Will Anybody Buy Rackspace?

There are recent indications that some of Rackspace's potential suitors may not be stepping up to the plate.

Jul 21, 2014 at 11:20AM

When Rackspace (NYSE:RAX) announced that Morgan Stanley would be helping it evaluate options in mid-May, it was easy to think that such a respected, high-profile company would get snapped up quickly. However, as time has gone on, more potential buyers have given indications that it won't be them. Will Rackspace's demise continue, or will it be acquired by International Business Machines (NYSE:IBM) or Hewlett-Packard Company (NYSE:HPQ), as industry sources have speculated?

Great company, tough market
Rackspace has been the best house, not in a bad neighborhood, but in a war zone. Even if you love the view, it would be tough to pay up for that kind of real estate, which may be what potential buyers of Rackspace are thinking. Rackspace is sitting in the crossfire of Amazon.com, Google, and Microsoft, each with substantially more resources to draw upon than a stand-alone service provider, if a pricing war ensues.

Pricing war rages
Google dropped prices by 50% on average this year, forcing a similar reduction by Microsoft. Amazon was only slightly behind in terms of reductions, which may have only been the case because it was leading the charge last year. Throughout this war, though, revenue is still increasing year over year. It's clear that customers want to work with Rackspace, but if they can get better pricing elsewhere, they will. This has caused operating income growth to plunge on a year-over-year basis.

Has Morgan Stanley produced a bidder?
Shortly after filing weak first-quarter results, Rackspace announced that it would be hiring Morgan Stanley to advise management in evaluating options. This is a step in the right direction, but doesn't guarantee that a bidder will be found. Once Fairfax had a good look at the difficulties the company faced, the $4.7 billion acquisition turned into a syndicated convertible bond private placement. While Rackspace did not ignore its problem for nearly a decade -- the way that Blackberry did -- but it could be facing a similar challenge.

Why are potential acquirers poaching and flaming Rackspace?
Rumors of acquisitions from IBM and Hewlett-Packard have been turning up on industry blogs such as Techcrunch, but if a deal was actually in the making, why would these companies indicate otherwise and poach employees? Re/code recently announced that Mark Interrante, Rackspace's senior VP for products and engineering, joined HP in a move that is a head-scratcher. Why would HP recruit a senior exec from a company that is on its acquisition list? Another head scratcher is why an IBM executive would tell VentureBeat that "the company doesn't have enough technology to warrant an acquisition."

Going private would be a last resort
The rumor du jour is that Rackspace wants to take itself private. If it wasn't in the middle of a price war that would benefit from economies of scale, that might make sense, but the war is raging and lenders of fixed-price debt would likely expect loan shark terms for funding at this time. Are IBM and HP avoiding buying a grenade?

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David Eller has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Google (A shares), Google (C shares), and Rackspace Hosting. The Motley Fool owns shares of Amazon.com, Google (A shares), Google (C shares), International Business Machines, and Microsoft. 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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