Description

Rackspace Hosting (RAX) - LONG

Stock Price: $43

Price Target $60

Market Cap: $6.2 b

ADV: $110 mm

Thesis

Rackspace (RAX) is a long because it is a high ROIC growth business that is loved by its customers who are part of the massive shift of corporate America moving away from on premise IT and into the cloud which we believe will drive 15-20% annual growth for RAX. RAX is misperceived to be a direct competitor to Amazon Web Services (AWS), Google Compute Engine (GCE), and Microsoft Azure, all of whom are willing to lose money to grow in the cloud. The reality is that 30-40% of the total $100 b TAM for cloud infrastructure will need managed services which RAX is the established leader in and in which AWS/GOOG/MSFT are unlikely to compete for. This misperception combined with a failed deal process has allowed us to invest in RAX at 8.2x 2015 EBITDA and 14.4x 2015 FCF for a high growth business with increasing estimates due to management under-promising to restore their credibility along with a recently announced 8% share buyback.

Our price target is $60/share or 40% upside based on 12x 2015 EBITDA (20x 2015 FCF) which compares to slower growth comps (AKAM, CCOI, EQIX) at 12x 2015 EBITDA. Note previous managed cloud private market transactions (SVVS & TMRK) went at 12-15x forward EBITDA.

Business Description

RAX is the leading managed cloud company with 300,000 customers that use RAX to move their data center needs (servers & storage) out of their legacy on-site premise and into a shared data center location. This shift is lower cost, allows for greater flexibility, and frees up company IT resources to focus on higher-value issues. RAX differentiates itself through their exceptional customer support (dubbed “Fanatical Support”) and high uptime service-level agreements (SLA’s).

RAX cloud offerings can be broken into Managed Hosting (dedicated equipment) and Public Cloud (on-demand capacity that is shared). Increasingly customers are demanding both dedicated equipment for certain IT functions but also public cloud for variable or less sensitive compute needs. This is called “Hybrid Cloud” which RAX offers as a seamless service.

Recent History & Competitive Landscape

In 2010 RAX identified public cloud or infrastructure as a service (IaaS) to be a huge trend as the flexible on-demand nature of the compute capacity would appeal to a large part of the market. RAX made a large bet with both money and management focus on the public cloud market which turned out to be a mistake by 2013 when it became clear that AWS and to a lesser extent GOOG/MSFT were willing to invest billions of dollars in IaaS and operate at minimal profits for the foreseeable future to grow market share. The silver lining here is that while competing heads-up against AWS was fruitless, it also became clear that a large part of the market would not only want access to the public cloud but also the service support that RAX is famous for. As a result RAX pivoted to become the leading “Managed Cloud” company which means offering dedicated hosting, public cloud, and hybrid cloud all managed seamlessly by RAX. After a slow down and margin compression in H1 13 RAX has begun to re-accelerate the top and bottom line.

AWS (and GCE and to a lesser extent Azure) are not going to compete against RAX in managed services. AWS is an organization of engineers who excel at building systems and applications for developers. AWS has neither intention nor the culture to become a 24x7 fanatical customer support organization. As a result, various companies (like DataPipe or INetU) have moved to fill this part of the ecosystem by offering managed services that run on top of AWS for customers that need their hands held. So while RAX is not going to be able to compete against AWS in IaaS/PaaS, managed services is an important and growing part of the cloud value chain that RAX is the clear leader in. In fact, AWS management told their channel partners at AWS re:Invent this year that they believe the demand for managed services is growing FASTER than demand for infrastructure.

This strategy shift followed by re-acceleration in the business was not without its hiccups. In February 2014 the then current CEO Lanham Napier announced his retirement which spooked the market. In March 2014 AWS and GOOG announced massive price cuts for their public cloud products which weighed heavily on investor sentiment as there was and likely continues to be a misperception that RAX and AWS are direct competitors. Then in May 2014 RAX announced that it had been approached by a potential buyer and was evaluating strategic alternatives. From May to September the RAX story was dominated by merger speculation rather than fundamentals until the company officially concluded their review and announced on 9/17 that they would remain independent.

So while RAX’s turnaround showed traction in the Q2 reported in August, it is really only in the last two months that management and investors have been able to focus entirely on the core business fundamentals. We think the Q3 earnings release on 11/10 is the first of several positive estimate revisions for RAX revenue, EBITDA, and EBITDA margins.

Management

The company is led by Graham Weston who is a co-founder, the current chairman, and was CEO from 1999-2006. Graham owns 19 mm shares or 13% of the company worth $820 mm and has not sold any stock in the last two years. Our research indicates he is a financially-focused owner having started in the real estate business.

Taylor Rhodes was appointed CEO in September 2014. Taylor is credited with leading the strategy shift away from public cloud to managed cloud and communicating that message to the customers as Chief Customer office from 2013 until his promotion in 2014.

Karl Pichler has been CFO since 2011 and joined the company in 2005 in a finance role. Before RAX, Karl worked at Stern Stewart and focused on their EVA consulting practice for SMB’s.

Valuation

We triangulate the value of RAX using EBITDA, FCF, and a SoP analysis (LeaseCo vs. ServiceCo). We are 3% higher than the street on 2015 EBITDA at $708 mm which at 12x is a target price of $60/share which implies 20x our 2015 FCF estimate of $3.00/share. We also break the company into a leasing company and a service company as we believe that RAX will de-emphasize the hardware component of their business over time and run off of AWS/GCE/Azure IaaS. While the assumptions required to separate the business have a necessarily wide range, at 2.0x book value for LeaseCo and 4.0x sales for ServiceCo (in line with cloud comps) we get to $50-$60/share.

Note that there is a lot of skepticism around EBITDA as a valuation metric because of capitalized software expenses and a higher level of capital intensity than the closest comps. We were initially skeptical as well, however after spending significant time and resources (including engaging a forensic accountant) we are understanding the issues with RAX’s EBITDA definition and by triangulating with FCF and an SoP we have conviction in our valuation estimate. While less intellectually rigorous, at the end of the day the street is going to use EBITDA because everything else is too complicated to have consensus on.

Risks

• Competition – We believe RAX has a real moat around their fanatical support and AWS/GOOG/Azure are more focused on offering infrastructure & applications and not building out a customer-support organization. However, the barriers to enter the managed cloud market are decreasing and we should expect to see competition in this space over time.

• Tension around reporting metrics – There is sufficient skepticism around RAX’s EBITDA metric and no simple way to value RAX such that the market may never award RAX the multiple we are underwriting.

Catalyst

• Continued quarterly earnings beats fueled by accelerating growth of the managed cloud TAM and the company’s ability to manage to higher EBITDA margins through capacity utilization increases and decelerating R&D investment (primarily in OpenStack).
• Growing recognition by the street that the IaaS competitive threat to RAX is misguided.
• Decision to offer managed services on top of AWS/GCE/Azure will begin to transform RAX from capital-intense to capital-light which the street will like as it removes the FCF debate from the stock and will buttress top line growth.
• Execution of recently announced $500 mm share repurchase authorization (including $200 mm ASR).
• Longer-term, RAX will be owned by a large tech/telco company that wants to accelerate their growth in the cloud, but it will be at a much higher price than the rumored CTL interest at $40-$45 bid in September.