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CFA Institute Research Challenge
Hosted by
Central America & Caribbean Local Challenge
Barna Business School
MARKET CAP $2.54B
SHARES
OUTSTANDING
134.7M
52 WEEKHIGH / LOW $56.2 /$17.2
50 DAY MOVING
AVERAGE
$22.89
200DAY MOVING
AVERAGE
$27.90
AVERAGE DAILY
VOLUME
2.5M
ADJUSTED BETA 1.48
DIVIDENDYIELD -
Summary: RAX is a global leader in providing managed hosting
solutions for business customers.
GICS Sector: Information Technology
Sub-Industry: Internet Software & Services
RAX has consistently delivered double-digit revenue growth on a
yearly basis and has earned stable near-30% EBITDA margins since 2010. Additionally, RAX has
enjoyed consistently low churn rates and healthy stream of recurring revenue. Furthermore,
RAX has been able to grow within its existing client base as indicated by net upgrades data.
At the close of 2014, RAX’s number of servers deployed had increased
41% from 2011 with over 112K servers. Similarly, RAX’s average monthly revenue per server grew
from $1,070 to nearly $1,330 during the same timeframe, a 24% increase.
RAX has recently formed partnerships with Amazon Web Services (AWS)
and Microsoft Azure, leading cloud providers, to provide its managed services to its clients.
We fully expect RAX’s young up-and-coming leadership to capitalize on a booming managed
cloud space aided mainly on these catalysts: (i) Growing enterprise adoption of OpenStack©,
and (ii) Successful partnerships with third-party cloud providers.
Organizations are moving towards OpenStack cloud for the promise
of no vendor lock-in, IT agility, and competitive differentiation. Disney, BMW, Expedia, eBay,
Wal-Mart and Time Warner are some examples of enterprises that chose this open-source
platform and are sharing their success stories.
Managed Services at Cloud Service Providers are
growing at a compound annual growth rate of 25.6%. These services account for 29.1% of total
cloud market revenue in 2014 and are projected to account for 36.3% of the total cloud market
revenue in 2018. As AWS and Azure grow their Infrastructure as a Service customer base, RAX
will be exposed to more potential markets to offer their managed services, taking advantage of
both Infrastructure as a Service and managed cloud services.
SOURCE: CAPITAL IQ
This report is published for educational
purposes only by students competing in
The CFA Institute ResearchChallenge
SOURCE: COMPANY DATA & TEAM ANALYSIS
VALUATION DATE: JANUARY 15, 2016 CURRENT PRICE: $18.84 RECOMENDATION: BUY (45.2% Upside)
TICKER: RAX TARGET PRICE: $27.36 NEW YORK STOCK EXCHANGE (NYSE)
Rackspace® Hosting, Inc. (NYSE:RAX) is a provider of managed cloud services headquartered in
San Antonio, Texas. Founded in 1998, RAX operated as a private company for 10 years until its IPO
in August 2008. With 13 data centers across the globe (Figure 1), RAX has been recognized for the
past two years as a leader in Gartner’s Magic Quadrant for Cloud Enabled Managed Hosting, both
in North America (contributing 69% of RAX’s revenue) and Europe (Figure 2).
RAX serves 300,000+ business customers,
including 69 of the enterprises in Fortune® 100, located in over 120 countries across four
continents through its subsidiaries and offices (APPENDIX 7). RAX helps its customers design,
deploy, manage and scale their operations in the cloud. Its value proposition consists of offering
customized hosting solutions across a variety of world leading platforms. Its key differentiator
resides on Fanatical Support®, the promise to deliver the best customer service through its 6,000+
skilled Rackers (Table 1).
RAX showcases a broad portfolio of integrated IT solutions,
combining different hosting categories and support levels in order to deliver tailored solutions to
specific customer needs. RAX also offers advisory services on technology strategy and
transformation, and application migration1. Since 2002, RAX has amplified the delivery of its support
capabilities for leading platforms atop its infrastructure as well as third party clouds. For further
details on RAX’s product and service offerings please refer to APPENDIX 8.
RAX service offering could be divided into two segments based on its growth
drivers and cost structure: (i) Managed Hosting, fueled by OpenStack© and characterized for heavy
infrastructure costs; and (ii) Fanatical Support® for Third Party Clouds, with a high demand for
skilled personnel, no CapEx, and driven by the expansion of unmanaged cloud providers.
— RAX focuses on providing beyond expectations
customer experience which in turn generates a powerful stream of recurring revenue (figure 3).
RAX’s Fanatical Support® has been recognized with the Stevie Awards for the 4th consecutive
year.
— RAX has recently expanded its service
portfolio to provide Fanatical Support® for unmanaged public cloud vendors such as AMZN’s
AWS and MSFT’s Azure. RAX expects these new offerings will ensure its position as a leading
provider in a fast growing market, representing its main growth driver through 2017 and beyond.
— In 2010, RAX cofounded OpenStack© - an open cloud
standard - along with NASA, in order to provide an alternative to proprietary cloud platforms. Five
years later, partnering with Intel®, RAX created the OpenStack© Innovation Center to recruit and
train open source developers to advance the platform. This initiative will accelerate features that
will make OpenStack© more scalable and secure, as well as more accessible for enterprises
looking to adopt it but which struggle due to scarce talent.
RAX’s public ownership is comprised of 300M authorized common stocks grouped within one
single class of shares. At the Valuation Date, the majority of its 134.7M outstanding shares are
institutionally owned (68.39%), while 17.97% are held by hedge funds and 14.79% by individuals
(Figure 4), with Fidelity Investments (14.83%) and Blue Harbour Group (8.44%) as top institutional
holders (APPENDIX 9). As part of RAX anti-takeover provisions, as of December 31, 2014, there were
50M authorized shares of preferred stock, of which none were outstanding.
RAX’s team of directors is diverse in terms of backgrounds and managerial experience, more than
15 years on average (APPENDIX 10). Members of the Board have started successful SaaS
companies, consulted for technology enterprises within firms like McKinsey & Bain. Chairman
Graham Weston has been through all of RAX’s transitions, from a pure Web hosting company to
IaaS provider to its current Managed cloud approach. Nonetheless, most named executives have
no relevant experience in business transformations outside of RAX. Fred Reichheld, board
member, is an expert on customer service and loyalty, pillar upon which RAX has built its main
competitive advantage. He founded the loyalty practice at Bain & Company where he is a partner,
and has also written many books on the subject. He is the second longest tenured member after
Weston having served 7 years (APPENDIX 11). We evaluated management’s track record using the
Economic Value Added model (EVA) to measure how effective has been RAX’s executives in value
generation and concluded that RAX has delivered excess returns every year since IPO, signaling
upright judgment at selecting projects.(APPENDIX 12 ).SOURCE:COMPANY DATA
SOURCE:COMPANY DATA
RAX has assembled a board of 9 directors, selected via voting at shareholders’ annual meetings, with 4
established committees: Nominating and Governance, Audit, Real Estate and Finance, and
Compensation. The Board is structured as classified, limiting directors’ accountability due to their 3-year
term election but encouraging a longer timeframe, desired for technology companies. Despite this
structure only two members, non-executive, have been onboard for more than 5 years. Moreover, the
company has set forth stock ownership requirements for all executives of at least 3x base salary to
encourage commitment to shareholder value creation. As of Jan 15, all directors and executives held a
combined 14.1% ownership on RAX (Table 2), a number largely skewed by founder Graham Weston
stake of 14.1%. Remuneration for the CEO and Executive team is structured using a “Say on Pay”
methodology with support from independent consultant Compensia Inc., leader in compensation
consultancy serving over 27% of the market for IT companies. In 2014, RAX’s performance-based
compensation for CEO and continuing named executive officers accounted for 44% and 34%
respectively of their total remuneration package, with the majority of the compensation vested over
multi-year periods – 87% and 72% respectively – aligning executives with the long-term interests of
shareholders. At the last annual meeting, compensation was approved with more than 87% of votes
“FOR”, which signals strong acceptance by the shareholders. Further details in APPENDIX 14.
RAX’s employee-led people-centric initiatives, such as Rack Gives Back and its fund, The RackSpace
Foundation, are aimed at elevating and further developing RAX’s surrounding communities through
volunteerism, grants and education. Additionally, RAX supports sustainability within the cloud industry
through its RackSpace Startup Program and The RackSpace Cloud University. Moreover, to ensure
environmentally conscious operations, RAX has committed to the goal of powering worldwide
operations with renewable energy and thus has been recognized through its listing on the Dow Jones
Sustainability Index and the FTSE4Good Index. Further details on social responsibility programs are
presented in APPENDIX 4.
- Enterprise IT investment is proportional to the state of the economy, thus strong
macroeconomic indicators represent a positive outlook for cloud computing as part of organizations’ IT
budgets. GDP as a measure of economic health paints an optimistic picture for upcoming years.
Estimated annual growth in the US comes north of 2.7% yearly until 2018 when it starts slightly dropping
but staying above 2.0% through 2020. Similarly, the EU is expected to come out of the lengthy period of
economic difficulty to present steady growth of 1.9% up to 2020, with UK as one of the leading factors
growing 2.2% a year3 (Figure 5).
. Cloud computing is
meaningfully responsible for the utter disruption of traditional business models’ practices. The cloud’s
elastic scalability (shift to Pay-as-you-go versus install-and-own), cost savings and resource
optimization is making it the fundamental IT engine for business customers. At a global level, cloud
computing is expected to grow at a remarkable rate of approximately 43.37% CAGR reaching $132B in
2020 (Figure 6)4. It is estimated that 11% of IT budget will shift away from in-house towards one or more
versions of cloud computing. Accordingly, spending on Infrastructure as a Service (IaaS) and Platform as
a Service (Paas) is expected to grow at a 30% CAGR (2013-2018) as opposed to 5% growth for overall
enterprise IT spending. Similarly, by 2018, over 60% of companies will have at least half of their
infrastructure on cloud-based platforms5
Customers today expect simple real-
time interactions anytime, anywhere through increasingly interconnected devices. By 2020, it is
estimated that 4B people and 31B devices will be connected to the Internet6, generating a tremendous
influx of unpredictable data. These trends require enterprises to rethink the way they are currently
delivering their business by migrating from rigid on-premise environments to dynamic and scalable
networks able to quickly address consumers’ needs. This can only be attained by the cloud, which
provides elastic on-demand provisioning of IT resources. Consequently, as supported by the survey
results in Figure 7, there is a shift within companies’ IT investment priorities by reallocating financial
resources to more strategic opportunities for businesses’ digital transformation. On average, more than
60% of IT organizations are increasing operational IT budgets for 2016 while IT CapEx remains relatively
unchanged (Figure 8). This tendency of lowering IT spending as a percentage of increasing revenues is
mainly explained by the steady stream of companies migrating to the cloud and thus lagging behind in
IT employee headcount.
– Cloud computing is on the verge of major growth in the
public sector. Many government organizations have been historically cautious about cloud adoption
due to privacy and security concerns but today governments worldwide are supporting cloud-related
standards development (e.g., US, EU), investing to create economic regions of cloud technology (e.g.,
China, Japan) or migrating their own IT infrastructures to cloud services (e.g., US, UK, Japan) 8. By 2018,
the global government cloud market will be worth $18.5B (45% CAGR from $2.78B in 2013)9 accounting
for more than half of global software, server and storage spending growth 10. In 2013 the CIA awarded a
$600M private cloud contract to AWS, a milestone for this transition.
- The most aggressive growth rates for cloud ecosystems are
occurring in Asia-Pac (68% CAGR through 2018), EMEA (70%) and LatAm (47%) 7. Emerging markets are
increasingly exploiting the cloud’s potential and translating it to economic growth and global trade expansion.
Businesses in emerging economies benefit from reduction of technology barriers, scalability, costs reduction
and opportunities for new service and product development. These markets, divested of legacy systems and
IT infrastructure, are more agile to adopt cloud resources leapfrogging more mature markets.
In today’s global technological outlook of innovations and rapid change, qualified talent is
regarded as a key driver for strategic business development. As cloud computing keeps it rapid-paced
growth, demand for capable IT professionals is outpacing supply, and thus enterprises worldwide are
faced with the challenge to compete for qualified candidates or struggle to up-skill in-house personnel.
Consequently, cloud computing professionals earn one of the top average salaries within IT (Figure 9).
As of December 2015, there were 420,000+ full time job positions open with only an average of 7
qualified candidates available per opening (9 in 2014) with an average posting of 45 days, making IT
positions some of the most challenging to fill 11. This talent shortage translates into higher IT payroll
spending, organizations settling for under-qualified candidates, or IT task outsourcing.
Cloud computing’s early stage adoption was mostly
limited to IT companies which had the expertise and resources required to deploy cloud technologies.
The industry has seen how the draw of low-cost cloud infrastructure accelerated adoption by
companies across all sectors as they move their workloads into the cloud. Having limited access to
required skills, said companies are leveraging the economies of expertise offered by managed cloud
providers thus outsourcing resource-consuming IT tasks. Furthermore, hybrid cloud offerings have
gained traction over the past 5 years due to an increasing number of enterprises continuously looking
for integrated and flexible cloud solutions. This is showcased by Northbridge’s 2015 “Future of the Cloud
Survey” where results indicate that hybrid solutions currently account for 47% of IT strategies12. (Fig. 9)
Although cloud adoption and spending is estimated to
continue its rapid growth, there are still persistent concerns which prevent a wider adoption of the
cloud. For IT professionals, top inhibitors to cloud adoption include data security (45%), regulatory
compliance (36%), privacy (29%), vendor lock-in (26%) and complexity (23%) (Figure 10). In the wake of the
Snowden/PRISM scandals, governments and enterprises worldwide are increasingly concerned with
data residency, giving way to concepts such as national cloud to gain traction. The recent European
Court of Justice ruling (October, 2015) invalidating the Safe Harbor data-sharing agreement between
U.S.-EU, indicates how stricter government regulations on data sovereignty threaten to undermine the
economic potential of the cloud, presenting new hurdles for cloud adoption .
The managed cloud segment is expected to have strong long-
term revenues 13, hence it is characterized by a high fragmentation and rivalry (APPENDIX 16). Gartner,
leading IT research firm, ranks vendors in this sector in one of four categories according to their
performance within the market: leaders, challengers, visionaries, and niche players (APPENDIX 17).
Within the North American and European markets, RAX has been recognized as an industry leader due
to its market presence, satisfactory customer experience and flexible business model 14. A key pillar
within this positioning is RAX’s workforce and organizational culture, which has been recognized by
Fortune© as one of America’s top workplaces in six of the past seven years. Other vendors competing in
this leadership category include Datapipe, Interoute, Claranet, BT Global Services, and Colt. For further
details on competitors’ analysis please refer to APPENDIX 18.
In the beginning of its operations, RAX
started out by renting servers and later evolved to a full service Web hosting provider with a strong
emphasis on customer support. As IT infrastructure underwent a rapid shift from in-house to over the
internet, so did RAX model as it pivoted into being a cloud infrastructure provider. Having to face taut
price competition from industry giants such as AMZN, MSFT and GOOG, in 2014 RAX evolved once
again to a managed cloud approach discontinuing its sole IaaS offering and bundling it with its support
package. During 2015, RAX has expanded its services by offering its flagship customer support for third-
party clouds. We believe that the various successful transitions in RAX’s business model serves as
evidence in the company’s ability to identify market trends and adapt accordingly, a clear competitive
advantage in a constantly evolving industry. Please refer to APPENDIX 19 for our holistic assessment.
Cloud computing is progressively being adopted by non-IT business
customers and SMBs, which do not have the necessary technical expertise and require a managed
service provider to help them overcome the hurdles of cloud adoption15. Our analysis reveals the
importance of vendors’ ability to provide aggregated value for customers due to the many alternatives
to managed cloud services available (Figure 11). RAX’s value proposition is based on creating
customized IT solutions to address obstacles faced by customers when moving to the cloud
(APPENDIX 8). Its Fanatical Support acts as a key differentiator and source of customer retention.
As aforementioned, one of the key inhibitors why enterprises are
reluctant to adopt cloud technologies is the fear of being locked-in by cloud vendors through
proprietary platforms and the lack of flexibility to which it translates (Figure 10). Banking on this market
opportunity, in July 2010, RAX cofounded OpenStack as a collaborative approach to cloud computing.
Five years later, the open source project has become a leading software platform with more than 520
member companies and 27,000 individual contributors across 167 countries, one of the fastest growing
communities in the world. As a founding father RAX has a solid competitive first-mover advantage,
having profound expertise in managing and scaling OpenStack clouds and operating the largest
worldwide production OpenStack cloud.
SOURCE: CloudTech
We issue a BUY recommendation for RAX with a target price of $27.36 per share, representing a 45.2%
upside from its closing price of $18.84 at the Valuation Date (Table 3). We fully expect RAX’s young up-
and-coming leadership to capitalize on a booming managed cloud space aided mainly on these
catalysts: (i) Growing enterprise adoption of OpenStack ©, and (ii) Successful partnerships with Third-
Party cloud providers.
