Hooray! Rackspace Hosting, Inc. Might Double in a Quick Buyout! Here's Why I Hate That Short-Sighted Idea


Rackspace, the open cloud company, might soon become some other company's open cloud division. Source: Rackspace.

Shares of Rackspace Hosting (NYSE: RAX  ) jumped 20% higher on Friday, boosted by buyout speculation. The company has hired a major Wall Street firm to "explore options," and every pundit is now betting on exactly who the intended buyer might be.

That's not what I'm here to do. As a Rackspace shareholder myself, I sincerely hope that the company doesn't find a buyer, and that the "options" will lead Rackspace to a better place -- without losing its independence.

Yeah, I know. That is just crazy talk. What Rackspace investor wouldn't jump on a chance to harvest a big overnight gain? It's the big payday that many investors dream of, after all.

Analysts have pegged Rackspace's buyout value as high as $67 per share, which would be an 82% boost from Friday's increased prices. Comparing that target to Thursday's $30.68 closing price, it's a 118% boost.

And if Rackspace sells out for $67 a share today, that would be at 109 times trailing earnings. Clear some space in the nosebleed section, people!

Yes, but ...
Rackspace is the kind of misunderstood hypergrowth stock that I expect to deliver multibagger returns in the long run. I would much rather hold on to that long-term rocket ship than jump aboard a one-time payout followed by much slower permanent growth.

Rackspace is riding a pair of powerful megatrends. The company is a pioneer in cloud computing services, which is an increasingly popular method to manage computing infrastructures both big and small.

Moreover, Rackspace's OpenStack platform is a leader in private cloud solutions. That's where companies go when they want the flexibility of a centrally managed and heavily virtualized computing structure, without giving some other company the keys to your kingdom.

The private cloud option suddenly become important last year, when the Snowden leaks shone a cold, hard spotlight on the risks of doing business online. Keeping data close to the vest jumped way up the priority list, and the balance between security and flexibility is now a major concern.

There are no magic bullets, no one-size-fits-all solutions, but private clouds such as OpenStack installations solve this conundrum in many cases.

Couple this fortuitous and proactive business focus with a hard-earned reputation for top-notch customer service, and you get a winner for the long haul.

And it shows in Rackspace's numbers, too. Sales have nearly tripled over the past five years, while earnings did even better, soaring 230% higher.

RAX Chart

RAX data by YCharts

What's wrong with the buyout idea?
So what's wrong with picking up this winning model and baking it into a larger parent company with much larger resources? Let's say that Cisco Systems (NASDAQ: CSCO  ) or Amazon.com (NASDAQ: AMZN  ) end up buying the company, for example. These are among the most popular speculation targets in the Rackspace saga, and for good reason.

Cisco is branching out from pure networking operations and hopes to become the leading IT platform overall. The company could use a credible private cloud solution like Rackspace, if only to present a more complete package to potential customers.

Amazon is Rackspace's most direct cloud service competitor, but it doesn't really do private cloud services yet. Buying Rackspace would eliminate a key competitor (raising antitrust review questions in the process, by the way), while adding a key piece to Amazon's cloud-based platform puzzle.

Assuming that a Rackspace deal would be worth $67 per share, the price tag would stop at $7.8 billion minus $1.6 billion in net assets, for a final enterprise value just north of $6 billion.

Cisco has $47 billion of cash equivalents on its balance sheet and generates nearly $10 billion in annual free cash flows. Amazon isn't quite that well-heeled, but would be able to finance a Rackspace deal with less than three years of free cash generation. And of course, both titans command market caps north of $120 billion. A stock-based $6 billion deal wouldn't hurt existing investors all that much.

So these deals could happen. But how much of a difference would Rackspace really make to Cisco or Amazon? Consider their relative sizes:

RAX Revenue (TTM) Chart

RAX Revenue (TTM) data by YCharts

RAX Free Cash Flow (TTM) Chart

RAX Free Cash Flow (TTM) data by YCharts

No matter how you slice it, Rackspace can't move the needle very far as part of these massive organizations. Even if you double or triple the company's revenues or cash flows, and throw in another large premium to account for synergies, the addition still looks like a flatline next to these highly mature enterprises.

A Rackspace buyout might make strategic sense for someone like Cisco, but it's not a game-changer. Owning Amazon or Cisco isn't a terrible idea at all, but I'd much rather stay laser-focused on Rackspace's individual growth prospects.

Looking for much bigger returns, even if the payoff is delayed
Working together with IT giants like Cisco and Amazon makes a ton of sense for Rackspace, which is why I'm hoping that the company is steering its "options" talks in that direction. An acquisition might enrich Rackspace insiders very quickly, if it triggers lucrative buyout clauses in their contracts. That's one reason it might happen, regardless of other winning long-term strategies.

But for us individual investors, there's nothing like owning a small but hyper-focused company as it grows into its breeches. For a couple of familiar examples, let's say you owned Amazon for 10 years, shortly after its IPO in the late 1990s:

AMZN Market Cap Chart

AMZN Market Cap data by YCharts

... or maybe Cisco, in the decade where the Internet hit the mainstream:

CSCO Market Cap Chart

CSCO Market Cap data by YCharts

That's the kind of payoff I want out of my Rackspace shares. You won't find me crying into my beer if a tech titan doubles my Rackspace returns overnight, but again, the real opportunity here is so much larger if the company stays independent.

Are you as excited about Rackspace's long-term value as I am? Or am I just crazy after all? Let me know what you think in the comments box below.

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