Should You Byte on This Data Center IPO?

Rackspace Hosting, which operates data centers providing Web hosting and utility computing services, recently announced initial terms for its IPO. The offering is interesting for a few reasons, not the least of which is that the firm is using an auction rather than the traditional IPO process, meaning anyone who submits a high enough bid will get shares. (For more information about how the auction process will work, see Page 34 of this Rackspace prospectus.)

The initial price range for Rackspace ($12-$16) is fairly wide, as is common in the auction process.  Google (GOOG) and Netsuite , two of the most prominent auction IPOs in recent memory--other than Morningstar's, of course--similarly saw a wide initial range and a lot of volatility. Here's the data:

Google
July 26, 2004:            $108-135 (24.6m shares)
August 16:                 $108-135 (25.7m shares)
August 18:                 $85-95 (19.6m shares)
August 18 (IPO):       $85 (19.6m shares)
First day close:           $100.34
End of 2004:              $192.79                             

Netsuite
December 5, 2007:     $13-16 (6.2m shares)
December 18:             $16-19 (6.2m shares) 
December 19:             $19-22 (6.2m shares)
December 19 (IPO):   $26 (6.2m shares) 
First day close:            $35.50 
Last quote:                  $16.57

As with Google and Netsuite, there is considerable uncertainly concerning Rackspace's future and the value of its shares. The data center business has been growing rapidly recently, with demand generally outstripping supply. Rackspace posted nearly 56% revenue growth during the second quarter, with the number of customers served more than doubling year over year. Rivals are also reporting strong growth, including  Savvis , which saw a 25% gain in data-center revenue year over year, with strong demand for both lower- and higher-end services.  

Our fear with Rackspace is that as more capital is deployed in the industry to increase hosting space and equipment--including the capital Rackspace hopes to raise--supply will outstrip demand and providers will resort to price-cutting to fill unused space. This is exactly what happened in the late 1990s, culminating in financial ruin for the likes of Exodus Communications (once the largest data center provider in the U.S.). The list of firms investing in data center space today is long. For example, Savvis, which inherited Exodus' assets, began building new space for the first time in several years during 2007. Larger diversified firms such as  IBM (IBM) and  AT&T (T) are also investing heavily in data center space. In fact, Big Blue recently announced it will spend another $400 million to expand data center capacity. In addition, less conventional players such as  Amazon (AMZN) and Google are attempting to leverage their vast information technology structures for similar uses, such as utility computing.

We believe there is a wide range of potential outcomes for Rackspace and that the initial price range the firm has provided is fair. The worst case for the firm would entail a deepening economic downturn into 2009 that results in declining demand just as additional space is coming online. One of the things we like about Rackspace is its focus on returns on invested capital and management's seeming willingness to walk away from unprofitable business (though this is admittedly easy to do when demand is strong). Rackspace has been profitable in recent years, despite its rapid growth, and has generally invested back into the business only the cash its operations generate, rather than take on debt to expand more quickly. These tactics, coupled with a fairly sticky customer base that generates recurring revenue, should benefit the firm in a downturn. Best case, we are in the midst of a data center renaissance and we have only seen the beginning of the move to outsource IT functions to hosting firms. Even if this scenario plays out, though, we aren't convinced the firm's strategy will provide it with a sustainable advantage over time versus the multitude of firms with which it competes. As a result, we would hesitate to bid aggressively for the shares.

This report is made available compliments of Morningstar IPO Research Services. For further information on our IPO research, contact Marc DeMoss at marc.demoss@morningstar.com or +1 (312) 384-4052.