Why a Rackspace Sale to CenturyLink Would Make Sense

NEW YORK (TheStreet) -- According to multiple reports, CenturyLink  (CTL) , the country's third-largest telecommunications company, is in talks to buy Web-hosting provider Rackspace (RAX) for $5.3 billion in a deal that could be at the start of the shakeout in business of cloud computing.

Reports of the talks sent shares of Rackspace up 6% to $39.47 late Monday morning. The stock is up less than 1% so far this year, compared with an 8.4% gain for the Standard & Poor's 500 Index.

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CenturyLink shares were down 2% to $40.63. They have risen 27.6% this year.

Neither Rackspace nor CenturyLink was immediately available for comment.

The reported talks come at a point when San Antonio-based Rackspace is putting its growth problems behind it. In the second quarter, revenue rose 17%, as its profit nudged up.

So why would Rackspace take an offer that gives its own shareholders no premium, unless it's anticipating a bidding war.

The reason, it seems to me, is that Rackspace needs the capital base of Louisiana-based CenturyLink, a phone company that largely serves rural customers and that acquired Savvis, a Web-hosting company, in 2011 for $2.5 billion.

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CenturyLink generated $5.6 billion in operating cash flow last year, and it has been willing to invest some of that money -- $1.4 billion so far this year -- in its operations. Unlike Verizon (VZ) and AT&T (T) , CenturyLink has a history, through Savvis, of putting cloud computing first in its plans, and has made several cloud-based acquisitions during the past two years.

Cloud hosting has become a high-stakes game in which only big boys need apply. Google (GOOG) and Amazon (AMZN) regularly put $1 billion each quarter into their data centers and other infrastructure. IBM (IBM) , Hewlett-Packard (HPQ) , Dell and other companies are also investing in cloud as fast as they can in order to gain some foothold in what they see as the future of the corporate computing market.

The goal, as technology trade organization Open Group once noted, is to stay well ahead of demand and keep pushing prices down, increasing the value of the technology to customers. Thus, Amazon has been reducing prices, and rivals such as Google and Microsoft (MSFT) have followed suit.

It's great for customers, but capacity is being added faster than customers can absorb it, at virtually any price. When the inevitable cloud crash occurs, only big companies with other sources of income will be able to survive.

Thus Rackspace is wise to put itself up for sale. It's just not the cash, but also the company's long-term survival. The rumored talks could signal the start of many more deals in the cloud business as web-hosting companies look to secure their futures.

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At the time of publication, the author owned shares of Google and Amazon.

Follow @DanaBlankenhorn

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


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 increase in net income. However, as a counter to these strengths, we also find weaknesses including a generally disappointing performance in the stock itself and disappointing return on equity."

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