© In recent years OpenStack© has evolved from a tech user
orientation to a more robust and reliable platform making it a viable option upon which a broader range
of business customers can depend, with success adoption stories by Fortune© 100s like Walmart and
BMW (APPENDIX 19). Benefits such as operational efficiency, ease of application deployment and lack
of vendor lock-in (Figure 12)16 make OpenStack© a growing preferred choice for building private and
public clouds. Nonetheless there are still several barriers for OpenStack© adoption, lack of internal IT
skills being the top concern (Figure 13). Consequently, enterprise customers look for OpenStack©
managed service providers to address these obstacles. We consider this should help propel
OpenStack© as a steady source of revenue growth for RAX which holds huge first mover advantage as
one of the founders of the standard.
AWS revenues alone are estimated to grow to $24B by 2022 while the managed
services within it are projected to account for 30% of said amount17. Even though we expect the recently
formed partnerships with AWS and Azure will represent a slight dilution in EBITDA Margins, we believe
the bigger addressable market will offset this reduction. Moreover, we expect other unmanaged cloud
providers to ink alliances with RAX. Therefore, we believe RAX is in great position to stand on the
shoulders of these industry heavyweights and grow revenues.
Over the last 12 months RAX has shed more than 58% of its market capitalization due to
qualms about their ability to withstand aggressive price cuts in the commoditized IaaS/PaaS market.
We believe this to be an indicator that the market has not factored-in the main strategies laid out by
RAX’s leadership. However, based on our DuPont Analysis (see table below), we do expect RAX’s
recently amplified service portfolio to generate excess returns for shareholders by enabling coopetition
with industry giants instead of lose-lose price wars.
Our target price is derived from two standard valuation approaches: Discounted Cash Flow Model (DCF)
and Peer Multiple Pricing Model. This model mix considers the current value of RAX’s long-term growth
opportunities and the market’s perspective of its worth. We assigned a weight of only 30% to our Peer
Pricing Model due to the significant impact that the beginning-of-year market selloff has had on
industry multiples, failing to properly reflect the value of RAX and its peers (Figure 14). Additionally, we
believe an intrinsic valuation approach, such as the DCF, delivers a better price estimate for an
enterprise undergoing a pivot in its business model, as is the case of RAX. Our DCF analysis, centered on
year to year forecast through 2025, delivered an estimated price for RAX’s common stock of $27.60. In
turn, our relative valuation approach provided an estimated share price of $26.81 from the selected peer
group of similar-sized US listed companies using a cross sectional regression analysis.
For the purpose of our forecast, we broke down RAX’s income statement into two business segments
according to the hosting infrastructure provider: (i) Managed Hosting, RAX’s managed solutions atop its
proprietary infrastructure, and the recently launched (ii) Fanatical Support for Third Party Clouds. We did
so by considering the different maturity levels and key growth drivers of both offerings.
Driven by an increasing number of enterprise adopting OpenStack ©, we expect this
segment to grow at a 10.98% CAGR throughout the forecasted period. However, by the end of the
forecasted period, we anticipate EBITDA and EBIT margins to decrease to 22.9% and 9.0%, respectively,
mainly due to the arrival of new competitors and potential price wars (Figure 18).
For this segment we project a revenue growth driven mainly by
the late majority pushing their infrastructure to public cloud vendors but lacking the expertise to do it on
their own. We expect RAX to account for 10% of the managed services running on top of major
unmanaged cloud providers by 2020 and 6.7% at the end of the forecasted period. Furthermore, our
estimates indicate EBITDA and EBIT margins for this segment will be lower than the more traditional
services due to training and recruitment costs, sales and marketing expenses, and reselling fees.
Investors should consider the following key risks: (i) Competition in a highly fragmented industry with
many nascent companies, including VC Backed startups, could put pressure on economic rents; (ii)
margin dilution given the wars for scarce talent, increases in energy costs, employee training and
certification, and the need to increase idle capacity to better serve different standards besides
OpenStack©; (iii) Slower than expected OpenStack© adoption could hinder growth; (iv) Breaches in
quality of service like system failures and security issues could increase clients to switch to other
service providers; and (v) Disruptive technology and processes could make RAX technology and
services obsolete or financially inefficient.
SOURCE:TEAM ESTIMATES
SOURCE: OpenStack.org User Survey, 2015
Building upon a diversified client base, RAX’s Managed Hosting revenue
has consistently showed yearly double-digit growth (2014:16.9% and 2015:11.5%) albeit posting a slight
slowdown in the last couple years due to slower than expected customer installations and a stronger
US dollar (Figure 15). Encouraged by the expected growth of the cloud and faster enterprise adoption
of OpenStack©, we estimate 12% year on year growth up to 2020 followed by a slight deceleration
due to inevitable price wars. We believe Managed Hosting will reach its stable stage by 2025 with a
constant growth rate of 8.4%. According to our estimates, by the end of the forecasted period, the
Managed Hosting segment will reach Net Revenue of $5.6B, from $2B in 2015 (Figure 15).
AWS is the undisputable leader of the unmanaged cloud
segment, holding a 27.2% market share, with Microsoft, IBM and Google Completing the Big 4 with a
participation of 16.2%, 11.8% and 3.6% respectively (Figure 17). However, we assumed a conservative
approach and decided to estimate the size of RAX’s potential unmanaged market based solely on
AWS’ growth prospects (Figure 16). AWS’ revenues are estimated to reach $20B by 2020 (24.82%
CAGR from 2015), outpacing the estimated growth rate for global IaaS spending (10.27% CAGR) 18. This
rapid growth is mainly driven by its global operations’ scale, adoption rates, price reductions and its
success in increasingly providing premium services. Therefore, the starting point for our forecast was
AWS’s net revenues for 2015 and from then onto 2022 we considered a CAGR of 17.9% resulting in a
total of $24B, which was followed by a slight deceleration ending leading to $36.7B of revenues by
2025. Additionally, several studies show an ever-growing demand for managed cloud services thus
we estimate over 30% of AWS’s clients will procure these services by 2025. We expect RAX to capture
10% of the managed cloud services for AWS during the first years of the partnership followed by a
decline at the end of the forecasted period due to intensifying competition. In short, we anticipate
Fanatical Support® for Third-Party Clouds will reach $2.4B by the end of our forecast, for a 30% stake
of RAX’s Total Net Revenue.
RAX has delivered stable EBITDA and EBIT Margins for the last 5 years, averaging 30.4%
and 10.6% respectively (Figure 18). For Managed Hosting, we expect these margins to remain constant
at 30.7% during the forecasted period. As for the results of RAX’s partnership with third party cloud
providers, we see relatively high Costs of Revenues highlighted by a less scalable labor-intensive
business model. Consequently, we are estimating this business segment to deliver inferior EBIT
through 2025 at a constant 4.6%. At a global level, we believe this should translate to an average
EBITDA and EBIT Margin of 22.5% and 8.9%, respectively, during the forecasted 10-year period.
In tandem with RAX’s aforementioned historical revenue growth, its working capital
management has shown continuous efficiency throughout the company’s lifetime. Its average
collection period of less than 30 days falls well below the latest available industry average of 47
days20, which, along with RAX’s average days -payable of 80+, is generating strong cash flows from
operations of near 29% of Total Net Revenue. In our forecast, we expect RAX to maintain its focus on
operating efficiency, minimizing its annual investment in net working capital to >1% of Net Revenues
(Figure 19).
RAX’s CapEx relate mainly to Customer Gear, which in turn refers to servers,
firewalls, load balancers, cabinets, backup libraries, storage drives and network cabling. These items
historically represent more than 60% of RAX’s CapEx. The rest is comprised of data center and office
build-outs, as well as capitalized software. For our forecast, we divided these investments into two
types: Maintenance CapEx and Growth CapEx. The first was estimated pursuant RAX’s guidance,
which allocates a permanent 10% of its revenues to these purposes. For the second item, Growth
CapEx, we analyzed the historical behavior of RAX’s CapEx in relation to its Net Revenues during the
2010-2014 timeframe, excluding periods 2011 and 2013 for being deemed outliers. As a result, we
observed that, on average, RAX assigns 12.7% of its Net Revenues to Growth Capex with 8.1%
pertaining to Customer Gear. Therefore, in our Base Case, we assumed a steady 10% as Maintenance
CapEx and a 12.7% as Growth CapEx (Figure 20).
At the close of 3Q15, RAX presented a Debt/Capital
ratio of 22.7%, well below the selected peers’ mean of 48.6%. Similarly, its Debt/EBITDA ratio of 0.7x
falls under its industry peers’ mean of 2.4x, which signals room to finance future growth opportunities
in the managed cloud space through debt (Figure 20). As part of our forecast, we expect RAX’s
current Debt/Capital ratio to move towards that of its peers. Therefore, we assumed a target ratio of
30% throughout the 10 year period. We believe RAX has the capacity to withstand this level of debt
considering its strong financial position as well as it’s Altman Z-Score of 6.8 for 3Q15 (APPENDIX 21).
To assess earnings quality, we conducted an 8 variable Beneish
M-score analysis for the last five year-end financial statements reported by RAX. Based on the output,
we gauge the likelihood of RAX manipulating earnings as low. Through our analysis, we observed an
average of -3.74 M-score with a 5-year low of -3.50, well below the recommended threshold of -2.22
– being the lower the better (APPENDIX 22). During the same period, RAX’s accounting policies
haven’t been modified. Furthermore, annual audits have been conducted by KPMG, whose opinion for
the last three years states that consolidated financials fairly present the financial position of RAX.
With its proven expertise and award winning customer service, RAX has enjoyed
consistently low churn rates and healthy stream of recurring revenue (Table 4). Additionally, RAX has
been able to grow within its existing client base as indicated by net upgrades data. We expect Fanatical
Support© to keep acting as a customer magnet and clients to increase the level of assistance they
require from RAX .
RAX’s growth has also resonated in per server figures. At the close of 2014,
RAX’s number of servers deployed had increased 41% from 2011 with over 112K servers. Similarly, RAX’s
average monthly revenue per server grew from $1,070 to nearly $1,330 during the same timeframe, a
24% increase. We believe this trend to continue onto 2025 when we expect RAX to surpass 280K servers
deployed, with each one generating almost $1,670 on a monthly basis.
We applied the DCF Model to arrive at a price estimate per share for RAX’s common equity. Based on
this methodology, we estimated RAX’s Equity Value at $3.7B (Table 5).
We determined RAX’s WACC to be 9.36% based on a target
Debt/Capital of 30% (Table 6 ). Using the CAPM we estimated RAX’s Cost of Equity to be 11.08%. For the
Risk Free Rate we used the 10-year US Government Bond yield of 2.02% at the valuation date.
Furthermore, we calculated an Adjusted Beta of 1.48 by regressing historical RAX’s monthly returns
against the S&P 500’s from January 2011 to December 2015, a total of 60 observations. Lastly, we based
the Equity Risk Premium of 6.12% on Damodaran’s most recent Implied Risk Premium computations at
the time of our valuation. We considered the yield of RAX’s senior notes at Valuation Date, 8.04%, as its
pre-tax Cost of Debt (Table 6).
We acknowledged RAX’s two business segments have different growth
drivers and therefore we forecasted Net Revenue, CapEx, Costs and Operating Expenses separately
through 2025 using a two-stage growth model. The first phase, RAX’s growth stage, was based on a
detailed year to year forecast up to 2020. This was followed by a phase of slight deceleration reaching
the maturity stage by the end of 2025. Based on these assumptions, we calculated RAX’s Unlevered
Free Cash Flows for each year. Additionally, we estimated the PV of these cash flows to be $1,789M
using as discount rate RAX’s WACC of 9.36%, considering a target Debt/Capital of 30% (Table 6) .
The terminal growth for both of RAX’s business segments will be mainly driven by the
US IT spending growth, which in turn depends greatly on the performance of the US economy.
According to the IMF, Real GDP in the US is expected to grow at an annual rate21 of 2.7% through 2018
and to maintain an above 2% annual increase thereon. However, to determine RAX’s Terminal Growth
Rate, we considered the yield of 10-year US Government Bond to be a more conservative proxy given it
accounts for both the expected inflation and the expected real interest rate. At the Valuation Date, the
yield of the 10-year US Government Bond was 2.09%. Taking this rate into account, we estimated RAX’s
Terminal Value at $5.7B for a PV of $2.5B using as discount rate the aforementioned WACC. Refer to
APPENDIX 23 for further details on our assumptions.
For our Peer Multiple Pricing Model we identified a set of 21 listed peers for RAX based on the following
criteria: (i) infrastructure outsourcing (e.g. cloud infrastructure, colocation services and datacenter
hosting) as one of the main revenue STREAMS, and (ii) US and UK as their main geographic sources of
revenue (APPENDIX 24). Based on standard multiples for this industry, RAX is trading at a discount when
compared to most of its peers (Table 7), as evidenced by: EV/Sales of 1.4x for RAX versus the peer
median of 3.8x, a 63.16% discount. Additionally, Forward P/E shows a discount of 43.98% for RAX at 19.4x
against median of 34.6x for selected peers. Historically, this has not been the case as RAX was trading at
a premium against the same peer set just 2 years ago. For the Peer Pricing Model we chose the Forward
EV/EBITDA due primarily to the following considerations:
• Standard deviation of EBITDA margins for the peer set is just 481.10 with a median of 176.10 which
gives us a coefficient of variation (CV) of 36%; meaning a low variance in the distribution.
• EBITDA is an overall better representation of cash flows independent of capital programs.
• RAX issued senior notes during 4Q15; thus we believe debt is priced efficiently. RAX has not issued
preferred shares.
• EBITDA is less likely than earnings to be subject to manipulations by accounting practices.
Our peer comparison model was constructed using a cross-sectional regression analysis[i] (APPENDIX
24) to adjust for differences in risk and growth the market expects for each peer. We used Damodaran’s
approach in order to account for these fundamentals, and found an important correlation (0.645 R-
Squared) between Forward EV/EBITDA, Estimated Annual Revenue Growth for the next 2 Years,
Effective Tax Rate and Total Debt/Capital. Our estimated value for RAX’s Forward EV/EBITDA is 7.09x,
which gives us a price of $26.81
“SOURCE:COMPANYDATA
“SOURCE:TEAM COMPUTATIONS
“SOURCE:TEAM COMPUTATIONS
“SOURCE:TEAM COMPUTATIONS
As previously stated, our target price was derived from two valuation approaches to which we
assigned different weights. A DCF model, accounting for 70% of the weight, delivered a price per
RAX's share of $27.60. On the other hand, a Peer Pricing Multiple Model resulted on a share price of
$26.81. Therefore our one year target price for RAX is$27.36, for a 45.2% upside from its closing price
at the Valuation Date.
Fluctuations in the key assumption variables could affect our one year target price and may lead us
to downgrade our BUY recommendation. Some of these key variables relate directly to RAX’s growth
prospects in each of its two business segments, while others are closely linked to our WACC and
Terminal Value computations. Therefore, we followed two different and independent approaches to
measure the potential impact of these variables and the probability of a change in our
recommendation. First, we conducted a Monte Carlo Simulation to test RAX’s growth variables. Lastly,
we assessed the sensitivity of our estimation of RAX’s equity value to individual changes in our
methodological assumptions, holding all other variables unchanged.
We performed a Monte Carlo Simulation to measure the impact of the following
variables in our growth estimates for RAX: (i) OpenStack© Enterprise Adoption Rate, (ii) Third-Party
Clouds Growth Rate, (iii) Fanatical Support’s Share of the Managed Cloud Space, (iv) Growth CapEx on
Customer Gear, as well as (v) cost and expenses items. We believe RAX’s future earnings and
Unlevered Cash Flows depend heavily on these key variables. After running 1million simulations, we
observed a probability of 54.03% of obtaining a target price per share consistent with our BUY
threshold of 30% upside. Moreover, considering the 70% weight assigned to the DCF Analysis, we
observe a probability of 35.8% of obtaining a target price per share that downgrades our
recommendation for RAX. In addition, from the Monte Carlo, we concluded that the most impactful
variable in our model is Fanatical Support’s Share of the Managed Cloud Space, contributing to 30.7%
of the variability in our price target. Therefore, RAX’s equity value could be diminished if not able to
capitalize of its current and future partnerships with third party cloud providers. For further details on
our Monte Carlo Simulation please refer to APPENDIX 25..
Independently from the Monte Carlo, and holding all growth variables unchanged,
we performed a Sensitivity Analysis on the key inputs underlining the Discount Rate and Terminal
Value computations. Specifically, we tested RAX’s Terminal Growth Rate and WACC (APPENDIX 25).
In order to downgrade our recommendation to a HOLD, the Terminal Growth
Rate would need to decrease from 2.02% to 0.16% (a 92% decrease). Furthermore, even with a rate of
0.0% our recommendation would not turn into a SELL (Table 8).
In order to downgrade our recommendation to a HOLD, the WACC would need to increase
from 9.36% to 10.35%. Furthermore, it would have to exceed 13.43% (a 43.5% increase) for us to issue a
SELL recommendation (Table 9).
driving more business to
RAX Managed Security Services. IT budget growth has remained flat year on year with 6% of their
total budget directed to security projects. As security threats increasingly become a concern for
enterprises, IT professionals are inclined to reevaluate their security budgets in order to address them
accordingly. In fact, a significant amount of IT managers feel their organization is not investing in
security and a big part of these IT managers believe their data is not adequately protected.
