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Why Private Equity Firms Are Pursuing Rackspace

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Factors impacting Rackspace stock

Earlier in the series, we discussed Rackspace’s (RAX) possible sale to a private equity firm. Increased competition in the cloud space has significantly impacted Rackspace’s growth.

Moreover, the intensifying competition between the two leading players in the cloud space, Amazon (AMZN) AWS and Microsoft (MSFT), has put pressure on Rackspace. Rackspace lacks the scale and footprint that Amazon and Microsoft enjoy. Lack of size, scale, and presence limit the growth potential of Rackspace and similar small players in the cloud space.
rackspace cfo

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Voicing concern over Rackspace after the company’s fiscal 1Q16 results, Michael Bowen, an analyst at Pacific Crest Securities, stated, “The lack of near-term catalysts for growth, in a cloud sector marked by growth, will likely result in continued weakness in the shares despite an aggressive buyback program.”

Rackspace’s fiscal 1Q16 revenues, which failed to meet analysts’ expectations, coupled with the growing competition in the cloud space weighed heavily on Rackspace’s stock. Moreover, the company’s guidance for fiscal 2Q16 also fell short of analysts’ expectations.

The news of Rackspace’s possible sale provided a major boost to the stock. It surged ~30% on August 4, 2016.

Improved operating cash flows will facilitate Rackspace’s sale

To combat the increased competition in the cloud space, Rackspace changed its strategy of reselling the capabilities offered by Amazon’s AWS, Microsoft Azure, and Google Cloud Platform. This strategy has yielded results. Through its focus on higher-margin services, Rackspace has managed to improve its CFO (cash flow from operations). Private equity firms demand a higher rate of return than commercial lenders, which is why their focus is more on a company’s operating cash flow and prospects.

The above chart shows Rackspace OCF (operating cash flow) and FCF (free cash flow) in previous quarters. Though Rackspace cash flows have not had a smooth ride, they have increased in the past two quarters. In fiscal 1Q16, Rackspace reported OCF and FCF of $156 million and $73 million, respectively.

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