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Shares of Rackspace Hosting (RAX) fell over 9% in the past trading week. The provider of cloud computing services to small and medium sized businesses reported its third quarter results on Tuesday.

Third Quarter Results

Rackspace reported third quarter revenues of $336 million, up 27% on the year. Revenues were up 5.3% compared to second quarter revenues. Revenues came in line with analysts expectations.

Adjusted EBITDA rose 38% on the year to $121.7 million. EBITDA margins came in at 36.2% which was a 110 basis point improvement compared to the second quarter, and up 290 basis points on the year before.

Net income rose 36% to $27 million, with diluted earnings per share coming in at $0.19 per share, in line with analysts expectations. Net earnings rose 8.2% compared to the second quarter as net margins rose to 8.1% of revenues.

The total server count rose 4.8% on the quarter to 89,051. The number of customers rose by 3.5% to 197,635.

CEO Lanham Napier commented on the results, "Rackspace just open sourced the cloud. We're excited to report that the rollout of our new Open Cloud platform, built on OpenStack, is finally complete. With the new products now in production, Rackspace offers a better, faster and more valuable cloud experience, built on an open platform that gives our customers true choice and control without the fear of being locked-in to one vendor's technology."

Valuation

Rackspace ended its third quarter with $258 million in cash and equivalents. Debt and capital lease obligations totaled $150 million, for a net cash position of $108 million.

For the first nine months of 2012, Rackspace generated revenues of $956.3 million. Net income came in at $75.5 million, or $0.54 per diluted share. At this rate, the company is on track to generate full year revenues of $1.3 billion, on which it could earn almost $105 million.

After last week's decline, the market values Rackspace at $8.3 billion, which implies a valuation of the company's operating assets at $8.2 billion. Operating assets are valued at 6.7 times annual revenues and roughly 78 times annual earnings.

Rackspace currently does not pay a dividend.

Some Historical Perspective

Year to date, shares of Rackspace have risen some 40%. Shares rose from $42 in January to highs of $60 during spring, before pulling back to the low forties during the summer. From that point in time shares recovered to $70 in October, currently exchanging hands at $60 per share.

Shares of Rackspace rose steadily from lows of $4 in 2009, reaching all time highs of $70 a couple weeks ago. Between 2008 and 2012, Rackspace more than doubled revenues from $532 to an estimated $1.3 billion this year. Net income rose from $21.7 million to an estimated $105 million.

Booming Demand

Rackspace is benefiting from the increase in data usage and the fact that most users tend to access data on mobile devices in the future. Given the limited storage capabilities of these mobile devices, more and more data will be stored in the cloud.

While these developments are obviously very good for Rackspace the company is already benefiting from virtualization technologies. This technology allows the multiplication of server capacity, therefore reducing the number of servers which Rackspace needs to maintain. As such, Rackspace can offer its services at even more competitive prices.

Rackspace is really excited about the roll out of OpenStack, the open cloud platform. Rackspace hopes that more customers will switch to the open-source platform to avoid being locked out to certain suppliers, as is the case with customers of Amazon.com's (AMZN) cloud business.

Possible Acquisition

Cloud based solutions are the hottest area in today's technology industry. Big names such as Google (GOOG) and IBM (IBM) have already announced their ambitions in the field, but refrained from making transformational deals so far.

In 2011, Oracle (ORCL) acquired RightNow for $1.5 billion, valuing the company at over 6 times annual revenues. German based SAP (SAP) acquired Ariba (ARBA) earlier this year for $4.3 billion, valuing the company at roughly 10 times annual revenues.

The likelihood of a knock-out bid remains a very real possibility with so many large technology firms, being swamped in cash, and having announced their ambitions in the field.

Investment Thesis

While shares are anything but cheap on traditional valuation metrics, there are arguments to support Rackspace's current valuation. In the past year, several billion dollar deals have been executed at similar multiples compared to the valuation of Rackspace. Several public offerings in the area have done extremely well including that of Palo Alto Networks (PANW).

Rackspace's operational performance has been solid over the past quarter and management seems excited about the future contributions from OpenStack. I am a buyer on significant dips based on operational excellence with a possible option of a take-out.

Source: Rackspace Hosting - Cloud Remains The Hot Area For The Future