Furthermore, due to recent serious security threats IT managers have implemented changes in their
security practices23. This growing awareness in the importance of addressing these security threats
may lead IT professionals to RAX for help.
RAX has signed business
agreements with both AMZN and MSFT to offer their managed services atop their IaaS offerings.
Similar partnerships with other unmanaged cloud providers could act as a key catalyzer for RAX’s
growth.
Container Technology being developed by Dockers, an open-source project that
automates app deployment within software containers, could allow cloud providers more flexibility
with client’s environment transitions, which in turn would stimulate client base growth. According to
Thinkstock “containers are a solution to the problem of how to get software to run reliably when
moved from one computing environment to another. This could be from a developer's laptop to a test
environment, from a staging environment into production and perhaps from a physical machine in a
data center to a virtual machine in a private or public cloud”. In 3Q15 RAX announced Carina®, a
service based on Dockers’ containers to capitalize on a growing segment within the cloud computing
market.
“SOURCE:TEAM COMPUTATIONS
“SOURCE:TEAM COMPUTATIONS
Information security is a major concern for customers
switching to the cloud with 38% of IT managers surveyed in North Bridge’s 2015 “Future of Cloud”
study, putting it as the top challenge to their migration. Of those currently using the cloud, 85% are
confident in their cloud vendor’s ability to provide a secure environment as opposed to 90% of IT
managers who lack confidence in their companies’ ability to detect problems internally, which
signals strong confidence in cloud security. Regardless, RAX could be exposed to breaches and
interruptions that could lead to reputational effects, revenue loss and lawsuits. In order to mitigate
this risk, the company has put together a team of security professionals and infrastructure to secure
their datacenters from internal and external threats, becoming compliant with top industry
standards such as ISO/IEC 27001:2005 Information Security Management System (ISMS) Standard,
ISAE 3402 / SSAE 16 Type II SOC 1 and Payment Card Industry Data Security Standard..
Alterations to electronic data protection laws could
allow governments, in countries where cloud computing companies host their data centers, access
to information stored by business customers even if they are not based on that country. Likewise,
laws and regulations could be passed by client-side governments to limit the ability of companies to
either send data overseas or outsource processes like information security to other countries in
order to ensure data privacy according to national laws. This could slowdown cloud adoption as
companies would try to prevent their data from being accessed and exposed by foreign
governments.
Service outages or any interruptions that cause
downtime will affect RAX’s customers directly. Frequent interruptions may cause clients to have
reservations about RAX’s reliability and switch to other managed service providers. Additionally, as
part of RAX’s Service Level Agreement (SLA), uptime for their services must be at least 99.99% or
they may incur in penalties of up to 10% of revenues for each hour of downtime which would
represent approximately $228,325 of revenue lost per hour down based on 2016 data. RAX mitigates
this risk by designing datacenters with redundancies and constantly backing up data with replication
among their 13 datacenters, which translated to a total stoppage of just 7.52 hours during 2014
(Figure 23). For 2016, in case total downtime exceeds 262 hours, loss of revenues and penalty fees
would change our recommendation to a HOLD..
Unmanaged cloud providers could integrate
forward and enter the space to compete directly with RAX, leveraging an already extensive global
network of professionals and clients. We believe this is unlikely to take place any time soon as
AMZN, GOOG and MSFT have focused their strategy on their core business, outsourcing managed
cloud services to hundreds of different providers to deliver this added value to their clients. Other
sources of competition include startups that offer managed services through partnerships with big
IaaS providers, which may allow them to gain important market share in the managed cloud
segment becoming direct competitors for RAX. Our recommendation would change to a HOLD if
RAX’s share of managed cloud services atop unmanaged cloud providers does not reach at least
6.25%.
The further development of SaaS as the predominant
business model for cloud services could reduce workload processing needs for RAX's customers
due to centralization of infrastructure in the SaaS provider. With most new software being built for
cloud from the outset, it is predicted that by 2016 over a quarter of all applications (approximately
48M) will be running atop the cloud. Worldwide SaaS market is expected to grow at an astounding
20.2% CAGR from $18.2B in 2012 to $45.6B in 201725.
Increase in the availability of cheap skilled
labor could render RAX’s managed cloud services less attractive by lowering in-house cloud
management costs for businesses. A potential catalyst of higher skilled labor availability might be
changes in migration laws that could potentially generate an accelerated influx of IT professionals,
especially from India, lowering IT personnel hiring costs to the point where RAX’s service offerings
no longer makes sense financially. Currently, Visas like the H-1B allow companies to employ foreign
workforce for lower salaries which received support from some congressmen that intend to enact a
bill to triple the amount of such visas being issued. In the industry, the costs savings of hiring an H-
1B over an American are approximately 43%.
.
“SOURCE:TEAM ANALYSIS
Accelerated disruptive innovations could lead to “autonomic
computing” of most of the tasks offered by managed cloud providers, rendering RAX’s services
unnecessary for most companies. Startups like CloudHealth Technologies have been working on
platforms to perform IT cloud service management through automated governance rules or
artificial intelligence instead of manual processes. This technology is still in early stages of
development and might take years for full commercial use. Additionally, disruptive technologies,
especially enterprise oriented innovations, tend to hit mainstream status after 3-5 years in the
market, so we wouldn’t expect any new technology to affect RAX business at least until 2021,
when cloud autonomics’ impact could change our recommendation to a HOLD if Fanatical Support
for Third Party Clouds projected revenues were cut by 80%.
Over 30% of RAX’s revenue is generated in foreign
currency, especially GBP. Strengthening of the US Dollar against other currencies could lead to a
reduction in revenues from foreign subsidiaries.
Serious economic slowdown, especially in the US and UK
where most of RAX’s revenues are generated, could impact its sales growth as IT has historically
been an early budget-cut casualty in most recessions when companies are expecting lower or
inexistent progress. Economists at reputable investment firms put the chances of a recession
within the next 5 years above 50% (Table 11). Even though it is rare for economists to accurately
forecast a recession, in the US they occur every 5 years on average. Additionally the Chauvet
Model (“An Econometric Characterization of Business Cycles with Factor Structure and Markov
switching") to calculate the probability of a recession sits close to 25%, up from 5% last year. We
don’t expect RAX to be significantly affected by slight contraction in GDP since back in 2008 and
2009 they managed to grow revenues by 46% and 18% respectively despite the deepest recession
in more than 70 years. However if revenue growth were to fall below xx% due to systemic
slowdown, our recommendation would change from a BUY to a HOLD.
As part of our growth projections, we expect RAX to take on
more debt in the medium term to finance growth. The Federal Reserve increased the interest rate
a quarter of a percentage point on December 2015 and Janet Yellen suggested more increases in
the future. These raises will likely increase interest expenses for the company in future debt
transactions, impacting the bottom line. Should conditions result in RAX having a cost of debt
above the 13.03% mark, it would change our recommendation from a BUY to a HOLD.
“SOURCE:FIRMS’WEBSITES
Flow
As part of management decision making process before undertaking projects, an Economic Value Added (EVA) analysis must be
conducted. This, in order to assess if economic profit added through the years has been in line with shareholders’ required returns.
RAX’s CFO Karl Pichler is an alumni of Stern Stewart, who developed the methodology.
780.6 1,025.1 1,309.2 1,534.8 1,794.4 2,000.1
79.6 123.5 172.7 133.1 167.5 189.6
(27.9) (42.4) (64.3) (44.8) (51.5) (63.5)
51.7 81.0 108.4 88.3 116.1 126.1
497.4 609.4 698.5 872.0 1,031.1 1,203.1
9.4% 9.4% 9.4% 9.4% 9.4% 9.4%
5.1 24.0 43.0 6.7 19.6 13.5
$400,000 $790,361 $1,749,878 $2,940,239
$3,071,372 $2,636,855 $12,721,045 $18,429,272
$3,471,372 $3,427,216 $14,470,923 $21,369,511
$400,000 $367,515 $0.00 $767,515
$2,180,038 $1,567,167 $6,314,752 $10,061,957
$2,580,038 $1,934,682 $6,314,752 $10,829,472
$566,519 $536,418 $11,399,910 $12,502,847
$1,645,281 $2,060,984 $7,825,850 $11,532,115
$2,211,800 $2,597,402 $19,225,760 $24,034,962
In order to assess RAX’s Corporate Governance, its strength and weaknesses, we resorted to the Institutional Shareholder Services
(ISS) Rating Methodology. This scoring tool was applied in order to identify and assess risks within RAX’s Corporate Governance
structure.
10 Insignificant threat to Shareholders
8 Low threat to Shareholders
6 Moderate threat to Shareholders
4 Significant threat to Shareholders
2 High Threat to Shareholders
8/10 20% 0.16
8/10 35% 0.28
6/10 20% 0.12
7/10 25% 0.18
7.35/10 100% 73.50
Company maintains independence guidelines set forth by SEC and NYSE. An
example of this is Mr. Weston, former Chief Executive Officer, who was an
employee of the Company prior to 2015 and is therefore not “independent,” so the
Board of Directors has appointed Michael Sam Gilliland as its lead independent
director, or “Lead Director”, to preside at all executive sessions of “non-employee”
directors, as defined under the rules of theNYSE.
In the last year board and CEO compensation growth has far outpaced stock
price growth. The board maintains this compensation package was designed to
retain executivetalent.
Graham Weston, member of the Real Estate & Finance committee. RAX has leased
office space to Santa Clara Land Company, Ltd, of which Graham Weston is a
minority partner. Mr. Weston’s interest in this transaction would be approximately
$84,732.53. Audit Committe believes the terms of this transaction are no less
favorable to the company than could have been obtained from unaffiliated third
parties.
Company maintains independence guidelines set forth by SEC and NYSE. An
example of this is Mr. Weston, former Chief Executive Officer, who was an
employee of the Company prior to 2015 and is therefore not “independent,” so the
Board of Directors has appointed Michael Sam Gilliland as its lead independent
director, or “Lead Director”, to preside at all executive sessions of “non-employee”
directors, as defined under the rules of theNYSE.
In the last year board and CEO compensation growth has far outpaced stock
price growth. The board maintains this compensation package was designed to
retain executivetalent.
Graham Weston, member of the Real Estate & Finance committee. RAX has leased
office space to Santa Clara Land Company, Ltd, of which Graham Weston is a
minority partner. Mr. Weston’s interest in this transaction would be approximately
$84,732.53. Audit Committe believes the terms of this transaction are no less
favorable to the company than could have been obtained from unaffiliated third
parties.
We deem this favorable. CEO does not serve on other boards. 3 members sit on
0 boards. 3 members sit on 1 board. 1 sits on 2 boards. 1 sits on 3 boards. The
only director who sits on excessive boards is 1 who sits on 8 boards
Non Audit fees represent 0% of total fees. No member of Audit Committe may sit
on more than 3 other boards. Two financial experts sit on this committee, one CPA
and one MBA.
Classified board. Board has power to emit blank check preferred stock. No poison
pill.
Founder is chairman of the board. CEO and Executive compensation plan is
performance based. Company requires 3x salary worth of stock ownership.
Company ranks third highest among its peers in insider ownership with a 14.79%
insider ownership.
RAX uses Say-on-Pay and lets shareholders vote on compensation packages.
There is no unequal voting structure, all classes of stock can vote for all directors.
The board is scheduled to hold its regular meetings at least once a quarter, at least
one additional time per year to review and approve yearly goals and operating
plans. In practice the board of directors held 19 meetings during the year ended
December 31, 2014. Each director attended at least 75% of the aggregate of the
meetings of the Board of Directors and of the committees on which he or she
served during the period for which he or she was a director or committee member,
respectively.
They can serve three years, but can stand for reelection. Although the company
lacks formal term limits, approximately nine to twelve years of service is an
expected commitment for any individual director. For example, Mr. Mellin and Mr.
Bishkin, consistent with the Company’s guiding principles for Board development
and succession, have declined to stand for re-election in 2015 and will not be
directors following the annual meeting.
RAX strives to support Self-funded
startups and entrepreneurs affiliated with
Accelerators, Incubators, Universities and
Venture Capital Firms. Through this
program, qualified startups can benefit
from up to $2,000 per month in free
hosting for a year as well as RAX’s
Fanatical Support® and expertise to
accompany them in building applications
and scaling on the cloud.
CloudU™ is a cloud curriculum for IT
professionals looking to reinforce their
knowledge of Cloud Computing. The
program, designed through a
collaboration between RAX and
industry analysts, offers access to a
comprehensive database of
educational resources aimed at
increasing cloud computing knowledge
among businesses. Given its vendor-
neutral nature, CloudU™ is open for
anyone who is interested on cloud
adoption, regardless of vendor or
platform.
RAX’s global initiative focuses on three pillars:
People, Planet and Pocket.
• People: The core of RAX’s social responsibility
programs resides on its service culture and
thus on the Rackers who volunteer to be part
of the environmental solution and give
Fanatical Support to the communities in which
the company operates.
• Planet: As part of its decision-making, RAX
integrates both energy conservation &
efficiency into for building, buying and
operating.
• - Pocket: Finding the best sustainable choices
which are also financially efficient and
effective by empowering customers, through
corporate responsibility and maximizing
stockholder and customer long-term value.
Being an employee-led volunteer force,
the program supports the community by
focusing on three main areas: offering
grants aimed at arts and culture in order
to establish a creative class of citizens;
education, specifically related to STEM;
and technology. Rack Gives Back
includes employee volunteerism,
corporate funding and grants and The
Rackspace Foundation.
Founded in 2009, The Rackspace
Foundation functions as a public charity
that focuses on elevating the community
on RAX’s headquarters’ surrounding
neighborhood. Primarily funded through
payroll contributions, The Foundation
invests on non-profits that work in school
and afterschool based programs.
As cloud computing becomes increasingly mainstream, the challenges faced by enterprises for adopting these technologies
account for the rapid growth of the managed cloud market. Since this segment is expected to have strong long-term revenues, it is
highly attractive for new competitors with regulation in the sector still in its early stages, presenting low or no entry barriers for new
players. Given the company’s nature of being capital intensive, high sunk costs are incurred when setting up the infrastructure. New
entrants could work around that and partner with unmanaged cloud giants to offer their services on top of their infrastructure and
thus benefit from their economies of scale, stablished customer base and growth in the industry. However, these companies are
wary of their reputation and partnerships require a solid track record. Furthermore, economies of expertise are a solid barrier to
entry, given the low availability of skilled labor. These conditions somewhat limit the entrance of new players, hence we assess this
as a MODERATE threat for the business.
Electricity providers are one of the most important suppliers of the business in terms of cost of revenue, but as a heavily regulated
industry with commoditized prices, there is low threat of electricity suppliers exercising bargaining. Other important suppliers
include hardware and connectivity, both of which are commoditized and not concentrated, none of these are monopolistic
industries and switching costs are relatively low. Moreover, RAX’s service centric business model puts a lot of weight on talent as a
“supplier”. Even though there is a shortage of qualified personnel, none of RAX’s 6,000+ employees are represented by a collective
bargaining agreement. We assess the bargaining power of suppliers as posing a LOW threat to the business given the stated
analysis.
There is a HIGH threat of substitute products as customers of managed cloud services might see more added value in other options
such as handling computing in-house in their own datacenters which provides flexibility and oftentimes lower lead times;
Outsourcing their IT infrastructure to a service provider, ensuring standardization and usually qualified professionals; Opt for the
unmanaged cloud services which provides the cheapest option and higher level of flexibility. The impact of this threat depends on
the cost of specialized IT staff and infrastructure engineer and the level of flexibility required by companies as technology becomes
a more integral part of business, often requiring lower lead times. The different options available to businesses to fulfill their IT
needs leads us to assess the threat of substitute products as HIGH.
As stated, RAX’s customer base is solid (average monthly churn of 0.6% for 2014) and well diversified (300,000+ customers) with no
single client representing more than 2% of revenues. Even though there are many providers in the segment, customers face high
switching costs when trying to change from one vendor to another due to proprietary technologies, the industry’s lack of common
protocols and standards, and the service provider’s experience and understanding of the customer’s technology backbone. Given
RAX’s diversified customer base and the limitations for switching cloud service providers, we assess the bargaining power of
customers as MODERATE.
We assess the competitive rivalry within the managed cloud segment as being MODERATE due to its high fragmentation, having a
broad set of players with multiple delivery models. Competition is increasingly becoming more intense as the segment continues to
grow and develop. Given that revenues for the segment are driven by the added value offered by vendors, said competition
focuses on service differentiation as opposed to price cuts. Incentives to fight are present despite the stellar industry growth thanks
primarily to the vast economies of scale that characterizes the cloud..
Gartner’s Magic Quadrant positions technology players within a specific market. The assessment presents a broad view of the
relative positions of the market's competitors, how well technology vendors are executing their stated visions and how they are
performing against Gartner's market view. This assessment results in the positioning of the market players within four quadrants:
Leaders - Have proved a powerful market position and technical competence, constantly innovate on current product offering, and
have a reliable service for corporate-class needs being able to cater to a wide variety of customers by addressing a wide set of use
cases with stand-alone or integrated solutions.
