Rackspace Readies for the Big Time - TheStreet

SAN FRANCISCO -- Analysts expect a relatively warm response to an IPO by Rackspace Hosting (RAX) , but the company faces tough competition in its attempt to produce long-term growth.

Some 15 million shares in the Web-hosting company, which had revenue of $362 million last year, are expected to price late Thursday between $12 and $16 in a modified Dutch auction, in which the underwriters may modify the offer price after all the bids are tallied. The offering is expected to raise $210 million.

After a drought in which no venture-capital backed offerings came to market during the second quarter of 2008, according to analyst Scott Sweet of IPO Boutique, Rackspace is testing investors' tolerance for new issues. Sweet says chatter indicates that the shares will price at the high end, and possibly at $17, despite the disappointing performance of most recent IPOs.

GT Solar

(SOLR)

, one of the few recent tech IPOs, came to market at $16.50 on July 24 and ended its first trading day down 12% at $14.59, according to IPO analysis firm MorningNotes. It was trading recently at $11.83.

MorningNotes expects Rackspace will price at or just below $16. The firm suspended its B rating on the issue "until we can get a clearer picture," MorningNotes stated in a research note Wednesday.

Early investors in Rackspace include venture firms Sequoia Capital and Norwest Venture Partners, which are hanging onto their stakes.

Linux software developer

Red Hat

(RHT) - Get Report

, which invested in the company in 2007, will sell 26% of its stake of 1.9 million shares in the IPO.

Rackspace's revenue for the first quarter of 2008 jumped 59% year over year to $119.6 million, comparable to its annual growth rate in each of the past three years. Revenue in 2007 grew 62%.

Gartner analyst Lydia Leong estimates the U.S. market for Web hosting, which typically involves providing server space for companies' external Internet operations, will grow at a compound annual rate of 19% through 2012. The U.S. market is expected to rake in $10.6 billion in 2008.

The company's hosting competitors include

Savvis

(SVVS)

,

AT&T

(T) - Get Report

and

Terremark

(TMRK)

among others.

"Rackspace is growing three to four times rate of the Web-hosting market as a whole, because they offer a differentiated service experience," Leong says. "To scale a service business growing at the rate they are is a tremendous challenge."

Rackspace also competes in the emerging "cloud-computing" market, in which companies such as

Amazon

(AMZN) - Get Report

,

IBM

(IBM) - Get Report

and

Microsoft

(MSFT) - Get Report

will let corporate clients to transfer their internal software applications to data centers run by these tech giants.

From a virtually nonexistent market today, "we expect to see the majority of

corporate IT infrastructure move into the cloud" over the next two decades, Leong says.

The changing dynamics of the Web-hosting-to-cloud-computing market could spell longer-term trouble for Rackspace, unless it can buy or build and integrate a broad portfolio of business software, says David Tapper, vice president of outsourcing research at IDC.

As a Web host, Rackspace's business model is caught between on-demand software-hosting companies like

Salesforce.com

(CRM) - Get Report

and the tech-savvy behemoths, Tapper says.

Those tech giants represent "major competition, no question about it," Tapper says. "You have to have global reach, scale and the ability to integrate applications to meet the needs of corporations.

The giants will provide a broad portfolio of their hosted software and services to clients, as will application-specific companies like Salesforce. The IBMs and Amazons are scaling up by building massive data centers worldwide.

On the other hand, Rackspace will be squeezed toward smaller clients, as it lacks the international data centers and scale of, say, IBM, Tapper says. Mid-market companies want their hosts to provide an extremely broad portfolio of sophisticated, integrated business software, he adds.

"A key element of our growth strategy is to further expand our customer base internationally and successfully operate data centers in foreign markets," Rackspace's prospectus states. "We have limited experience operating in foreign jurisdictions and expect to rapidly grow our international operations."

Citing business failures that stemmed from an inability to meet demand quickly, Tapper says he expects Rackspace to be challenged to ramp up fast enough in the face of such deep-pocketed competitors.

But even the tech giants will have their own challenges: They don't have recognizable brand names for their cloud-center services, Tapper says. Rackspace already has that, he added.

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