It may be too early to write off Rackspace Hosting's ( RAX) recent IPO as a disappointment. The IT hosting company headed to the public markets amid
buzz that its shares would price at $17. They ended up pricing at $12.50, near the bottom of its proposed range, then falling as much as 20% below that price in its first day on the NYSE. Because Rackspace looked so promising at first, it was seen as a canary in the scary coal mine that the U.S. stock market has become this summer. So its initial plunge set off discussion about what happened. After Rackspace started trading, I wrote a columnwith my take: The company has seen profit margins deteriorate slowly but steadily over the past couple of years, and it had some outages that affected bloggers, who in turn directed a lot of publicity about the outages. Its valuation seemed a little rich for a turbulent market. Since then the stock has rebounded a bit, closing up last week to $10.69 (on Monday, it was off 7 cents). I received a few thoughtful emails, some from Rackspace clients saying they liked the company's service, and some suggesting my view was too bearish. Then I came across a report from Renaissance Capital, an investment research firm publishing some of its work on the site IPOHome.com, that offered an interesting counter-argument. Matt Therian, a research analyst at Renaissance, took a look at the 18 IPOs that used the Dutch auction process rather than the more traditional pricing method favored by Wall Street underwriters. In a Dutch auction, a pricing is set after taking all bids and determining the highest price at which the total offering can be sold.
In Rackspace's IPO auction, investors with at least $2,000 in an account at
certain firms could collectively help set Rackspace's initial price through their bids. With $188 million in proceeds raised, Rackspace was the third-largest Dutch-auction IPO among those studied, following Google ( GOOG) and Interactive Brokers ( IBKR). The overall performances run the gamut from goats to heroes. Two of the 18, Briazz ( BRZZQ) and RedEnvelope, went bankrupt. Avalon Pharmaceuticals ( AVRX) is down 94% since its IPO, while New RiverPharma priced at $8 in 2004 and was bought last year for $64 a share. Peet's Coffee and Tea ( PEET) and Morningstar ( MORN) have more than tripled. Within that broad range, there are some trends. On average, the Dutch-auction IPOs averaged a gain of 2.4% on their first day of trading, and then went on to see an average of 104% since then, according to Renaissance's report. And that was after they saw their official offering prices drop in the auctions by an average of 7% from the midpoint of their initially proposed ranges. Most famously, Google's ( GOOG) Dutch auction caused its offering price to fall to $85, significantly below its initial range of $108-$135. But Google rose 18% on its first day and has given faithful investors a return of 500% overall. "Dutch Auctions typically result in smaller first day gains for investors as the auctionprocess, coupled with strong demand for shares, soaks up much of the initial valuation upside," the Renaissance report said. "Nevertheless, investors that held onto the shares of fundamentally solid businesses that went public through Dutch Auctions and generated less-than-stellar first day pops have been rewarded with substantial returns."
By contrast, Netsuite ( N) -- the fourth largest Dutch-auction IPO since 2000 -- priced well above its initial range amid huge buzz. And although it rose another 37% on its first day, it's now 34% below its offering price of $26. Overall, Dutch-auction IPOs that raised more than $100 million and priced within or below the midpoint of their original range were more likely to produce positive long-term performance. That phenomenon describes Rackspace, so based on that trend, the report says, "Rackspace's stumbling debut may not be indicative of the stock's long-term return potential." I asked Therian whether he thought Rackspace's falling margins, coming at a time when IT spending is down, would be a concern in the future. "They came to market to get additional capital, and that's putting pressure on them," he said. Rackspace's margins have come down as it has expanded data centers. "As they fill new space in the data centers, their margins are likely to come up." The build-out isn't finished. In its prospectus, Rackspace says it will spend $335 million in capital spending this year -- $160 million for a new headquarters in San Antonio, Texas, more data centers, and $175 million to buy new IT equipment. Rackspace has its share of challenges before it, especially as long as themarket remains choppy, but it's encouraging to hear some argue that the recent past of the stock isn't necessarily prologue of what lies ahead.