Challengers - Have are known for delivering good service capabilities, nonetheless are trailing the market's evolution. Challengers
are usually companies with sound legacy managed hosting services but have not exploited technology and market demand to
develop cloud-enabled hosting services.
Visionaries – Disruptive approach to the market mostly comprised of new, and limited, service portfolios. Visionaries have an early-
mover advantage as well as roadmaps that may take them to a Leader position in the future.
Niche Players – Either emerging vendors or specialists with a focused product portfolio serving a specific use case with a higher
level than generalized vendors.
In accordance to RAX’s business model, Gartner positions the company within its Magic Quadrant for Cloud-Enabled Managed Hosting
along with other leading players both in North America and Europe. Nonetheless, even though RAX’s value proposition focuses in
delivering over the top customer experience through its broad portfolio offering of managed cloud solutions, its Managed Hosting is
still compared against unmanaged cloud giants such as AWS and Azure.
According to Gartner’s Magic Quadrant for Cloud Infrastructure as a Service, the following vendors compete within this market:
Amazon AWS - ranked as the highest IaaS provider in both ability to execute and holistic vision, AWS has 10 times the compute
capacity utilization level of all other 14 providers in the IaaS Magic Quadrant combined. AWS is regarded as innovative and agile,
serving the broadest range of use cases. The technology is reinforced by a wide network of partners that provide various IT
professional services.
Microsoft Azure – Currently Microsoft compute capacity utilization is twice as much than the 13 other providers in the IaaS Magic
Quadrant. With Azure, Microsoft is developing an aggressive roadmap of new features and differentiated capabilities. Nonetheless, it’s
still missing key security, flexibility and availability features.
IBM SoftLayer – has a broad portfolio comprised of public, private and managed cloud products. Its strength resides on its product and
service interoperability, as well as its consulting and outsourcing capabilities.
Google Cloud Engine – Initiated only in 2012, has achieved an extensive experience with cloud-native application development and
management. Cloud Engine is considered to offer an excellent value and prompt provisioning, being differentiated by platform and
manageability features as opposed to price. However, Google is on the early stages of developing engagement with enterprise and
midmarket customers, and still has a nascent partner program.
VMware vCloud Air – focused on driving adoption by leveraging its already built influence in on-premise data centers and thus offering
a coherent experience across VMware-based infrastructure.
True to RAX’s focus on a customer centric service offering, it delivers a holistic portfolio of IT solutions based on added value for its
business clients. As opposed to the unmanaged cloud providers, a more diverse and integrated service offering through diverse cloud
form factors based on open source standards.
According to Gartner’s Magic Quadrant for Cloud-Enabled Managed Hosting, the following vendors compete within the same “Leaders”
quadrant as RAX:
Datapipe: midsize hosting and cloud IaaS provider operating data centers in 7 locations in North America, and also has facilities in
Europe and Asia-Pac. Datapipe has truly integrated its hosting and cloud IaaS capabilities with AWS and Azure.
BT Global Services: Europe based provider of managed network, communications and IT services, focused on vertical industry
solutions. Through its Cloud Management System offers business and bundling capabilities.
Interoute – offers a comprehensive portfolio of networking colocation, hosting and cloud services, showing an structured offering from
completely self-service to fully managed products. With data centers stablished across major European countries, Interoute is
currently expanding to North America.
Claranet – As managed hosting provider with a Pan-European presence, Claranet offers colocation, hosting, network and application
services, including hybrid solutions through its partnership with AWS. The provider offers regionalized business services, thus offering
solutions for data sovereignty and technical support. Claranet provides a different service approach for each country, resulting into an
inhomogeneous solution portfolio.
Colt - international network and provider of colocation and hosting services in Europe, U.S. and Asia. Due to its strong Pan-European
presence, Colt is ahead of customers’ data sovereignty needs. The company heavily focuses on partnerships with large vendors
making it subject to their roadmaps.
IaaS Market Key Players Comparison
Dedicated
Hosting
a a
Public Cloud a a a a a a
Private Cloud a a a a
Hybrid Cloud a a a
Customer
Support
a a
Platform
OpenStack Proprietary Proprietary Proprietary Proprietary Proprietary
SLA Level 100% 99.99% 99.95% 100% 99.95% 99.95%
SLA Credit
Unmanaged: 5% /
hour
Managed: 10% / hour
10% of annual
bill
<99.9% - 10%
<99% - 25% 10% - 50%
AMZN has established a global partner tiered program, AWS Partner Network (APN), comprised of Consulting and Technology
Partners, who advance through various stages based on engagement with AWS. Through its Premier Consulting Partner tier,
AWS highlights the top global APN Consulting partners with extensive experience in deploying customer solutions on AWS,
have a strong bench of trained and certified technical consultants, have at least one APN Competency, have expertise in project
management, and have a healthy revenue-generating consulting business on AWS. Click here to learn more about becoming a
Premier Partner.
Considering the significant dependency of our DCF model in RAX’s ability to capture future market share from the manages
services provided atop AWS, we regard as necessary conducting a thorough assessment of RAX’s direct competitors as a new
AWS Premier Consulting Partner.
2nd Watch: AWS Premier Partner providing managed cloud to enterprises and helps automate the development, deployment,
governance, procurement, financial management, migration and operations of over 400 enterprise workloads and
approximately 75,000 instances in its managed cloud.
Apps Associates LLC: is a global provider of business and IT consulting services. They help clients adapt and grow in a changing
world of technology by focusing on innovation, process, workforce development and re-usable solutions.
Aquilent – is a recognized leading provider solutions for federal customers with an emphasis on cloud computing, mobile and
digital strategy, web content management, user experience and portal & application development.
ClearScale – has the proven capability to build, deploy, automate and manage cloud architectures on AWS. Their core
competency is delivering custom cloud projects and services for clients who have limited cloud expertise on staff or who need
additional resources to execute better and faster. Based in San Francisco Area.
Cloudnexa – deploys and manages cloud infrastructure for AWS clients. Their cloud management as-a-service from with no
upfront fees or long-term contracts, architecture and migration services included.
Cloud Technology Partners – is an innovative cloud consulting and professional services firm serving mid-market, enterprise
customers and software providers. Its consulting expertise includes migrating applications and data to the platform, developing
cloud-native applications on AWS, and architecting, building and managing AWS deployments.
Corpinfo – A leading technology firm providing Cloud Consulting Services, Infrastructure Solutions, and Managed Services. They
use their experience to ensure that clients have the best technical solutions to solve their business challenges and deliver value
for their organization.
CSC - CSC leads clients on their digital transformation journey, providing innovative next-generation technology solutions and
services that leverage deep industry expertise, global scale, technology independence and an extensive partner community.
Logicworks – is an enterprise cloud automation and managed service provider that combines advanced automation and
DevOps capabilities with 22+ years of legacy IT experience.
Mobiquity - is a mobile computing professional services firm helping clients design, develop and deploy custom mobile
solutions.
Pariveda Solutions Inc: is a leading management consulting firm specializing in improving their clients’ performance. Provide
strategic consulting services and custom application development solutions for mobility, cloud computing, data, portals and
collaboration, CRM, custom software, enterprise integration and user experience needs of their clients.
REAN Cloud – A cloud-native firm with experience supporting enterprise IT infrastructures and applications. Their key
differentiator is their experience in implementing complex and scalable architectures, which support secure, compliant
operations in highly regulated industries such as the Financial Services, Healthcare/Life Sciences, Education, and Public Sector
verticals.
Smartronix - is a global professional solutions provider specializing in cloud computing, application integration and
development, software and hardware engineering, networking and system management, and cyber security.
TriNimbus: Leading DevOps service provider with DevOps and Big Data Competencies. The team focuses exclusively on AWS
and its surrounding ecosystem to support customers who are using the cloud to elevate their culture, environment and
operations to the next level.
Wipro – leading Information Technology, Consulting and Outsourcing company, that delivers business outcomes through its
industry experience and a 360 degree view of 'Business through Technology' – helping clients create successful and adaptive
businesses.
In order to evaluate internal and external factors that influence RAX’s current strategic situation, a SWOT Analysis was prepared
that describes positive attributes, tangible and intangible, that allow RAX to differentiate from competitors; characteristics of RAX
that detract from the value offered or places the firm at a competitive disadvantage; reasons RAX is likely to thrive and issues
beyond the company’s control that could put the business at risk.
We assessed the importance of each factor to RAX as graphed in the Y axis for strengths and weaknesses. In regards to the
opportunities and threats our Y axis shows the probability of becoming materialized.
Through the SWOT Analysis graphs we concluded that RAX's most relevant weakness is how it is pricier than other managed
cloud solutions. Nonetheless, this is directly related to RAX’s highly specialized workforce, a key strength, a main differentiation
that can allow them to capitalize on the opportunity of operating within a rapidly growing industry. We have identified as a the
likeliest threat the development of new technologies that reduce engineering complexity such as Open Compute Project, Open
Network Linux, Dockers and containerization.
In order to assess and understand RAX’s financial results and thus verify its earnings quality, we used the Beneish M-Score Analysis
(1999) for earnings manipulation detection. The M-Score is comprised of eight different variables that identify either financial
statement distortions or indicate a firm’s likelihood of earnings manipulation: DSRI = Days’ Sales in Receivables Index
• GMI = Gross Margin Index
• AQI = Asset Quality Index
• SGI = Sales Growth Index
• DEPI = Depreciation Index
• SGAI = Sales, General and Administrative expenses Index
• LVGI = Leverage Index
• TATA = Total Accruals to Total Assets
The M-Score can be calculated considering 8 or 5 indices as follows:
• 5-variable Model: M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717 SGI + .107 DEPI
• 8-variable Model: M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI -.172 SGAI + 4.679 Accrual to TA - .327
Leverage
M-Score lower than -2.22 – The firm is not likely to be a manipulator.
M-Score greater than -2.22 – The firm is likely to be a manipulator.
Based on the M-Score Analysis conducted, RAX is not likely to be manipulating its earnings results.
Below we present the rationale behind our main assumptions. Our revenue assumptions are detailed as part of the written
report.
Beta – In order to assess RAX’s level of systemic risk, we calculated a Beta by regressing its historical monthly returns from
January 2011 to December 2015 against each of the following indices: S&P 500, NASDAQ and Russell 1000.
Our calculations revealed that the NASDAQ has a stronger correlation with RAX based on the resulting R-Squared of 0.25,
meaning that 25% of variation in returns can be explained by that of said index. Moreover, said regression resulted on a P-
Value of 0.01%, the smaller the value the stronger the evidence that observations are significant in predicting RAX’s returns.
On the other hand, the S&P500 resulted on a weaker R-Squared of 0.2% and P-Value of 0.02%. Nonetheless, in order to be
conservative, we used the S&P500 due to its higher value for Beta.
Cost of Debt - At the valuation date, the market value of RAX’s debt was $451.9M with a yield of 8.04% (average yield of
7.0%). For the computation of RAX’s Cost of Capital we assumed the current yield to be its Cost of Debt.
Debt/Capital – We expect RAX’s current Debt / Capital ratio of 22.7% to move towards that of its peers (48.6%). Therefore,
we assumed a target ratio of 30% throughout the forecasted period.
Cost of Revenue – RAX’s Cost of Revenue is mainly comprised of fixed items such as employee-related expenses and data
center operation costs. In addition, RAX incurs in variable costs including, but not limited to, power and bandwidth. For the
purposes of our 10-year projection, we analyzed the historical behavior of this cost item as a percentage of revenue over
the period 2011-3Q15. As a result, we observed RAX’s Cost of Revenue has been stable with a standard deviation of 0.8%.
Therefore, we assumed the mean of this sample to be our Cost of Revenue as a percentage of sales throughout our 10-year
forecast base case. We ran a regression for the Cost of Revenue historical values against Total Net Revenue resulting in a
0.06% P-Value. This reassures that Total Net Revenue is statistical significant for determining the Base Case Cost of
Revenue percentage.
Research & Development – RAX first disclosed its R&D related expenses in 2011. For RAX, this item includes costs for employee and
consultants focused on the deployment of new technologies and the development/enhancement of proprietary tools. For our
forecast, we analyzed the historical behavior of this cost item as a percentage of Net Revenue over the period 2011-3Q15. The mean
value for this sample was 5.2%. We do not foresee changes in RAX’s R&D activities. Thus, we assumed the mean as RAX’s R&D
expenses as percentage Net Revenue for the Managed Hosting business segment throughout our Base Case 10-year forecast. We
ran a regression for the R&D historical values against Total Net Revenue resulting in a 0.41% P-Value. This reassures that Total Net
Revenue is statistical significant for determining the Base Case R&D percentage.
Selling, General & Administrative – For our forecast, we analyzed the historical behavior of this expense item as a percentage of
Total Net Revenue over the period 2011-3Q15. However, we deemed periods 2013 and 3Q15 to be outliers and did not consider them
for the purposes of this analysis. Excluding said periods from the sample, we observed a mean value of 31.4% with a standard
deviation of 0.3%. We assumed the mean to be RAX’s Selling, General and Administrative expense as percentage of Total Net
Revenue throughout our base case 10-year forecast. We ran a regression for the SG&A historical values against Total Net Revenue
resulting in a 0.2% P-Value. This reassures that Total Net Revenue is statistical significant for determining the Base Case SG&A
percentage.
Depreciation and Amortization – For our forecast, we analyzed the historical behavior of this expense item as a percentage of Total
Net Revenue over the period 2011-3Q15. As result, we observed a mean value of 19.8% with a standard deviation of 0.7%. We
assumed this mean value to be RAX’s Depreciation and Amortization expense as percentage of Total Net Revenue throughout our
base case 10-year forecast. We ran a regression for the DNA historical values against Total Net Revenue resulting in a 0.01% P-
Value. This reassures that these inputs have a statistical significance for determining the Base Case DNA percentage for the
forecasted period. This reassures that Total Net Revenue is statistical significant for determining the Base Case DNA percentage.
Cost of Revenue – The Cost of Revenue for this business segment will be mainly comprised of employee-related expenses, as well
as reselling charges from Third-Party Cloud providers. In this regard, for the purposes of our 10-year forecast, we estimated these
reselling charges to be equal to the projected Depreciation and Amortization expense of the Managed Hosting segment, 19.8% of its
Net Revenues. This assumption is consistent with RAX’s management guidance as expressed during 3Q15’s earnings call.
Furthermore, we expect the costs related to personnel to resemble RAX’s Cost of Revenue for Managed Hosting which translate to
a 32.7% of Net Revenues. As a result, we estimate RAX’s Fanatical Support for Third-Party Clouds to deliver stable Gross Profit
margins of 47.5% through 2025.
Selling, General and Administrative – We considered RAX’s pre-IPO and IPO years to be an adequate proxy of the amount of
resources that need to be allocated in order to best-position the new service offering. Therefore, we calculated RAX’s average
Selling, General and Administrative expenses as percentage of Net Revenues for the three-year period 2006-2008 and assumed
this value, 42.9%, for our 10-year forecast.
Other considerations – This business segment is characterized for a high demand of human capital and lack of infrastructure needs.
Therefore, in our forecast we do not expect RAX to incur in Depreciation and Amortization expenses or Capital Expenditures for
Fanatical Support for Third-Party Clouds. This has been confirmed by RAX’s Leadership during its last earnings call.
Accounts Receivable, net – RAX business is mainly based on a pay-as-you-use monthly model. Therefore, we assumed 30 days of
sales outstanding to calculate its net receivables, slightly above RAX’s historical figures.
Accounts Payable – Based of RAX’s number of days payable outstanding for 2014, which we assumed to remain constant
throughout the forecasted period.
Property and Equipment, net – Calculated based RAX’s Property and Equipment balance at the close of 2014, and the
aforementioned assumptions for both CapEx and DNA.
Accrued Expenses – Based on a fixed percentage of the Cost of Revenue forecasted for the Managed Hosting segment. Therefore,
we calculated this ratio for RAX’s 2014 fiscal year and assumed this value, 11.5%, for our 10-year forecast.
Other Current Liabilities – Based on a fixed percentage of the Cost of Revenue forecasted for the Managed Hosting segment. We
calculated this ratio for RAX’s 2014 fiscal year and assumed this value, 5.6%, for our 10-year forecast.
The Altman Z-Score, developed by Edward Altman, determines a company’s financial health. For publicly traded companies, this
indicator is calculated as follows: (1.2*X1) + (1.4*X2) + (3.3*X3) + (0.6*X4) + (1.0*X5). Where:
X1 – Working Capital / Total Assets
X2 – Retained Earnings / Total Assets
X3 – Operating Income / Total Assets
X4 – Market Capitalization / Total Liabilities
X5 – Sales / Total Assets
Altman Z-Score below 1.80 – This is considered a distress zone indicating firm with a high probability of bankruptcy
Altman Z-Score above 3.00 – This is considered a safe zone, indicating firms unlikely to a high probability of bankruptcy
Based on the Altman Z-Score model, considering the financial information for the five year period 2011-2015, RAX has LOW
probabilities of filing for bankruptcy.
