An expensive valuation could cost Rackspace investors

The company is quite expensive at a P/E ratio of 53. This is quite steep as the industry average is 16.3. Rackspace is expensive as compared to the industry P/E on a forward P/E basis as well, with a ratio of 36. The company's PEG ratio is also expensive at 2.71. The company also has a weak earnings outlook. In the last five years, Rackspace's bottom line has improved at a rate of 28% per annum, which is way more than the expectation of 19% for the next five years.

The company's results have been weak as well. In the recently reported first quarter, Rackspace's earnings dropped 7% year over year. The company's revenue growth rate has also taken a hit in the last few years. Bloomberg reports:

"Analysts on average expect revenue to rise 16 percent this year to $1.79 billion, according to data compiled by Bloomberg. That's slower growth than 31 percent in 2011, 28 percent in 2012 and 17 percent last year."

So, it will be difficult for Rackspace to either find a buyer, or even get the financing it needs to take the company private. Additionally, taking a look at the amount of competition that Rackspace is facing, it will be difficult for the company to get back on the growth track.

Competition is another worry

Amazon (NASDAQ:AMZN) recently cut the pricing plan for a number of its cloud services. The S3 storage service, the EC2 cloud computing platform, RDS cloud databases, all have received a price cut. Amazon has reduced the prices of its cloud services for a whopping 42 times in the last eight years. It is facing competition from Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and so it might continue cutting prices going forward.

Even Google had cut pricing for its cloud computing services in March. Its Compute Engine witnessed a 32% drop in pricing, and the App Engine received a price cut of 30%. Additionally, the search giant's big data analytics database, known as BigQuery, received a price cut to the extent of 85%. So, Google and Amazon are engaged in a stiff price war, and this will continue to pressurize Rackspace's prospects.

Conclusion

So, even though Rackspace has risen in the last couple of months due to speculation of a buyout, investors should remember that it will be difficult for the company to execute the other strategic alternatives that it has in mind due to the above-mentioned reasons. So, investors should stay away from Rackspace.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.