RackSpace Payday Not in Your Near Future

NEW YORK (TheStreet) -- Web-hosting service provider Rackspace Hosting's (RAX) shares exploded higher when news broke that the company hired Morgan Stanley (MS) to explore strategic options.

"Explore strategic options" is Wall Street-speak for "We don't believe what we're doing is going to continue working, and we hope we can find someone to buy us before the wheels fall off." Herb Greenberg wrote a Reality Check piece with his thoughts on why he removed the stock off his watch list while reminding investors that risks remain.

From my seat, the rally is more to do with short-sellers becoming squeezed than smart money buying shares for a large upcoming payday. I base my conclusion from the reported 12% short interest rate and the market clue left after the open.

When a stock gaps higher and fails to continue higher, AKA "gap and crap," it's usually a sign that the smart money is selling out while they can. The "dumb money" in this case are short sellers that may not be all that dumb. The stock is trading at a considerable level below the 200-day moving average (200MA) price of $40.

In other words, what we likely witnessed at the open was mostly short-sellers taking profits with a few hopefuls thinking the stock may continue ripping higher. Who was selling? Stuck bag-holders that finally had a chance to break even or maybe even make a few dollars that they all but gave up hope of ever seeing.

Notice how today's opening price just so happens to line up nicely with the highs of Feb. 11 after the stock gapped lower, and the lows of Dec. 2, 2013, before gapping lower the next trading day. That's an immense amount of inventory of shareholders underwater wanting to find an exit. Today at the open was their plan "B" and they took it.

After today's open, those who figured out no one was behind them to push the stock higher left as quickly as they could. The reality is that a takeover candidate that fails to break the key 200MA is in a world of hurt, and those who understand aren't going to stick around to see how it plays out.

Sure, there's a chance the company receives a wonder bid, but that's synonymous with playing the greater fool game. It's a game that you're not likely to do well unless you're the first to know.

Rackspace recently reported decent earnings, but it's no secret that it may be one of the last estimate beats the company can make. The company is competing in a space that includes the most competitive and highly financed technology giants in the world. Amazon (AMZN) is the number one Web-hosting company.

I recently wrote about number two provider Microsoft (MSFT), and its growth as a real contender to displace Amazon. Rounding out the list are IBM (IBM) at number three and a distant Google (GOOG) trails.

If we compare cloud hosting companies offering Iaas, PaaS, Private & Hybrid solutions, Rackspace Hosting doesn't rank as a top five, according to Synergy Research Group. Then why is it the market is pricing an incredibly massive 40+ price-to-earnings ratio?

In order to buy Rackspace with a P/E of 40, an investor has to believe a buyer will step up with a bid worth at least a 60 times multiple. The reason why is that if a deal doesn't materialize -- and considering the company doesn't have a bid in hand that's a mighty big if -- the shares will probably fall to the mid or lower $20s.

In order to justify the risk your shares won't drop by 30% overnight, either the chances of a deal must be relatively high or the potential takeover price must be high. We know that the chances of a deal aren't high because Morgan Stanley was just hired (compared to an offer in hand), leaving only a high price, which is simply crazy.

Who is going to step up to pay a 50, 60, or more P/E for a company that is in the middle of a battlefield with Amazon, Microsoft and Google slugging it out? I don't question there is someone out there dumb enough to do it, but what are the odds of someone actually coming forward to sign up for that?

One of the key above-mentioned competitors could make an offer to gain an instant increase in marke tshare, but don't expect it to pay more than what it thinks it will cost in price concessions to gain the same.

Rackspace is a quality company, and I do believe it will find a buyer -- but I don't think the numbers support the currently gargantuan premium. A P/E of 25 to 32 is reasonable under the situation resulting in a buyout price of $24-$30.

At the time of publication the author had no position in any of the stocks mentioned.

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This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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