To identify a set of comparables for RAX, we screened all active companies registered in US exchanges under the SIC Codes below
which we identified as the ones typically used for cloud companies and managed services providers. We also utilized cloud service
providers’ rankings and awards as sources for the unfiltered list. Said screening was performed within three databases: Compustat©,
Mergent© and OneSource©.
The following set of criteria was used to weed out the companies from the original list:
 Significantly different services
 Financially distressed
 Insufficient financial Information
 Dissolved, bankrupt, privatized, merged or inactive
 Significantly different functions
 Significant government sales
 Significantly different geographical markets
 Insufficient description
 Duplicate or related entities
To deepen our analysis on comparability, we went through the details for each company individually, reading the Business Description
section from the 10-K filing as well as the breakdown of revenues when disclosed. We only selected companies for our peer set that
included outsourced infrastructure as one of their main sources of revenues and generated most of their sales in either US or UK. Our
resulting list included 21 companies and REITs listed in US exchanges which service portfolio comprised one or more of the following
services:
 Cloud Infrastructure Outsourcing
 Data Center Colocation
 System Integrators / Data Center
 Data Center Hosting
With the final list of peers, we gathered data corresponding to standard financial metrics for each of the selected companies. When
analyzing the data set, EBITDA showed the lowest dispersion thus we chose Forward EV/EBITDA as our valuation multiple.
We used Forward EV/EBITDA as our independent variable and regressed it against the strongest underlying fundamentals of EBITDA
which according to Damodaran are: (i) projected revenue growth, Estimated Annual Revenue Growth in the next 2 years, we used
market consensus to capture as much information from the markets as possible; (ii) Debt/Capital, to consider differences in capital
structure; and (iii) Effective Tax Rate. Our regression analysis was weighted based on market capitalization to account for the size of
each company.
We performed several sanity checks to our model and concluded that our regression could be used to predict the value of the
multiple. In the first place, we assessed the statistical quality of the selected observations. For this we evaluated the existence of
autocorrelation among observations by applying the Durbin-Watson method and resolved that there was a healthy independence
among the chosen observations. Moreover, we confirmed no significant multicollinearity issue with the data. On the other hand, we
assessed the significance of said observations for determining the Forward EV/EBITDA. Our model’s R-Squared stands at a healthy
0.645 which means that our measures of risk and growth explain 64.5% of changes in said ratio for companies in our sample.
Furthermore, the significance level (P-Value) of 0.000 obtained shows that the regression model is a good fit of the data assuring a 95%
confidence interval (Any value below .005 is accepted) and significance for each variable individually ranging from .003 to .045 (Any
value below .05 is accepted).
The "R-Squared" represents the coefficient of determination, which is the proportion of variance in the dependent variable (Forward
EV/EBITDA) that can be explained by the independent variables (technically, it is the proportion of variation accounted for by the
regression model above and beyond the mean model).
The F-ratio in the ANOVA table tests whether the overall regression model is a good fit for the data. The table shows that the
independent variables are statistically significant, meaning variation in the dependent variable’s results is explained by the independent
variables as opposed to random chance (the regression model explains over 95% of variation with P-Value < .05)
We tested for the statistical significance of each of the independent variables separately. With a P-Value lower than 5%, we concluded
that the coefficients are statistically significant. The T-Value and corresponding P-Value are located in the "t" and "Sig." columns in the
table below, respectively. Values in the “Sig.” column show that all independent variable coefficients are different from 0 and thus
statistically significant
Based on our model to predict Forward EV/EBITDA we arrived at a price for this methodology of $26.81 as follows:
We performed a Monte Carlo Simulation to determine the possible outcomes of our financial model and their probability of
occurrence. For this exercise we selected nine variables that we believe are of greatest impact for RAX’s Unlevered Free Cash Flow
generation during the forecasted period. Five of these variables are directly related to the Managed Hosting segment while the rest
pertain to Fanatical Support for Third-Party Clouds.
For the Managed Hosting segment the Monte Carlo accounted for the following inputs: (i) OpenStack© Enterprise Adoption Rate [V1], (ii)
Customer Gear Growth CapEx [v2], (iii) Cost of Revenue [V3], (iv) Selling, General and Administrative Expenses [V4], and (v) Depreciation
and Amortization [V5]. Similarly, for Fanatical Support for Third-Party Clouds the following variables were considered: (i) Third Party
Cloud Growth Rate [V6], (ii) RAX’s market share [V7], (iii) Cost of Revenue [V8] and (v) Selling, General and Administrative Expenses [V9].
For all of the aforementioned variables we assumed a triangular probability distribution. Therefore, we defined a most likely value to
occur, a minimum value and a maximum value. The minimum and maximum values for V1, V6 and V7 were established based on our
market analysis and insights from industry research firms. For the rest of the variables, to determine the minimum and maximum we
used the Base Case value +/- two standard deviations (95% confidence interval) except for V2 for which we assumed the Base Case
value +/- one standard deviation (67% confidence interval).
After running 1 million simulations, we observed a probability of 54.03% of obtaining a target price per share consistent with our BUY
threshold of 30% upside. Moreover, considering the 70% weight assigned to the DCF Analysis, we observe a probability of 35.8% of
obtaining a target price per share that downgrades our recommendation for RAX. The Histograms below show the distribution of the
resulting values of the simulation considering both a 100% and 70% weight for the DCF Model within the target price.
Finally, from the Monte Carlo, we concluded that the variable with the highest impact within our model is V7, contributing to 30.7% of
the variability in our price target as shown in the graph below. Therefore, RAX’s equity value could be diminished if not able to
capitalize of its current and future partnerships with third party cloud providers.
Independently from the Monte Carlo, and holding all growth variables unchanged, we performed a Sensitivity Analysis on the key
inputs underlining the discount rate and Terminal Value computations. Specifically, we tested the RAX’s Terminal Growth Rate and
WACC.
Terminal Growth Rate – For our DCF Analysis to deliver a price estimate for RAX with at least a 30% upside, the Terminal Growth Rate
must be equal to or greater than 0.69% (a decrease of 66% from the Base Case value). However, considering the 70% weight we
assigned to our intrinsic valuation model, the Terminal Growth Rate would need to decrease from 2.02% to 0.16% for us to change our
recommendation to a HOLD. Furthermore, even with a terminal 0.0% our recommendation would not turn into a SELL.
WACC - For our DCF Analysis to deliver a price estimate for RAX with at least a 30% upside, the WACC must be equal to or greater than
10.09% (an increase of 8%). However, considering the 70% weight we assigned to our intrinsic valuation model, the WACC would need
to increase from 9.36% to 10.35%% for us to change our recommendation to a HOLD. Furthermore, a WACC greater than 13.43% (an
increase of 43.5%) would be necessary to turn our recommendation to a SELL.
During the first half of 2014, after RAX’s former CEO Lanham Napier retired, the company was rumored to be an acquisition target
for large Telcos and tech companies including IBM and HPE. Based on this event, and considering that the cloud computing
industry is characterized by a high M&A activity, we decided to conduct a brief research of the industry’s M&A track record.
Sept. 15, 2015 – Accenture (NYSE: ACN) entered into an agreement to acquire Cloud Sherpas, a leader in cloud
advisory and technology services specializing in Google, Salesforce and ServiceNow. The move will further strengthen Accenture’s
position as a cloud services provider and enhance its ability to provide clients with cloud strategy, technology consulting, and
cloud application implementation, integration and management services.
May 26, 2015 - Storage giant EMC Corporation announced the acquisition of cloud computing management software
and IaaS provider Virtustream for $1.2B. The acquisition could help the company expand its presence in the growing cloud
computing domain and improve its range of offerings.
Sept. 11, 2014 - HPE announced a definitive agreement to acquire Eucalyptus, a provider of open source software
for building private and hybrid enterprise clouds. Since introducing HPE Helion in May 2014, HP shares in private cloud grew and
was ranked as the leader in the Forrester Wave report for Private Cloud Solutions. HPE expects the acquisition to close in the
fourth quarter of its fiscal year 2014. Terms of the deal were not disclosed.
Oct. 16, 2014 - Ericsson (NASDAQ:ERIC) announced its acquisition of Redwood City, CA-based Sentilla Corp., a provider of IT
infrastructure intelligence software. The deal was aimed at enhancing Ericsson’s ability to help service providers support IT
organizations that are struggling to overcome new network complexities introduced by mobility and the cloud.
Aug. 19, 2014 - Datapipe, a global provider of cloud and managed services and a Leader in Gartner’s
Magic Quadrant for Cloud Enabled Hosting, announced its acquisition of managed hosting and cloud company
Layered Tech. The acquisition was aimed at fueling Datapipe’s continued growth and leadership in delivering
managed cloud services, as well as its expansion into the Government sector with FISMA and FedRAMP compliant
Federal cloud offerings.
Jan. 27, 2011 - Verizon Communications Inc. (NYSE: VZ) paid $1.4B to acquire Terremark Worldwide Inc., an
operator of data centers, in an effort aimed at selling more computing services to business customers. The deal came
as telecom operators are moving deeper into selling processing power, data storage and software hosting services
over the Internet as their landline businesses shrink. The acquisition could help VZ secure more cloud computing deals
and compete with companies like Amazon.com Inc.
SOURCE: Companies’ press releases
In order to gauge market sentiment on RAX, we used a variety of tools like Heckyl and Cityfalcon, as well as standard ratios.
According to Heckyl proprietary research, sentiment dipped mid-january when the stock was being dragged down with the market
by worries of a slowdown. We have seen so far how the sentiment has rebounded and is now trending upwards into positive
territory again (above 0)
Source: Heckyl
Cityfalcon’s data points out to an uptick in the number of stories, including a downgrade by Zacks research on their stock
recommendation. Nonetheless, sentiment on RAX has been recovering slightly despite a bigger peak later that contain positive
news such as RBC and Cowen Capital reiterating BUY recommendation.
Source: CityFalcon
Among analysts, the consensus seems to be that the stock is still a BUY, despite recent downgrades by investment firms. Out of 20
analysts in the Dataset, at least 60% rates the stock as an either BUY or OUTPERFORM with 25% rating the stock as SELL or
UNDERPERFORM.
Source: Heckyl
Capital IQ also shows a similar situation, with most analysts hovering around the 30 mark for RAX as a target price with a steep
drop back in August 2015 due when the stock price was closer to the 50s.
Source: Capital IQ
Of the 11 publicly disclosed analysts’ recommendations on Capital IQ: 1 advised a SELL, two more a HOLD and 8 issued a BUY on
RAX.
Source: Capital IQ
Another trend worth noting is that 80% of hedge funders tracked by Heckyl have been adding to their positions on RAX while the
other 20% have been either reducing their positions or dumping the stock all along.
Source: Heckyl
Target Price Recommendation
Evercore ISI 33.00 E Hold (3)
Analyst Schildkraut, Jonathan A. Schildkraut, Jonathan A.
FBN Securities, Inc. 31.00 E Sell (5)
Analyst Seyrafi, Shebly Seyrafi, Shebly
Jefferies LLC 33.00 E Hold (3)
Analyst McCormack, Michael McCormack, Michael
JMP Securities 55.00 E Outperform (2)
Analyst Walravens, Patrick D. Walravens, Patrick D.
Morningstar Inc. 32.00 E Buy (1)
Analyst Summer, Rick Summer, Rick
Needham & Company - Hold (3)
Analyst - Kugele, Richard
Oppenheimer & Co. Inc. 43.00 E Buy (1)
Analyst Horan, Timothy K. Horan, Timothy K.
Pacific Crest Securities-KBCM 45.00 E Buy (1)
Analyst Bowen, Michael George Bowen, Michael George
Raymond James & Associates 48.00 E Buy (1)
Analyst Louthan, Frank G. Louthan, Frank G.
Wells Fargo Securities, LLC - Buy (1)
Analyst - Powell, Gray
William Blair & Company L.L.C. - Buy (1)
Analyst - Breen, James D.
But still, the float for the stock has been increasingly negative, meaning a possible trend reversal and the selloff of the stock. We
attribute this partially to recent turmoil affecting the overall markets, but investors are starting to short the stock signaling a bearish
view on RAX. For the last six month short interest ratio has been on a rollercoaster, but steadily increasing the last few months.
We assessed the overall sentiment of the market for the stock as improving and this should reflect in a better short ratio over the next
few months.
n this graph we can see that for the 50 day moving average the stock has a $52.50 stock price resistance. We can also see that the
stock has broken its support of $27.00 and is now trading at $19.53.
The graph shows the trailing twelve months with its Bollinger Bands and with two overlays, the 200 day moving average and 50 day
moving average.
