The cloud space is exploding. However, because of its amazing growth prospects, it is quickly becoming an extremely competitive space, where Internet giants such as Amazon.com and Google compete against traditional IT players like IBM for a piece of the market. All of these players have invested billions of dollars in infrastructure to improve their competitiveness.
As the battle for the cloud gets fiercer, mid-size players such as Rackspace Hosting (NYSE:RAX) -- originally a company providing hosting through dedicated servers -- may find it difficult to keep themselves in the game. In the near future, the company could be challenged to differentiate its services from competitors, while providing low prices and permanent support.
To provide differentiation, the company will need to invest heavily in infrastructure, research, and technology, yet its budget may not be as big as those of Google, Amazon, or IBM. In this context, several analysts have suggested "strategic options" for the future, including a possible merger with giant CenturyLink (NYSE:CTL). Is Rackspace a good fit for CenturyLink?
The pro-merger argument
According to Citi analyst David Phipps, Rackspace is a good fit for CenturyLink because by acquiring the hosting company, CenturyLink would double its data services revenue, increase customer stickiness, and raise leverage.
Like Rackspace, CenturyLink is also competing against Amazon Web Services for the cloud market. CenturyLink has expanded rapidly in the cloud arena by providing low prices and extra cloud capacity. Through the acquisition of Tier3 and Savvis, the company got access to 11 operating cloud centers, and it plans to add more this year, including one in Canada and one in the United Kingdom. By acquiring Rackspace, CenturyLink could get access to nine data centers in six regions including Chicago, Dallas, Northern Virginia, London, Hong Kong, and Sydney.
The merger of CenturyLink and Rackspace -- which recently hired Morgan Stanley in order to explore acquisitions or partnership requests -- would create a network of more than 20 cloud centers, and plenty of synergies between Century Link's infrastructure and Rackspace's technology.
The cost of acquiring Rackspace
As Rackspace's market capitalization is higher than $5 billion -- equivalent to roughly one quarter of CenturyLink's market capitalization -- this acquisition would require roughly $6 billion in financing. If CenturyLink does decide to acquire Rackspace, the move could probably lead to a credit downgrade for the telecom giant. That being said, CenturyLink is well known in the industry for making billion-dollar acquisitions. For example, it spent $2.5 billion in 2011 to buy cloud infrastructure firm Savvis.
From now on
Consolidation in the cloud industry is rapidly taking place, as evidenced by Rackspace's announcement that it is officially exploring "strategic options." Because of a huge difference in scale advantages, small players are likely going to have an extremely difficult time competing against Internet giants, traditional IT players, and even telecom and cable companies for a piece of the cloud market.
Final Foolish takeaway
By acquiring Rackspace, CenturyLink could double its data services revenue, own nine additional cloud centers, get access to OpenStack technology, and consolidate itself as a major player in the cloud sphere. On the other hand, Rackspace's decision to consider being acquired is quite responsible. The company had a great first quarter; it reported a 16% increase over sales recorder during the same quarter in 2014. Revenue came in at $421 million, beating the Street consensus by $2 million. These numbers shall allow Rackspace to get a decent premium in case it is acquired.
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Victoria Zhang has no position in any stocks mentioned. The Motley Fool recommends Rackspace Hosting. 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.