NEW YORK (TheStreet) -- At the end of its most recent quarter, Cisco (CSCO) - Get Report had $50 billion in cash on the balance sheet and another $13 billion in operating cash flow. So there's very little that the networking giant can't afford. But the company has struggled with growth.
That, however, has not stopped investors from wondering "what if?" With the stock closing Monday at $25.23, shares are now up roughly 13% on the year to date.
Although growth has come in limited supply, Cisco's cash position and its strong 3.10% yield makes it tough to overlook the stock. For this reason, and the renewed confidence of investors, Cisco can't afford to pass up on an opportunity to grow its cloud presence. A deal for Rackspace Hostings (RAX) is what the doctors orders for Cisco's future and its stock.
Cisco has the cash and Rackspace is motivated to sell. Back in May, Rackspace management disclosed it has fielded M&A overtures from several companies. Some of which also expressed a desire to form strategic partnerships.
I can only speculate on which companies these might have been. Calls and emails to Rackspace representatives were not immediately returned.
While Rackspace does have a strong base of customers willing to shell out the cash it needs to grow its business its high-end outsourced cloud service model, competition from the likes of Amazon (AMZN) - Get Report, Google (GOOG) - Get Report and VMware (VMW) - Get Report (among others) are making it tough for Rackspace to compete.
This, however, legitimizes Rackspace's business model and lends credence to why it is an attractive target. With its market cap right around $5 billion and its $71 million debt, Cisco only needs to shell out $7.5 billion (50% premium) to get this deal done. Essentially, for less than 12% of Cisco's combined cash and operating cash flow, Cisco would instantly become a feared cloud rival to Amazon, Google and IBM (IBM) - Get Report.
What we've come to know as "the cloud" is evolving. OpenStack is the new battleground. It is the term used to describe a worldwide collaboration of developers and cloud-computing experts who are working together on an open-source platform. The goal is to advance the public and private clouds.
The problem is that OpenStack has become a misunderstood buzzword, which is now being redefined by several companies that had no cloud presence until it became a popular thing to claim. Except very few are able to deliver to market scalable cloud solutions that are feature-rich, yet easy to implement.
No one understands this better than Red Hat (RHT) - Get Report. This, of course, is according to Red Hat's CEO Jim Whitehurst. He's already called "game -- set -- match." His company is the champion, as far as he's concerned. Given Red Hat's long history with Linux and Open Source technology, Whitehurst shouldn't be doubted.
Cisco, meanwhile, doesn't have a comprehensive OpenStack strategy to complement its software-defined networking initiative. This is why a deal for Rackspace, which, along with NASA, founded the original OpenStack concept in 2010, makes sense.
What's more, despite the heightened competitive threats, Rackspace is still growing revenue at around 16% year over year. Equally impressive is the company's average monthly revenue per server is still trending up, which Cisco can leverage for upselling opportunities. Despite the strong sales, however, Rackspace's profits plummeted 37% due to pricing pressure.
Rackspace set the bar pretty high when it was the only name in the game. Over the next couple of quarters, it's going to have a tough time beating its year-over-year numbers, especially since larger software names likes IBM, Microsoft (MSFT) - Get Report and Oracle (ORCL) - Get Report have developed and/or acquired their own OpenStack capabilities.
At the time of publication, the author held no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.
TheStreet Ratings team rates RACKSPACE HOSTING INC as a Hold with a ratings score of C. TheStreet Ratings Team has this to say about their recommendation:
"We rate RACKSPACE HOSTING INC (RAX) a HOLD. The primary factors that have impacted our rating are mixed ? some indicating strength, some showing weaknesses, with little evidence to justify the expectation of either a positive or negative performance for this stock relative to most other stocks. The company's strengths can be seen in multiple areas, such as its robust revenue growth, largely solid financial position with reasonable debt levels by most measures and good cash flow from operations. However, as a counter to these strengths, we also find weaknesses including a generally disappointing performance in the stock itself, deteriorating net income and disappointing return on equity."
Highlights from the analysis by TheStreet Ratings Team goes as follows:
- Despite its growing revenue, the company underperformed as compared with the industry average of 21.2%. Since the same quarter one year prior, revenues rose by 16.2%. This growth in revenue does not appear to have trickled down to the company's bottom line, displayed by a decline in earnings per share.
- Although RAX's debt-to-equity ratio of 0.06 is very low, it is currently higher than that of the industry average. To add to this, RAX has a quick ratio of 1.55, which demonstrates the ability of the company to cover short-term liquidity needs.
- The gross profit margin for RACKSPACE HOSTING INC is rather high; currently it is at 66.65%. Regardless of RAX's high profit margin, it has managed to decrease from the same period last year. Despite the mixed results of the gross profit margin, RAX's net profit margin of 6.04% is significantly lower than the industry average.
- The company's current return on equity has slightly decreased from the same quarter one year prior. This implies a minor weakness in the organization. When compared to other companies in the Internet Software & Services industry and the overall market, RACKSPACE HOSTING INC's return on equity is below that of both the industry average and the S&P 500.
- Reflecting the weaknesses we have cited, including the decline in the company's earnings per share, RAX has underperformed the S&P 500 Index, declining 5.78% from its price level of one year ago. Looking ahead, we do not see anything in this company's numbers that would change the one-year trend. It was down over the last twelve months; and it could be down again in the next twelve. Naturally, a bull or bear market could sway the movement of this stock.
- You can view the full analysis from the report here: RAX Ratings Report