Rackspace: Unconventional IPO With Potential

| About: Rackspace Hosting, (RAX)

Rackspace, Inc. (NYSE:RAX) will list shares on the NYSE this week, offering investors a chance to own a small part of this dynamic, growing technology company. The deal is expected to price between $12 and $16 and there are 15 million shares being offered. The number of shares outstanding will be north of 115 million which means that only 13% of the total shares will be in float to start with. Goldman Sachs, Credit Suisse, and Merrill Lynch will be the lead underwriters, with a small handful of other firms also participating.

The company has decided to take a non-traditional approach in offering the shares to the public. The process resembles a Dutch Auction where potential buyers are asked to submit the number of shares they would be willing to buy, and the price they would be willing to pay. Once the bids are collected, the underwriters determine at what price the total block of 15 million shares would be sold and then distributes the shares to successful bidders. All shares are distributed at the same price so if a bidder was willing to buy 20,000 shares at $18.00 and the underwriters determine the offering price to be $15.50, then the bidder would receive his full 20,000 shares at the $15.50 offering price.

While this type of offering is a bit non-conventional, it is not without precedent. Google Inc. (NASDAQ:GOOG) actually used an auction format for its IPO which turned out to be tremendously successful.

Rackspace as a company has an enviable track record of growth and profitability. The company has seen its revenue grow by 59% annually over the last five years. While this type of growth is sometimes seen with a new startup fledgling company, it is even more impressive that Rackspace has turned a profit during this entire period. The margins are not extremely attractive, but the track record of growth and financial discipline point to solid decisions by management.

It is also helpful to note that the company enjoys a diverse customer base of 31,000 different accounts (as of March 31, 2008). While serving a vast number of different clients creates more logistical work, it also provides stability as the loss of one or two key customers would not likely have a material effect on the company.

The business model is centered around providing hosting services for clients’ technology needs. The four primary services offered are Managed Hosting, Cloud Hosting, Email Hosting, and Platform Hosting. In an age where it is important for nearly every business to have a web presence, these services are in high demand. However with the cost of in-house IT departments becoming prohibitively high, Rackspace fills a needed role for many small and mid-sized companies.

In reading through the prospectus, it is interesting to note the veracity in which the company approaches customer service. The corporate culture appears to strongly encourage individual responsibility at every level of employment, and as a result, the company is well known for its attention to customer needs. This is very important for a company that serves such a vast number of clients and handles such an important business function for these clients.

The IPO will transpire with the actual company selling 12.7 million shares, and existing stockholders selling 2.3 million shares. This appears to be a healthy balance as most of the capital raised will be used for growth initiatives and to pay down borrowings. Rackspace has about $83 million in liabilities which does not appear excessive given the asset levels and income levels of the company. The selling stockholders include some private equity firms that likely placed startup capital with the firm as well as some executives and other miscellaneous individuals.

At this point it does not appear that any shareholders are liquidating a material portion of their holdings, which is encouraging. This likely points to the current shareholders' confidence in the future prospects of the business. However, one should keep an eye on these shareholders throughout the next several months as a mass liquidation could eventually pressure the shares. At this point, however, it appears these shareholders are on board with the company.

Rackspace appears to be a solid potential investment. My firm will likely be participating in the deal and I am sure it is a high priority for many other institutional accounts. The stock will likely be very volatile for the first few weeks as investors work to add or subtract shares to get their position size in line. But long-term I expect this stock to perform well and give holders some attractive gains.

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