BBS TEAM - RAX VALUATION REPORT 2016
BBS TEAM - RAX VALUATION REPORT 2016
BBS TEAM - RAX VALUATION REPORT 2016
BBS TEAM - RAX VALUATION REPORT 2016
BBS TEAM - RAX VALUATION REPORT 2016
BBS TEAM - RAX VALUATION REPORT 2016

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BBS TEAM - RAX VALUATION REPORT 2016

  • 1. CFA Institute Research Challenge Hosted by Central America & Caribbean Local Challenge Barna Business School
  • 2. MARKET CAP $2.54B SHARES OUTSTANDING 134.7M 52 WEEKHIGH / LOW $56.2 /$17.2 50 DAY MOVING AVERAGE $22.89 200DAY MOVING AVERAGE $27.90 AVERAGE DAILY VOLUME 2.5M ADJUSTED BETA 1.48 DIVIDENDYIELD - Summary: RAX is a global leader in providing managed hosting solutions for business customers. GICS Sector: Information Technology Sub-Industry: Internet Software & Services RAX has consistently delivered double-digit revenue growth on a yearly basis and has earned stable near-30% EBITDA margins since 2010. Additionally, RAX has enjoyed consistently low churn rates and healthy stream of recurring revenue. Furthermore, RAX has been able to grow within its existing client base as indicated by net upgrades data. At the close of 2014, RAX’s number of servers deployed had increased 41% from 2011 with over 112K servers. Similarly, RAX’s average monthly revenue per server grew from $1,070 to nearly $1,330 during the same timeframe, a 24% increase. RAX has recently formed partnerships with Amazon Web Services (AWS) and Microsoft Azure, leading cloud providers, to provide its managed services to its clients. We fully expect RAX’s young up-and-coming leadership to capitalize on a booming managed cloud space aided mainly on these catalysts: (i) Growing enterprise adoption of OpenStack©, and (ii) Successful partnerships with third-party cloud providers. Organizations are moving towards OpenStack cloud for the promise of no vendor lock-in, IT agility, and competitive differentiation. Disney, BMW, Expedia, eBay, Wal-Mart and Time Warner are some examples of enterprises that chose this open-source platform and are sharing their success stories. Managed Services at Cloud Service Providers are growing at a compound annual growth rate of 25.6%. These services account for 29.1% of total cloud market revenue in 2014 and are projected to account for 36.3% of the total cloud market revenue in 2018. As AWS and Azure grow their Infrastructure as a Service customer base, RAX will be exposed to more potential markets to offer their managed services, taking advantage of both Infrastructure as a Service and managed cloud services. SOURCE: CAPITAL IQ This report is published for educational purposes only by students competing in The CFA Institute ResearchChallenge SOURCE: COMPANY DATA & TEAM ANALYSIS VALUATION DATE: JANUARY 15, 2016 CURRENT PRICE: $18.84 RECOMENDATION: BUY (45.2% Upside) TICKER: RAX TARGET PRICE: $27.36 NEW YORK STOCK EXCHANGE (NYSE)
  • 3. Rackspace® Hosting, Inc. (NYSE:RAX) is a provider of managed cloud services headquartered in San Antonio, Texas. Founded in 1998, RAX operated as a private company for 10 years until its IPO in August 2008. With 13 data centers across the globe (Figure 1), RAX has been recognized for the past two years as a leader in Gartner’s Magic Quadrant for Cloud Enabled Managed Hosting, both in North America (contributing 69% of RAX’s revenue) and Europe (Figure 2). RAX serves 300,000+ business customers, including 69 of the enterprises in Fortune® 100, located in over 120 countries across four continents through its subsidiaries and offices (APPENDIX 7). RAX helps its customers design, deploy, manage and scale their operations in the cloud. Its value proposition consists of offering customized hosting solutions across a variety of world leading platforms. Its key differentiator resides on Fanatical Support®, the promise to deliver the best customer service through its 6,000+ skilled Rackers (Table 1). RAX showcases a broad portfolio of integrated IT solutions, combining different hosting categories and support levels in order to deliver tailored solutions to specific customer needs. RAX also offers advisory services on technology strategy and transformation, and application migration1. Since 2002, RAX has amplified the delivery of its support capabilities for leading platforms atop its infrastructure as well as third party clouds. For further details on RAX’s product and service offerings please refer to APPENDIX 8. RAX service offering could be divided into two segments based on its growth drivers and cost structure: (i) Managed Hosting, fueled by OpenStack© and characterized for heavy infrastructure costs; and (ii) Fanatical Support® for Third Party Clouds, with a high demand for skilled personnel, no CapEx, and driven by the expansion of unmanaged cloud providers. — RAX focuses on providing beyond expectations customer experience which in turn generates a powerful stream of recurring revenue (figure 3). RAX’s Fanatical Support® has been recognized with the Stevie Awards for the 4th consecutive year. — RAX has recently expanded its service portfolio to provide Fanatical Support® for unmanaged public cloud vendors such as AMZN’s AWS and MSFT’s Azure. RAX expects these new offerings will ensure its position as a leading provider in a fast growing market, representing its main growth driver through 2017 and beyond. — In 2010, RAX cofounded OpenStack© - an open cloud standard - along with NASA, in order to provide an alternative to proprietary cloud platforms. Five years later, partnering with Intel®, RAX created the OpenStack© Innovation Center to recruit and train open source developers to advance the platform. This initiative will accelerate features that will make OpenStack© more scalable and secure, as well as more accessible for enterprises looking to adopt it but which struggle due to scarce talent. RAX’s public ownership is comprised of 300M authorized common stocks grouped within one single class of shares. At the Valuation Date, the majority of its 134.7M outstanding shares are institutionally owned (68.39%), while 17.97% are held by hedge funds and 14.79% by individuals (Figure 4), with Fidelity Investments (14.83%) and Blue Harbour Group (8.44%) as top institutional holders (APPENDIX 9). As part of RAX anti-takeover provisions, as of December 31, 2014, there were 50M authorized shares of preferred stock, of which none were outstanding. RAX’s team of directors is diverse in terms of backgrounds and managerial experience, more than 15 years on average (APPENDIX 10). Members of the Board have started successful SaaS companies, consulted for technology enterprises within firms like McKinsey & Bain. Chairman Graham Weston has been through all of RAX’s transitions, from a pure Web hosting company to IaaS provider to its current Managed cloud approach. Nonetheless, most named executives have no relevant experience in business transformations outside of RAX. Fred Reichheld, board member, is an expert on customer service and loyalty, pillar upon which RAX has built its main competitive advantage. He founded the loyalty practice at Bain & Company where he is a partner, and has also written many books on the subject. He is the second longest tenured member after Weston having served 7 years (APPENDIX 11). We evaluated management’s track record using the Economic Value Added model (EVA) to measure how effective has been RAX’s executives in value generation and concluded that RAX has delivered excess returns every year since IPO, signaling upright judgment at selecting projects.(APPENDIX 12 ).SOURCE:COMPANY DATA SOURCE:COMPANY DATA
  • 4. RAX has assembled a board of 9 directors, selected via voting at shareholders’ annual meetings, with 4 established committees: Nominating and Governance, Audit, Real Estate and Finance, and Compensation. The Board is structured as classified, limiting directors’ accountability due to their 3-year term election but encouraging a longer timeframe, desired for technology companies. Despite this structure only two members, non-executive, have been onboard for more than 5 years. Moreover, the company has set forth stock ownership requirements for all executives of at least 3x base salary to encourage commitment to shareholder value creation. As of Jan 15, all directors and executives held a combined 14.1% ownership on RAX (Table 2), a number largely skewed by founder Graham Weston stake of 14.1%. Remuneration for the CEO and Executive team is structured using a “Say on Pay” methodology with support from independent consultant Compensia Inc., leader in compensation consultancy serving over 27% of the market for IT companies. In 2014, RAX’s performance-based compensation for CEO and continuing named executive officers accounted for 44% and 34% respectively of their total remuneration package, with the majority of the compensation vested over multi-year periods – 87% and 72% respectively – aligning executives with the long-term interests of shareholders. At the last annual meeting, compensation was approved with more than 87% of votes “FOR”, which signals strong acceptance by the shareholders. Further details in APPENDIX 14. RAX’s employee-led people-centric initiatives, such as Rack Gives Back and its fund, The RackSpace Foundation, are aimed at elevating and further developing RAX’s surrounding communities through volunteerism, grants and education. Additionally, RAX supports sustainability within the cloud industry through its RackSpace Startup Program and The RackSpace Cloud University. Moreover, to ensure environmentally conscious operations, RAX has committed to the goal of powering worldwide operations with renewable energy and thus has been recognized through its listing on the Dow Jones Sustainability Index and the FTSE4Good Index. Further details on social responsibility programs are presented in APPENDIX 4. - Enterprise IT investment is proportional to the state of the economy, thus strong macroeconomic indicators represent a positive outlook for cloud computing as part of organizations’ IT budgets. GDP as a measure of economic health paints an optimistic picture for upcoming years. Estimated annual growth in the US comes north of 2.7% yearly until 2018 when it starts slightly dropping but staying above 2.0% through 2020. Similarly, the EU is expected to come out of the lengthy period of economic difficulty to present steady growth of 1.9% up to 2020, with UK as one of the leading factors growing 2.2% a year3 (Figure 5). . Cloud computing is meaningfully responsible for the utter disruption of traditional business models’ practices. The cloud’s elastic scalability (shift to Pay-as-you-go versus install-and-own), cost savings and resource optimization is making it the fundamental IT engine for business customers. At a global level, cloud computing is expected to grow at a remarkable rate of approximately 43.37% CAGR reaching $132B in 2020 (Figure 6)4. It is estimated that 11% of IT budget will shift away from in-house towards one or more versions of cloud computing. Accordingly, spending on Infrastructure as a Service (IaaS) and Platform as a Service (Paas) is expected to grow at a 30% CAGR (2013-2018) as opposed to 5% growth for overall enterprise IT spending. Similarly, by 2018, over 60% of companies will have at least half of their infrastructure on cloud-based platforms5 Customers today expect simple real- time interactions anytime, anywhere through increasingly interconnected devices. By 2020, it is estimated that 4B people and 31B devices will be connected to the Internet6, generating a tremendous influx of unpredictable data. These trends require enterprises to rethink the way they are currently delivering their business by migrating from rigid on-premise environments to dynamic and scalable networks able to quickly address consumers’ needs. This can only be attained by the cloud, which provides elastic on-demand provisioning of IT resources. Consequently, as supported by the survey results in Figure 7, there is a shift within companies’ IT investment priorities by reallocating financial resources to more strategic opportunities for businesses’ digital transformation. On average, more than 60% of IT organizations are increasing operational IT budgets for 2016 while IT CapEx remains relatively unchanged (Figure 8). This tendency of lowering IT spending as a percentage of increasing revenues is mainly explained by the steady stream of companies migrating to the cloud and thus lagging behind in IT employee headcount. – Cloud computing is on the verge of major growth in the public sector. Many government organizations have been historically cautious about cloud adoption due to privacy and security concerns but today governments worldwide are supporting cloud-related standards development (e.g., US, EU), investing to create economic regions of cloud technology (e.g., China, Japan) or migrating their own IT infrastructures to cloud services (e.g., US, UK, Japan) 8. By 2018, the global government cloud market will be worth $18.5B (45% CAGR from $2.78B in 2013)9 accounting for more than half of global software, server and storage spending growth 10. In 2013 the CIA awarded a $600M private cloud contract to AWS, a milestone for this transition.
  • 5. - The most aggressive growth rates for cloud ecosystems are occurring in Asia-Pac (68% CAGR through 2018), EMEA (70%) and LatAm (47%) 7. Emerging markets are increasingly exploiting the cloud’s potential and translating it to economic growth and global trade expansion. Businesses in emerging economies benefit from reduction of technology barriers, scalability, costs reduction and opportunities for new service and product development. These markets, divested of legacy systems and IT infrastructure, are more agile to adopt cloud resources leapfrogging more mature markets. In today’s global technological outlook of innovations and rapid change, qualified talent is regarded as a key driver for strategic business development. As cloud computing keeps it rapid-paced growth, demand for capable IT professionals is outpacing supply, and thus enterprises worldwide are faced with the challenge to compete for qualified candidates or struggle to up-skill in-house personnel. Consequently, cloud computing professionals earn one of the top average salaries within IT (Figure 9). As of December 2015, there were 420,000+ full time job positions open with only an average of 7 qualified candidates available per opening (9 in 2014) with an average posting of 45 days, making IT positions some of the most challenging to fill 11. This talent shortage translates into higher IT payroll spending, organizations settling for under-qualified candidates, or IT task outsourcing. Cloud computing’s early stage adoption was mostly limited to IT companies which had the expertise and resources required to deploy cloud technologies. The industry has seen how the draw of low-cost cloud infrastructure accelerated adoption by companies across all sectors as they move their workloads into the cloud. Having limited access to required skills, said companies are leveraging the economies of expertise offered by managed cloud providers thus outsourcing resource-consuming IT tasks. Furthermore, hybrid cloud offerings have gained traction over the past 5 years due to an increasing number of enterprises continuously looking for integrated and flexible cloud solutions. This is showcased by Northbridge’s 2015 “Future of the Cloud Survey” where results indicate that hybrid solutions currently account for 47% of IT strategies12. (Fig. 9) Although cloud adoption and spending is estimated to continue its rapid growth, there are still persistent concerns which prevent a wider adoption of the cloud. For IT professionals, top inhibitors to cloud adoption include data security (45%), regulatory compliance (36%), privacy (29%), vendor lock-in (26%) and complexity (23%) (Figure 10). In the wake of the Snowden/PRISM scandals, governments and enterprises worldwide are increasingly concerned with data residency, giving way to concepts such as national cloud to gain traction. The recent European Court of Justice ruling (October, 2015) invalidating the Safe Harbor data-sharing agreement between U.S.-EU, indicates how stricter government regulations on data sovereignty threaten to undermine the economic potential of the cloud, presenting new hurdles for cloud adoption . The managed cloud segment is expected to have strong long- term revenues 13, hence it is characterized by a high fragmentation and rivalry (APPENDIX 16). Gartner, leading IT research firm, ranks vendors in this sector in one of four categories according to their performance within the market: leaders, challengers, visionaries, and niche players (APPENDIX 17). Within the North American and European markets, RAX has been recognized as an industry leader due to its market presence, satisfactory customer experience and flexible business model 14. A key pillar within this positioning is RAX’s workforce and organizational culture, which has been recognized by Fortune© as one of America’s top workplaces in six of the past seven years. Other vendors competing in this leadership category include Datapipe, Interoute, Claranet, BT Global Services, and Colt. For further details on competitors’ analysis please refer to APPENDIX 18. In the beginning of its operations, RAX started out by renting servers and later evolved to a full service Web hosting provider with a strong emphasis on customer support. As IT infrastructure underwent a rapid shift from in-house to over the internet, so did RAX model as it pivoted into being a cloud infrastructure provider. Having to face taut price competition from industry giants such as AMZN, MSFT and GOOG, in 2014 RAX evolved once again to a managed cloud approach discontinuing its sole IaaS offering and bundling it with its support package. During 2015, RAX has expanded its services by offering its flagship customer support for third- party clouds. We believe that the various successful transitions in RAX’s business model serves as evidence in the company’s ability to identify market trends and adapt accordingly, a clear competitive advantage in a constantly evolving industry. Please refer to APPENDIX 19 for our holistic assessment. Cloud computing is progressively being adopted by non-IT business customers and SMBs, which do not have the necessary technical expertise and require a managed service provider to help them overcome the hurdles of cloud adoption15. Our analysis reveals the importance of vendors’ ability to provide aggregated value for customers due to the many alternatives to managed cloud services available (Figure 11). RAX’s value proposition is based on creating customized IT solutions to address obstacles faced by customers when moving to the cloud (APPENDIX 8). Its Fanatical Support acts as a key differentiator and source of customer retention. As aforementioned, one of the key inhibitors why enterprises are reluctant to adopt cloud technologies is the fear of being locked-in by cloud vendors through proprietary platforms and the lack of flexibility to which it translates (Figure 10). Banking on this market opportunity, in July 2010, RAX cofounded OpenStack as a collaborative approach to cloud computing. Five years later, the open source project has become a leading software platform with more than 520 member companies and 27,000 individual contributors across 167 countries, one of the fastest growing communities in the world. As a founding father RAX has a solid competitive first-mover advantage, having profound expertise in managing and scaling OpenStack clouds and operating the largest worldwide production OpenStack cloud. SOURCE: CloudTech
  • 6. We issue a BUY recommendation for RAX with a target price of $27.36 per share, representing a 45.2% upside from its closing price of $18.84 at the Valuation Date (Table 3). We fully expect RAX’s young up- and-coming leadership to capitalize on a booming managed cloud space aided mainly on these catalysts: (i) Growing enterprise adoption of OpenStack ©, and (ii) Successful partnerships with Third- Party cloud providers. © In recent years OpenStack© has evolved from a tech user orientation to a more robust and reliable platform making it a viable option upon which a broader range of business customers can depend, with success adoption stories by Fortune© 100s like Walmart and BMW (APPENDIX 19). Benefits such as operational efficiency, ease of application deployment and lack of vendor lock-in (Figure 12)16 make OpenStack© a growing preferred choice for building private and public clouds. Nonetheless there are still several barriers for OpenStack© adoption, lack of internal IT skills being the top concern (Figure 13). Consequently, enterprise customers look for OpenStack© managed service providers to address these obstacles. We consider this should help propel OpenStack© as a steady source of revenue growth for RAX which holds huge first mover advantage as one of the founders of the standard. AWS revenues alone are estimated to grow to $24B by 2022 while the managed services within it are projected to account for 30% of said amount17. Even though we expect the recently formed partnerships with AWS and Azure will represent a slight dilution in EBITDA Margins, we believe the bigger addressable market will offset this reduction. Moreover, we expect other unmanaged cloud providers to ink alliances with RAX. Therefore, we believe RAX is in great position to stand on the shoulders of these industry heavyweights and grow revenues. Over the last 12 months RAX has shed more than 58% of its market capitalization due to qualms about their ability to withstand aggressive price cuts in the commoditized IaaS/PaaS market. We believe this to be an indicator that the market has not factored-in the main strategies laid out by RAX’s leadership. However, based on our DuPont Analysis (see table below), we do expect RAX’s recently amplified service portfolio to generate excess returns for shareholders by enabling coopetition with industry giants instead of lose-lose price wars. Our target price is derived from two standard valuation approaches: Discounted Cash Flow Model (DCF) and Peer Multiple Pricing Model. This model mix considers the current value of RAX’s long-term growth opportunities and the market’s perspective of its worth. We assigned a weight of only 30% to our Peer Pricing Model due to the significant impact that the beginning-of-year market selloff has had on industry multiples, failing to properly reflect the value of RAX and its peers (Figure 14). Additionally, we believe an intrinsic valuation approach, such as the DCF, delivers a better price estimate for an enterprise undergoing a pivot in its business model, as is the case of RAX. Our DCF analysis, centered on year to year forecast through 2025, delivered an estimated price for RAX’s common stock of $27.60. In turn, our relative valuation approach provided an estimated share price of $26.81 from the selected peer group of similar-sized US listed companies using a cross sectional regression analysis. For the purpose of our forecast, we broke down RAX’s income statement into two business segments according to the hosting infrastructure provider: (i) Managed Hosting, RAX’s managed solutions atop its proprietary infrastructure, and the recently launched (ii) Fanatical Support for Third Party Clouds. We did so by considering the different maturity levels and key growth drivers of both offerings. Driven by an increasing number of enterprise adopting OpenStack ©, we expect this segment to grow at a 10.98% CAGR throughout the forecasted period. However, by the end of the forecasted period, we anticipate EBITDA and EBIT margins to decrease to 22.9% and 9.0%, respectively, mainly due to the arrival of new competitors and potential price wars (Figure 18). For this segment we project a revenue growth driven mainly by the late majority pushing their infrastructure to public cloud vendors but lacking the expertise to do it on their own. We expect RAX to account for 10% of the managed services running on top of major unmanaged cloud providers by 2020 and 6.7% at the end of the forecasted period. Furthermore, our estimates indicate EBITDA and EBIT margins for this segment will be lower than the more traditional services due to training and recruitment costs, sales and marketing expenses, and reselling fees. Investors should consider the following key risks: (i) Competition in a highly fragmented industry with many nascent companies, including VC Backed startups, could put pressure on economic rents; (ii) margin dilution given the wars for scarce talent, increases in energy costs, employee training and certification, and the need to increase idle capacity to better serve different standards besides OpenStack©; (iii) Slower than expected OpenStack© adoption could hinder growth; (iv) Breaches in quality of service like system failures and security issues could increase clients to switch to other service providers; and (v) Disruptive technology and processes could make RAX technology and services obsolete or financially inefficient. SOURCE:TEAM ESTIMATES SOURCE: OpenStack.org User Survey, 2015
  • 7. Building upon a diversified client base, RAX’s Managed Hosting revenue has consistently showed yearly double-digit growth (2014:16.9% and 2015:11.5%) albeit posting a slight slowdown in the last couple years due to slower than expected customer installations and a stronger US dollar (Figure 15). Encouraged by the expected growth of the cloud and faster enterprise adoption of OpenStack©, we estimate 12% year on year growth up to 2020 followed by a slight deceleration due to inevitable price wars. We believe Managed Hosting will reach its stable stage by 2025 with a constant growth rate of 8.4%. According to our estimates, by the end of the forecasted period, the Managed Hosting segment will reach Net Revenue of $5.6B, from $2B in 2015 (Figure 15). AWS is the undisputable leader of the unmanaged cloud segment, holding a 27.2% market share, with Microsoft, IBM and Google Completing the Big 4 with a participation of 16.2%, 11.8% and 3.6% respectively (Figure 17). However, we assumed a conservative approach and decided to estimate the size of RAX’s potential unmanaged market based solely on AWS’ growth prospects (Figure 16). AWS’ revenues are estimated to reach $20B by 2020 (24.82% CAGR from 2015), outpacing the estimated growth rate for global IaaS spending (10.27% CAGR) 18. This rapid growth is mainly driven by its global operations’ scale, adoption rates, price reductions and its success in increasingly providing premium services. Therefore, the starting point for our forecast was AWS’s net revenues for 2015 and from then onto 2022 we considered a CAGR of 17.9% resulting in a total of $24B, which was followed by a slight deceleration ending leading to $36.7B of revenues by 2025. Additionally, several studies show an ever-growing demand for managed cloud services thus we estimate over 30% of AWS’s clients will procure these services by 2025. We expect RAX to capture 10% of the managed cloud services for AWS during the first years of the partnership followed by a decline at the end of the forecasted period due to intensifying competition. In short, we anticipate Fanatical Support® for Third-Party Clouds will reach $2.4B by the end of our forecast, for a 30% stake of RAX’s Total Net Revenue. RAX has delivered stable EBITDA and EBIT Margins for the last 5 years, averaging 30.4% and 10.6% respectively (Figure 18). For Managed Hosting, we expect these margins to remain constant at 30.7% during the forecasted period. As for the results of RAX’s partnership with third party cloud providers, we see relatively high Costs of Revenues highlighted by a less scalable labor-intensive business model. Consequently, we are estimating this business segment to deliver inferior EBIT through 2025 at a constant 4.6%. At a global level, we believe this should translate to an average EBITDA and EBIT Margin of 22.5% and 8.9%, respectively, during the forecasted 10-year period. In tandem with RAX’s aforementioned historical revenue growth, its working capital management has shown continuous efficiency throughout the company’s lifetime. Its average collection period of less than 30 days falls well below the latest available industry average of 47 days20, which, along with RAX’s average days -payable of 80+, is generating strong cash flows from operations of near 29% of Total Net Revenue. In our forecast, we expect RAX to maintain its focus on operating efficiency, minimizing its annual investment in net working capital to >1% of Net Revenues (Figure 19). RAX’s CapEx relate mainly to Customer Gear, which in turn refers to servers, firewalls, load balancers, cabinets, backup libraries, storage drives and network cabling. These items historically represent more than 60% of RAX’s CapEx. The rest is comprised of data center and office build-outs, as well as capitalized software. For our forecast, we divided these investments into two types: Maintenance CapEx and Growth CapEx. The first was estimated pursuant RAX’s guidance, which allocates a permanent 10% of its revenues to these purposes. For the second item, Growth CapEx, we analyzed the historical behavior of RAX’s CapEx in relation to its Net Revenues during the 2010-2014 timeframe, excluding periods 2011 and 2013 for being deemed outliers. As a result, we observed that, on average, RAX assigns 12.7% of its Net Revenues to Growth Capex with 8.1% pertaining to Customer Gear. Therefore, in our Base Case, we assumed a steady 10% as Maintenance CapEx and a 12.7% as Growth CapEx (Figure 20). At the close of 3Q15, RAX presented a Debt/Capital ratio of 22.7%, well below the selected peers’ mean of 48.6%. Similarly, its Debt/EBITDA ratio of 0.7x falls under its industry peers’ mean of 2.4x, which signals room to finance future growth opportunities in the managed cloud space through debt (Figure 20). As part of our forecast, we expect RAX’s current Debt/Capital ratio to move towards that of its peers. Therefore, we assumed a target ratio of 30% throughout the 10 year period. We believe RAX has the capacity to withstand this level of debt considering its strong financial position as well as it’s Altman Z-Score of 6.8 for 3Q15 (APPENDIX 21). To assess earnings quality, we conducted an 8 variable Beneish M-score analysis for the last five year-end financial statements reported by RAX. Based on the output, we gauge the likelihood of RAX manipulating earnings as low. Through our analysis, we observed an average of -3.74 M-score with a 5-year low of -3.50, well below the recommended threshold of -2.22 – being the lower the better (APPENDIX 22). During the same period, RAX’s accounting policies haven’t been modified. Furthermore, annual audits have been conducted by KPMG, whose opinion for the last three years states that consolidated financials fairly present the financial position of RAX.
