Microsoft Deal Props Up Cloud Stock Rackspace With Acquisition Hopes

  • Rackspace retains a sky-high valuation despite slowing growth.
  • A deal with Microsoft gives it a big-money partner and could result in its acquisition.
  • There are other possibilities, but for how long?
Rackspace an acquisition target

Since early 2013 the only reason for buying and holding Rackspace (NYSE:RAX) has been the hope of a buy-out. Rackspace stock price has been cut in half since then, and the chief culprit is Amazon (NASDAQ:AMZN).

Amazon’s low-cost cloud infrastructure has slowed the march to “private” and “hybrid” cloud on which Rackspace’s OpenStack strategy was built. Its regular price cuts for bare-iron cloud has starved Rackspace of new capital, and slowed its growth.

Recent quarters tell the story. Revenues were $460 million in the September quarter, $472 million in December, and $480 million in March. Net income went from $26 million to $37 million to $28 million. Rackspace continues to enjoy a Price/Earnings multiple of over 50, but these are not the kinds of numbers that would inspire that much confidence.

What would is a take-out, and Rackspace’s recent deal with Microsoft (NASDAQ:MSFT) to support Azure is at the heart of that hope. With a market cap of just $5.6 billion, Rackspace would be easily digestible by Microsoft, which has just cleaned up its balance sheet by writing off the failed acquisition of Nokia.

Microsoft CEO Satya Nadella is cloud-oriented, and acquiring Rackspace would give him the leading place in OpenStack, the leading private cloud solution. The agreement ties Rackspace OpenStack resources even more closely with those of Microsoft Azure. It makes a lot more sense than buying Nokia did, because it’s a move from strength-to-strength, rather than weakness-to-weakness.

A Microsoft bid would also attract other sharks. IBM (NYSE:IBM) would need to get in, or watch its own cloud advantage go to Redmond. Verizon (NYSE:VZ), AT&T (NYSE:T) and CenturyLink (NYSE:CTL) would all have to consider bids. In search of a white knight, Rackspace might even consider a merger-of-equals with Red Hat (NYSE:RHT), the other main supplier of OpenStack software and services. Is there a name that’s missing here? Why, yes, HP (NYSE:HPQ) Enterprise, the services-and-support end of that business Meg Whitman says she will personally direct post the HP split. If Microsoft stalls, Rackspace might make HP Enterprise viable.

Too long a delay in making a sale, however, is bound to degrade the value of the asset being sold. We are approaching a cloud glut. We don’t know where it is, but we know it’s coming, because new cloud build-outs are moving ahead at an unsustainable rate. It’s already impacting OpenStack – that’s why Rackspace’s growth is slowing – and when it becomes obvious then the valuations on cloud infrastructure, and cloud stocks, will fall to the floor.

So, in short, the cloud clock is ticking in San Antonio. Rackspace needs strong hands to remain sustainable. Right now there are a lot of strong hands out there. Six months from now there will be fewer.

And it’s this hope that’s sustaining the Rackspace stock.

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