Is a Rackspace Hosting Acquisition Good for CenturyLink Shareholders?

If CenturyLink acquires Rackspace Hosting, should you still own its stock?

Jun 23, 2014 at 3:00PM

Rackspace Hosting Inc. (NYSE:RAX) takeover talks are heating up as analysts believe that CenturyLink (NYSE:CTL) has a high probability of making a bid. While this might make sense as a way to better compete against companies like Amazon.com (NASDAQ:AMZN), is this really in the best interest of shareholders?

Why would CenturyLink want Rackspace?
Rackspace operates two core segments: web hosting business and a variety of cloud infrastructure, or laaS, services. CenturyLink is a communications company, most notably in phone and broadband Internet services, but it also has a large network of data centers and assets in the cloud.

According to analyst David Phipps, there are four notable ways that Rackspace would be a good fit with CenturyLink. First, the combined company would create services revenue double that of CenturyLink's alone. Second, it would spark overall revenue growth. Third, it would increase customer stickiness. Lastly, it modestly boosts leverage.

In regards to boosting services revenue and leverage, both companies have made major attempts to grow in laaS in the last several months, including key announcements from both companies. With Amazon being such a juggernaut, it seems reasonable that many of Phipps's statements about increasing revenue, product synergies, and leverage have to do with this particular business.

Unfortunately, if the goal is to combine two up-and-coming players in the cloud to create more leverage and a stronger presence against the likes of Amazon, then a combined CenturyLink and Rackspace may not be the way to go. This marriage could have big problems.

Is CenturyLink really interested?
CenturyLink's existing laaS business is small, but earlier this year the company announced that it would be cutting prices and adding new features to its services plan. The company is leveraging the power and market-leading network of its data centers to keep costs in check rather than having to build centers that specialize in cloud infrastructure to handle the increased workload.

CenturyLink joins about half-a-dozen other companies that own roughly 3% of the laaS market. In fact, Amazon is the only distinguishing leader in laaS and controls one-third of the industry. IaaS is a large part of a broader cloud business that includes application platforms and is growing at 50% annually. First-quarter revenue was $3.5 billion.

CenturyLink has created its current market presence via the acquisition of two key companies: Tier 3 last year and its $2.5 billion purchase of Savvis in 2011. While $2.5 billion, plus the unknown price for Tier 3, might seem a bit outrageous for a 3% market share, it's important to note that Amazon's cloud business is valued at $50 billion with its one-third market share, meaning $2.5 billion was likely a fair price .

CenturyLink's acquisitive nature in laaS gives reason to believe that it might be interested in Rackspace, and that Phipps might be correct in making this call. It would definitely compliment Rackspace's decision to explore strategic options.

Would it be a mistake?
However, Rackspace is not the company that CenturyLink should chase. CenturyLink already has nearly $21 billion in debt on its balance sheet, and according to Phipps, the company would need $6 billion in financing in order to get the deal done, putting pressure on its balance sheet.

There are also operational reasons for why this deal could be bad news. Rackspace generates most of its revenue from web hosting, but its fastest growing segment is the cloud, which created revenue of $121.4 million in the first quarter with year-over-year growth of 34%. This growth lags the overall industry. Acquiring Rackspace would be would be purchasing a company that is losing market share in its only real growth segment.

Moreover, Rackspace has refused to follow industry peers like Amazon and CenturyLink with price cuts. Its chief technology officer recently said that Rackspace offers premium services and would not base its pricing off its peers. An example of Rackspace's premium products can be seen with its 15GB cloud server that costs $0.68 per hour. Amazon offers the same service for just $0.28 per hour. Rackspace lacks an edge, and with aggressive cost cutting, there should be concerns as to whether its 34% growth is sustainable.

Foolish thoughts
CenturyLink and Rackspace have operating margins of 15% and 8%, respectively. Pricing power is important for the sustainability of each company's valuation. However, Amazon's operating margin is only 1%, meaning it can continue to steal share and undercut both companies in laaS without the Wall Street backlash. While CenturyLink might be interested in Rackspace, investors should fear CenturyLink if this speculation turns into a reality.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Rackspace Hosting. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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