  • 8. With its proven expertise and award winning customer service, RAX has enjoyed consistently low churn rates and healthy stream of recurring revenue (Table 4). Additionally, RAX has been able to grow within its existing client base as indicated by net upgrades data. We expect Fanatical Support© to keep acting as a customer magnet and clients to increase the level of assistance they require from RAX . RAX’s growth has also resonated in per server figures. At the close of 2014, RAX’s number of servers deployed had increased 41% from 2011 with over 112K servers. Similarly, RAX’s average monthly revenue per server grew from $1,070 to nearly $1,330 during the same timeframe, a 24% increase. We believe this trend to continue onto 2025 when we expect RAX to surpass 280K servers deployed, with each one generating almost $1,670 on a monthly basis. We applied the DCF Model to arrive at a price estimate per share for RAX’s common equity. Based on this methodology, we estimated RAX’s Equity Value at $3.7B (Table 5). We determined RAX’s WACC to be 9.36% based on a target Debt/Capital of 30% (Table 6 ). Using the CAPM we estimated RAX’s Cost of Equity to be 11.08%. For the Risk Free Rate we used the 10-year US Government Bond yield of 2.02% at the valuation date. Furthermore, we calculated an Adjusted Beta of 1.48 by regressing historical RAX’s monthly returns against the S&P 500’s from January 2011 to December 2015, a total of 60 observations. Lastly, we based the Equity Risk Premium of 6.12% on Damodaran’s most recent Implied Risk Premium computations at the time of our valuation. We considered the yield of RAX’s senior notes at Valuation Date, 8.04%, as its pre-tax Cost of Debt (Table 6). We acknowledged RAX’s two business segments have different growth drivers and therefore we forecasted Net Revenue, CapEx, Costs and Operating Expenses separately through 2025 using a two-stage growth model. The first phase, RAX’s growth stage, was based on a detailed year to year forecast up to 2020. This was followed by a phase of slight deceleration reaching the maturity stage by the end of 2025. Based on these assumptions, we calculated RAX’s Unlevered Free Cash Flows for each year. Additionally, we estimated the PV of these cash flows to be $1,789M using as discount rate RAX’s WACC of 9.36%, considering a target Debt/Capital of 30% (Table 6) . The terminal growth for both of RAX’s business segments will be mainly driven by the US IT spending growth, which in turn depends greatly on the performance of the US economy. According to the IMF, Real GDP in the US is expected to grow at an annual rate21 of 2.7% through 2018 and to maintain an above 2% annual increase thereon. However, to determine RAX’s Terminal Growth Rate, we considered the yield of 10-year US Government Bond to be a more conservative proxy given it accounts for both the expected inflation and the expected real interest rate. At the Valuation Date, the yield of the 10-year US Government Bond was 2.09%. Taking this rate into account, we estimated RAX’s Terminal Value at $5.7B for a PV of $2.5B using as discount rate the aforementioned WACC. Refer to APPENDIX 23 for further details on our assumptions. For our Peer Multiple Pricing Model we identified a set of 21 listed peers for RAX based on the following criteria: (i) infrastructure outsourcing (e.g. cloud infrastructure, colocation services and datacenter hosting) as one of the main revenue STREAMS, and (ii) US and UK as their main geographic sources of revenue (APPENDIX 24). Based on standard multiples for this industry, RAX is trading at a discount when compared to most of its peers (Table 7), as evidenced by: EV/Sales of 1.4x for RAX versus the peer median of 3.8x, a 63.16% discount. Additionally, Forward P/E shows a discount of 43.98% for RAX at 19.4x against median of 34.6x for selected peers. Historically, this has not been the case as RAX was trading at a premium against the same peer set just 2 years ago. For the Peer Pricing Model we chose the Forward EV/EBITDA due primarily to the following considerations: • Standard deviation of EBITDA margins for the peer set is just 481.10 with a median of 176.10 which gives us a coefficient of variation (CV) of 36%; meaning a low variance in the distribution. • EBITDA is an overall better representation of cash flows independent of capital programs. • RAX issued senior notes during 4Q15; thus we believe debt is priced efficiently. RAX has not issued preferred shares. • EBITDA is less likely than earnings to be subject to manipulations by accounting practices. Our peer comparison model was constructed using a cross-sectional regression analysis[i] (APPENDIX 24) to adjust for differences in risk and growth the market expects for each peer. We used Damodaran’s approach in order to account for these fundamentals, and found an important correlation (0.645 R- Squared) between Forward EV/EBITDA, Estimated Annual Revenue Growth for the next 2 Years, Effective Tax Rate and Total Debt/Capital. Our estimated value for RAX’s Forward EV/EBITDA is 7.09x, which gives us a price of $26.81 “SOURCE:COMPANYDATA “SOURCE:TEAM COMPUTATIONS “SOURCE:TEAM COMPUTATIONS “SOURCE:TEAM COMPUTATIONS
  • 9. As previously stated, our target price was derived from two valuation approaches to which we assigned different weights. A DCF model, accounting for 70% of the weight, delivered a price per RAX's share of $27.60. On the other hand, a Peer Pricing Multiple Model resulted on a share price of $26.81. Therefore our one year target price for RAX is$27.36, for a 45.2% upside from its closing price at the Valuation Date. Fluctuations in the key assumption variables could affect our one year target price and may lead us to downgrade our BUY recommendation. Some of these key variables relate directly to RAX’s growth prospects in each of its two business segments, while others are closely linked to our WACC and Terminal Value computations. Therefore, we followed two different and independent approaches to measure the potential impact of these variables and the probability of a change in our recommendation. First, we conducted a Monte Carlo Simulation to test RAX’s growth variables. Lastly, we assessed the sensitivity of our estimation of RAX’s equity value to individual changes in our methodological assumptions, holding all other variables unchanged. We performed a Monte Carlo Simulation to measure the impact of the following variables in our growth estimates for RAX: (i) OpenStack© Enterprise Adoption Rate, (ii) Third-Party Clouds Growth Rate, (iii) Fanatical Support’s Share of the Managed Cloud Space, (iv) Growth CapEx on Customer Gear, as well as (v) cost and expenses items. We believe RAX’s future earnings and Unlevered Cash Flows depend heavily on these key variables. After running 1million simulations, we observed a probability of 54.03% of obtaining a target price per share consistent with our BUY threshold of 30% upside. Moreover, considering the 70% weight assigned to the DCF Analysis, we observe a probability of 35.8% of obtaining a target price per share that downgrades our recommendation for RAX. In addition, from the Monte Carlo, we concluded that the most impactful variable in our model is Fanatical Support’s Share of the Managed Cloud Space, contributing to 30.7% of the variability in our price target. Therefore, RAX’s equity value could be diminished if not able to capitalize of its current and future partnerships with third party cloud providers. For further details on our Monte Carlo Simulation please refer to APPENDIX 25.. Independently from the Monte Carlo, and holding all growth variables unchanged, we performed a Sensitivity Analysis on the key inputs underlining the Discount Rate and Terminal Value computations. Specifically, we tested RAX’s Terminal Growth Rate and WACC (APPENDIX 25). In order to downgrade our recommendation to a HOLD, the Terminal Growth Rate would need to decrease from 2.02% to 0.16% (a 92% decrease). Furthermore, even with a rate of 0.0% our recommendation would not turn into a SELL (Table 8). In order to downgrade our recommendation to a HOLD, the WACC would need to increase from 9.36% to 10.35%. Furthermore, it would have to exceed 13.43% (a 43.5% increase) for us to issue a SELL recommendation (Table 9). driving more business to RAX Managed Security Services. IT budget growth has remained flat year on year with 6% of their total budget directed to security projects. As security threats increasingly become a concern for enterprises, IT professionals are inclined to reevaluate their security budgets in order to address them accordingly. In fact, a significant amount of IT managers feel their organization is not investing in security and a big part of these IT managers believe their data is not adequately protected. Furthermore, due to recent serious security threats IT managers have implemented changes in their security practices23. This growing awareness in the importance of addressing these security threats may lead IT professionals to RAX for help. RAX has signed business agreements with both AMZN and MSFT to offer their managed services atop their IaaS offerings. Similar partnerships with other unmanaged cloud providers could act as a key catalyzer for RAX’s growth. Container Technology being developed by Dockers, an open-source project that automates app deployment within software containers, could allow cloud providers more flexibility with client’s environment transitions, which in turn would stimulate client base growth. According to Thinkstock “containers are a solution to the problem of how to get software to run reliably when moved from one computing environment to another. This could be from a developer's laptop to a test environment, from a staging environment into production and perhaps from a physical machine in a data center to a virtual machine in a private or public cloud”. In 3Q15 RAX announced Carina®, a service based on Dockers’ containers to capitalize on a growing segment within the cloud computing market. “SOURCE:TEAM COMPUTATIONS “SOURCE:TEAM COMPUTATIONS
  • 10. Information security is a major concern for customers switching to the cloud with 38% of IT managers surveyed in North Bridge’s 2015 “Future of Cloud” study, putting it as the top challenge to their migration. Of those currently using the cloud, 85% are confident in their cloud vendor’s ability to provide a secure environment as opposed to 90% of IT managers who lack confidence in their companies’ ability to detect problems internally, which signals strong confidence in cloud security. Regardless, RAX could be exposed to breaches and interruptions that could lead to reputational effects, revenue loss and lawsuits. In order to mitigate this risk, the company has put together a team of security professionals and infrastructure to secure their datacenters from internal and external threats, becoming compliant with top industry standards such as ISO/IEC 27001:2005 Information Security Management System (ISMS) Standard, ISAE 3402 / SSAE 16 Type II SOC 1 and Payment Card Industry Data Security Standard.. Alterations to electronic data protection laws could allow governments, in countries where cloud computing companies host their data centers, access to information stored by business customers even if they are not based on that country. Likewise, laws and regulations could be passed by client-side governments to limit the ability of companies to either send data overseas or outsource processes like information security to other countries in order to ensure data privacy according to national laws. This could slowdown cloud adoption as companies would try to prevent their data from being accessed and exposed by foreign governments. Service outages or any interruptions that cause downtime will affect RAX’s customers directly. Frequent interruptions may cause clients to have reservations about RAX’s reliability and switch to other managed service providers. Additionally, as part of RAX’s Service Level Agreement (SLA), uptime for their services must be at least 99.99% or they may incur in penalties of up to 10% of revenues for each hour of downtime which would represent approximately $228,325 of revenue lost per hour down based on 2016 data. RAX mitigates this risk by designing datacenters with redundancies and constantly backing up data with replication among their 13 datacenters, which translated to a total stoppage of just 7.52 hours during 2014 (Figure 23). For 2016, in case total downtime exceeds 262 hours, loss of revenues and penalty fees would change our recommendation to a HOLD.. Unmanaged cloud providers could integrate forward and enter the space to compete directly with RAX, leveraging an already extensive global network of professionals and clients. We believe this is unlikely to take place any time soon as AMZN, GOOG and MSFT have focused their strategy on their core business, outsourcing managed cloud services to hundreds of different providers to deliver this added value to their clients. Other sources of competition include startups that offer managed services through partnerships with big IaaS providers, which may allow them to gain important market share in the managed cloud segment becoming direct competitors for RAX. Our recommendation would change to a HOLD if RAX’s share of managed cloud services atop unmanaged cloud providers does not reach at least 6.25%. The further development of SaaS as the predominant business model for cloud services could reduce workload processing needs for RAX's customers due to centralization of infrastructure in the SaaS provider. With most new software being built for cloud from the outset, it is predicted that by 2016 over a quarter of all applications (approximately 48M) will be running atop the cloud. Worldwide SaaS market is expected to grow at an astounding 20.2% CAGR from $18.2B in 2012 to $45.6B in 201725. Increase in the availability of cheap skilled labor could render RAX’s managed cloud services less attractive by lowering in-house cloud management costs for businesses. A potential catalyst of higher skilled labor availability might be changes in migration laws that could potentially generate an accelerated influx of IT professionals, especially from India, lowering IT personnel hiring costs to the point where RAX’s service offerings no longer makes sense financially. Currently, Visas like the H-1B allow companies to employ foreign workforce for lower salaries which received support from some congressmen that intend to enact a bill to triple the amount of such visas being issued. In the industry, the costs savings of hiring an H- 1B over an American are approximately 43%. . “SOURCE:TEAM ANALYSIS
  • 11. Accelerated disruptive innovations could lead to “autonomic computing” of most of the tasks offered by managed cloud providers, rendering RAX’s services unnecessary for most companies. Startups like CloudHealth Technologies have been working on platforms to perform IT cloud service management through automated governance rules or artificial intelligence instead of manual processes. This technology is still in early stages of development and might take years for full commercial use. Additionally, disruptive technologies, especially enterprise oriented innovations, tend to hit mainstream status after 3-5 years in the market, so we wouldn’t expect any new technology to affect RAX business at least until 2021, when cloud autonomics’ impact could change our recommendation to a HOLD if Fanatical Support for Third Party Clouds projected revenues were cut by 80%. Over 30% of RAX’s revenue is generated in foreign currency, especially GBP. Strengthening of the US Dollar against other currencies could lead to a reduction in revenues from foreign subsidiaries. Serious economic slowdown, especially in the US and UK where most of RAX’s revenues are generated, could impact its sales growth as IT has historically been an early budget-cut casualty in most recessions when companies are expecting lower or inexistent progress. Economists at reputable investment firms put the chances of a recession within the next 5 years above 50% (Table 11). Even though it is rare for economists to accurately forecast a recession, in the US they occur every 5 years on average. Additionally the Chauvet Model (“An Econometric Characterization of Business Cycles with Factor Structure and Markov switching") to calculate the probability of a recession sits close to 25%, up from 5% last year. We don’t expect RAX to be significantly affected by slight contraction in GDP since back in 2008 and 2009 they managed to grow revenues by 46% and 18% respectively despite the deepest recession in more than 70 years. However if revenue growth were to fall below xx% due to systemic slowdown, our recommendation would change from a BUY to a HOLD. As part of our growth projections, we expect RAX to take on more debt in the medium term to finance growth. The Federal Reserve increased the interest rate a quarter of a percentage point on December 2015 and Janet Yellen suggested more increases in the future. These raises will likely increase interest expenses for the company in future debt transactions, impacting the bottom line. Should conditions result in RAX having a cost of debt above the 13.03% mark, it would change our recommendation from a BUY to a HOLD. “SOURCE:FIRMS’WEBSITES
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  • 26. As part of management decision making process before undertaking projects, an Economic Value Added (EVA) analysis must be conducted. This, in order to assess if economic profit added through the years has been in line with shareholders’ required returns. RAX’s CFO Karl Pichler is an alumni of Stern Stewart, who developed the methodology. 780.6 1,025.1 1,309.2 1,534.8 1,794.4 2,000.1 79.6 123.5 172.7 133.1 167.5 189.6 (27.9) (42.4) (64.3) (44.8) (51.5) (63.5) 51.7 81.0 108.4 88.3 116.1 126.1 497.4 609.4 698.5 872.0 1,031.1 1,203.1 9.4% 9.4% 9.4% 9.4% 9.4% 9.4% 5.1 24.0 43.0 6.7 19.6 13.5 $400,000 $790,361 $1,749,878 $2,940,239 $3,071,372 $2,636,855 $12,721,045 $18,429,272 $3,471,372 $3,427,216 $14,470,923 $21,369,511 $400,000 $367,515 $0.00 $767,515 $2,180,038 $1,567,167 $6,314,752 $10,061,957 $2,580,038 $1,934,682 $6,314,752 $10,829,472 $566,519 $536,418 $11,399,910 $12,502,847 $1,645,281 $2,060,984 $7,825,850 $11,532,115 $2,211,800 $2,597,402 $19,225,760 $24,034,962
  • 27. In order to assess RAX’s Corporate Governance, its strength and weaknesses, we resorted to the Institutional Shareholder Services (ISS) Rating Methodology. This scoring tool was applied in order to identify and assess risks within RAX’s Corporate Governance structure. 10 Insignificant threat to Shareholders 8 Low threat to Shareholders 6 Moderate threat to Shareholders 4 Significant threat to Shareholders 2 High Threat to Shareholders 8/10 20% 0.16 8/10 35% 0.28 6/10 20% 0.12 7/10 25% 0.18 7.35/10 100% 73.50 Company maintains independence guidelines set forth by SEC and NYSE. An example of this is Mr. Weston, former Chief Executive Officer, who was an employee of the Company prior to 2015 and is therefore not “independent,” so the Board of Directors has appointed Michael Sam Gilliland as its lead independent director, or “Lead Director”, to preside at all executive sessions of “non-employee” directors, as defined under the rules of theNYSE. In the last year board and CEO compensation growth has far outpaced stock price growth. The board maintains this compensation package was designed to retain executivetalent. Graham Weston, member of the Real Estate & Finance committee. RAX has leased office space to Santa Clara Land Company, Ltd, of which Graham Weston is a minority partner. Mr. Weston’s interest in this transaction would be approximately $84,732.53. Audit Committe believes the terms of this transaction are no less favorable to the company than could have been obtained from unaffiliated third parties.
