Will Rackspace Become a Takeover Target?

The sudden "retirement" of CEO Lanham Napier has brought to the surface a lingering question looming over Rackspace: Can the pure-play cloud and hosting provider sustain its battle with Amazon Web Services (AWS) and a slew of other formidable challengers?

After 14 years at Rackspace and eight years as its CEO, Napier is stepping down and his predecessor, Rackspace Chairman and Founder Graham Weston, is returning to the helm, the company announced Monday. Despite posting a decent fourth quarter of 2013 with $408 million in revenues -- up 16 percent year-over-year -- and earnings of $.14 a share, Rackspace's profit slipped 33 percent year-over-year. Moreover, growth has slowed and annual earnings declined for the first time since Rackspace went public in 2008.

Revenues for the year reached $1.5 billion and the company boasted having 100 customers of its OpenStack-based private cloud offering, launched in the middle of last year. While the company issued slightly better-than-expected guidance for this year, Napier's unexpected departure hammered the company's stock by about 25 percent, though it bounced back by about 3 percent Thursday.

During the earnings call Monday, Napier indicated his reason for leaving was burnout and the desire to move on. But as CEO, Napier oversaw Rackspace's bet-the-company move to take on Amazon by leading the OpenStack project, which has cut into its bottom line over the past few years. Nevertheless, Rackspace officials believe the move has positioned the company well for 2014 and beyond.

If the move to OpenStack was aimed at mounting a challenge against Amazon, that has yet to bear fruit. A survey of potential customers by investment banking firm Jefferies found 57 percent were considering Amazon for their cloud deployments compared with just 33 percent for Rackspace, The Wall Street Journal reported. Also, Rackspace's public cloud business grew only 35 percent last year.

"As far as the 35 percent growth, of course, we always wanted to grow faster," Weston said in response to an analyst question during the company's earnings call (see transcript). "But I think that it's important to just understand that all of our strength has always been around serving that pragmatist customer. And I think that an awful lot of the growth for the cloud so far at other companies has been serving the do-it-yourself company, the company that loves the science project that the cloud is giving them."

In other words, Rackspace sees its growth in serving enterprise customers running business-critical applications looking at hybrid cloud deployments and requiring services to provide that application integration. The problem is that so do AT&T, Hewlett-Packard, IBM, Microsoft, Oracle, VMware and Verizon, which are backed by much larger businesses with large enterprise customer bases. Despite vowing to remain independent, it begs the question: Can Rackspace go it alone indefinitely?

To be clear, I'm only posing the question. I've heard nothing to suggest this is under consideration but public companies are always weighing and making offers. Furthermore, I'm not advocating it as a good idea -- the more independent players, the greater competition we see, so long as the economics allow for it. But if, on the other hand, IBM, HP or someone else believes that with Rackspace they can challenge Amazon and the price is right, it's certainly not beyond the realm of possibility.

Weston's remarks that he is in no rush to hire a new CEO despite saying he is instituting a search of internal and external candidates suggest that maybe he's weighing other options. Maybe not. But considering the stock was trading near $41 per share before the news hit and some analysts believe it could fall to as low as $15, it could be attractive to a number of players looking to beef up their cloud footprint.

Before IBM acquired SoftLayer last year, rumors surfaced that Big Blue was circling the wagons but the price was too high. Now, with Rackspace trading more than 50 percent less, maybe IBM will give it a second look if the share price continues to fall. According to WSJ, even at its current stock price, Rackspace may be too expensive. But considering the stock once traded at a peak of $81, if it were to fall in the teens, investors are likely to become impatient.

As Forrester analyst James Staten noted in a blog post following the report, Rackspace is a company that has evolved from a traditional managed hosting provider to a pure-play cloud computing company by making the investments traditional managed service providers (MSP) balked at in fear of cannibalizing existing revenue streams.

"What makes Rackspace different is that it has already figured out that cloud computing is more profitable than traditional hosting," Staten wrote. "This is a serious struggle for most MSPs who have a hard time looking at cloud outside the lens of the traditional hosting business. When viewed this way, cloud looks cheaper, more risky and more expensive to operate. Plus customers can come and go as they please which upsets the capitalization model. But take this lens off and look at cloud with fresh eyes and you can see that it's actually more efficient, carries higher margins and delivers more predictable revenues."

I've talked to numerous Rackspace executives over the years and I doubt I've ever had one conversation when the exec didn't point out the company's "fanatical support." Indeed, this is what sets Rackspace apart from Amazon's "do-it-yourself" approach, as Rackspace put it.

"Loyalty in cloud isn't set by the contract but by the value delivered and where Rackspace shines is in support and service, where loyalty really lives," Staten added.

That has served Rackspace well when catering to midsized, organizations but the company has yet to gain a strong presence among large Fortune 500 enterprises.

"It's getting there slowly but breaking into the CIO ranks of the top companies takes time and persistence," Staten said. "Thankfully some of its long-loyal companies have grown into enterprise leaders and can help with reference calls. But many of the incumbents are now using a Rackspace calling card against them."

Posted by Jeffrey Schwartz on 02/13/2014 at 4:45 PM