  • 28. Company maintains independence guidelines set forth by SEC and NYSE. An example of this is Mr. Weston, former Chief Executive Officer, who was an employee of the Company prior to 2015 and is therefore not “independent,” so the Board of Directors has appointed Michael Sam Gilliland as its lead independent director, or “Lead Director”, to preside at all executive sessions of “non-employee” directors, as defined under the rules of theNYSE. In the last year board and CEO compensation growth has far outpaced stock price growth. The board maintains this compensation package was designed to retain executivetalent. Graham Weston, member of the Real Estate & Finance committee. RAX has leased office space to Santa Clara Land Company, Ltd, of which Graham Weston is a minority partner. Mr. Weston’s interest in this transaction would be approximately $84,732.53. Audit Committe believes the terms of this transaction are no less favorable to the company than could have been obtained from unaffiliated third parties. We deem this favorable. CEO does not serve on other boards. 3 members sit on 0 boards. 3 members sit on 1 board. 1 sits on 2 boards. 1 sits on 3 boards. The only director who sits on excessive boards is 1 who sits on 8 boards Non Audit fees represent 0% of total fees. No member of Audit Committe may sit on more than 3 other boards. Two financial experts sit on this committee, one CPA and one MBA. Classified board. Board has power to emit blank check preferred stock. No poison pill. Founder is chairman of the board. CEO and Executive compensation plan is performance based. Company requires 3x salary worth of stock ownership. Company ranks third highest among its peers in insider ownership with a 14.79% insider ownership. RAX uses Say-on-Pay and lets shareholders vote on compensation packages. There is no unequal voting structure, all classes of stock can vote for all directors. The board is scheduled to hold its regular meetings at least once a quarter, at least one additional time per year to review and approve yearly goals and operating plans. In practice the board of directors held 19 meetings during the year ended December 31, 2014. Each director attended at least 75% of the aggregate of the meetings of the Board of Directors and of the committees on which he or she served during the period for which he or she was a director or committee member, respectively. They can serve three years, but can stand for reelection. Although the company lacks formal term limits, approximately nine to twelve years of service is an expected commitment for any individual director. For example, Mr. Mellin and Mr. Bishkin, consistent with the Company’s guiding principles for Board development and succession, have declined to stand for re-election in 2015 and will not be directors following the annual meeting.
  • 29. RAX strives to support Self-funded startups and entrepreneurs affiliated with Accelerators, Incubators, Universities and Venture Capital Firms. Through this program, qualified startups can benefit from up to $2,000 per month in free hosting for a year as well as RAX’s Fanatical Support® and expertise to accompany them in building applications and scaling on the cloud. CloudU™ is a cloud curriculum for IT professionals looking to reinforce their knowledge of Cloud Computing. The program, designed through a collaboration between RAX and industry analysts, offers access to a comprehensive database of educational resources aimed at increasing cloud computing knowledge among businesses. Given its vendor- neutral nature, CloudU™ is open for anyone who is interested on cloud adoption, regardless of vendor or platform. RAX’s global initiative focuses on three pillars: People, Planet and Pocket. • People: The core of RAX’s social responsibility programs resides on its service culture and thus on the Rackers who volunteer to be part of the environmental solution and give Fanatical Support to the communities in which the company operates. • Planet: As part of its decision-making, RAX integrates both energy conservation & efficiency into for building, buying and operating. • - Pocket: Finding the best sustainable choices which are also financially efficient and effective by empowering customers, through corporate responsibility and maximizing stockholder and customer long-term value. Being an employee-led volunteer force, the program supports the community by focusing on three main areas: offering grants aimed at arts and culture in order to establish a creative class of citizens; education, specifically related to STEM; and technology. Rack Gives Back includes employee volunteerism, corporate funding and grants and The Rackspace Foundation. Founded in 2009, The Rackspace Foundation functions as a public charity that focuses on elevating the community on RAX’s headquarters’ surrounding neighborhood. Primarily funded through payroll contributions, The Foundation invests on non-profits that work in school and afterschool based programs.
  • 30. As cloud computing becomes increasingly mainstream, the challenges faced by enterprises for adopting these technologies account for the rapid growth of the managed cloud market. Since this segment is expected to have strong long-term revenues, it is highly attractive for new competitors with regulation in the sector still in its early stages, presenting low or no entry barriers for new players. Given the company’s nature of being capital intensive, high sunk costs are incurred when setting up the infrastructure. New entrants could work around that and partner with unmanaged cloud giants to offer their services on top of their infrastructure and thus benefit from their economies of scale, stablished customer base and growth in the industry. However, these companies are wary of their reputation and partnerships require a solid track record. Furthermore, economies of expertise are a solid barrier to entry, given the low availability of skilled labor. These conditions somewhat limit the entrance of new players, hence we assess this as a MODERATE threat for the business. Electricity providers are one of the most important suppliers of the business in terms of cost of revenue, but as a heavily regulated industry with commoditized prices, there is low threat of electricity suppliers exercising bargaining. Other important suppliers include hardware and connectivity, both of which are commoditized and not concentrated, none of these are monopolistic industries and switching costs are relatively low. Moreover, RAX’s service centric business model puts a lot of weight on talent as a “supplier”. Even though there is a shortage of qualified personnel, none of RAX’s 6,000+ employees are represented by a collective bargaining agreement. We assess the bargaining power of suppliers as posing a LOW threat to the business given the stated analysis. There is a HIGH threat of substitute products as customers of managed cloud services might see more added value in other options such as handling computing in-house in their own datacenters which provides flexibility and oftentimes lower lead times; Outsourcing their IT infrastructure to a service provider, ensuring standardization and usually qualified professionals; Opt for the unmanaged cloud services which provides the cheapest option and higher level of flexibility. The impact of this threat depends on the cost of specialized IT staff and infrastructure engineer and the level of flexibility required by companies as technology becomes a more integral part of business, often requiring lower lead times. The different options available to businesses to fulfill their IT needs leads us to assess the threat of substitute products as HIGH. As stated, RAX’s customer base is solid (average monthly churn of 0.6% for 2014) and well diversified (300,000+ customers) with no single client representing more than 2% of revenues. Even though there are many providers in the segment, customers face high switching costs when trying to change from one vendor to another due to proprietary technologies, the industry’s lack of common protocols and standards, and the service provider’s experience and understanding of the customer’s technology backbone. Given RAX’s diversified customer base and the limitations for switching cloud service providers, we assess the bargaining power of customers as MODERATE. We assess the competitive rivalry within the managed cloud segment as being MODERATE due to its high fragmentation, having a broad set of players with multiple delivery models. Competition is increasingly becoming more intense as the segment continues to grow and develop. Given that revenues for the segment are driven by the added value offered by vendors, said competition focuses on service differentiation as opposed to price cuts. Incentives to fight are present despite the stellar industry growth thanks primarily to the vast economies of scale that characterizes the cloud..
  • 31. Gartner’s Magic Quadrant positions technology players within a specific market. The assessment presents a broad view of the relative positions of the market's competitors, how well technology vendors are executing their stated visions and how they are performing against Gartner's market view. This assessment results in the positioning of the market players within four quadrants: Leaders - Have proved a powerful market position and technical competence, constantly innovate on current product offering, and have a reliable service for corporate-class needs being able to cater to a wide variety of customers by addressing a wide set of use cases with stand-alone or integrated solutions. Challengers - Have are known for delivering good service capabilities, nonetheless are trailing the market's evolution. Challengers are usually companies with sound legacy managed hosting services but have not exploited technology and market demand to develop cloud-enabled hosting services. Visionaries – Disruptive approach to the market mostly comprised of new, and limited, service portfolios. Visionaries have an early- mover advantage as well as roadmaps that may take them to a Leader position in the future. Niche Players – Either emerging vendors or specialists with a focused product portfolio serving a specific use case with a higher level than generalized vendors.
  • 32. In accordance to RAX’s business model, Gartner positions the company within its Magic Quadrant for Cloud-Enabled Managed Hosting along with other leading players both in North America and Europe. Nonetheless, even though RAX’s value proposition focuses in delivering over the top customer experience through its broad portfolio offering of managed cloud solutions, its Managed Hosting is still compared against unmanaged cloud giants such as AWS and Azure. According to Gartner’s Magic Quadrant for Cloud Infrastructure as a Service, the following vendors compete within this market: Amazon AWS - ranked as the highest IaaS provider in both ability to execute and holistic vision, AWS has 10 times the compute capacity utilization level of all other 14 providers in the IaaS Magic Quadrant combined. AWS is regarded as innovative and agile, serving the broadest range of use cases. The technology is reinforced by a wide network of partners that provide various IT professional services. Microsoft Azure – Currently Microsoft compute capacity utilization is twice as much than the 13 other providers in the IaaS Magic Quadrant. With Azure, Microsoft is developing an aggressive roadmap of new features and differentiated capabilities. Nonetheless, it’s still missing key security, flexibility and availability features. IBM SoftLayer – has a broad portfolio comprised of public, private and managed cloud products. Its strength resides on its product and service interoperability, as well as its consulting and outsourcing capabilities. Google Cloud Engine – Initiated only in 2012, has achieved an extensive experience with cloud-native application development and management. Cloud Engine is considered to offer an excellent value and prompt provisioning, being differentiated by platform and manageability features as opposed to price. However, Google is on the early stages of developing engagement with enterprise and midmarket customers, and still has a nascent partner program. VMware vCloud Air – focused on driving adoption by leveraging its already built influence in on-premise data centers and thus offering a coherent experience across VMware-based infrastructure. True to RAX’s focus on a customer centric service offering, it delivers a holistic portfolio of IT solutions based on added value for its business clients. As opposed to the unmanaged cloud providers, a more diverse and integrated service offering through diverse cloud form factors based on open source standards. According to Gartner’s Magic Quadrant for Cloud-Enabled Managed Hosting, the following vendors compete within the same “Leaders” quadrant as RAX: Datapipe: midsize hosting and cloud IaaS provider operating data centers in 7 locations in North America, and also has facilities in Europe and Asia-Pac. Datapipe has truly integrated its hosting and cloud IaaS capabilities with AWS and Azure. BT Global Services: Europe based provider of managed network, communications and IT services, focused on vertical industry solutions. Through its Cloud Management System offers business and bundling capabilities. Interoute – offers a comprehensive portfolio of networking colocation, hosting and cloud services, showing an structured offering from completely self-service to fully managed products. With data centers stablished across major European countries, Interoute is currently expanding to North America. Claranet – As managed hosting provider with a Pan-European presence, Claranet offers colocation, hosting, network and application services, including hybrid solutions through its partnership with AWS. The provider offers regionalized business services, thus offering solutions for data sovereignty and technical support. Claranet provides a different service approach for each country, resulting into an inhomogeneous solution portfolio. Colt - international network and provider of colocation and hosting services in Europe, U.S. and Asia. Due to its strong Pan-European presence, Colt is ahead of customers’ data sovereignty needs. The company heavily focuses on partnerships with large vendors making it subject to their roadmaps. IaaS Market Key Players Comparison Dedicated Hosting a a Public Cloud a a a a a a Private Cloud a a a a Hybrid Cloud a a a Customer Support a a Platform OpenStack Proprietary Proprietary Proprietary Proprietary Proprietary SLA Level 100% 99.99% 99.95% 100% 99.95% 99.95% SLA Credit Unmanaged: 5% / hour Managed: 10% / hour 10% of annual bill <99.9% - 10% <99% - 25% 10% - 50%
  • 33. AMZN has established a global partner tiered program, AWS Partner Network (APN), comprised of Consulting and Technology Partners, who advance through various stages based on engagement with AWS. Through its Premier Consulting Partner tier, AWS highlights the top global APN Consulting partners with extensive experience in deploying customer solutions on AWS, have a strong bench of trained and certified technical consultants, have at least one APN Competency, have expertise in project management, and have a healthy revenue-generating consulting business on AWS. Click here to learn more about becoming a Premier Partner. Considering the significant dependency of our DCF model in RAX’s ability to capture future market share from the manages services provided atop AWS, we regard as necessary conducting a thorough assessment of RAX’s direct competitors as a new AWS Premier Consulting Partner. 2nd Watch: AWS Premier Partner providing managed cloud to enterprises and helps automate the development, deployment, governance, procurement, financial management, migration and operations of over 400 enterprise workloads and approximately 75,000 instances in its managed cloud. Apps Associates LLC: is a global provider of business and IT consulting services. They help clients adapt and grow in a changing world of technology by focusing on innovation, process, workforce development and re-usable solutions. Aquilent – is a recognized leading provider solutions for federal customers with an emphasis on cloud computing, mobile and digital strategy, web content management, user experience and portal & application development. ClearScale – has the proven capability to build, deploy, automate and manage cloud architectures on AWS. Their core competency is delivering custom cloud projects and services for clients who have limited cloud expertise on staff or who need additional resources to execute better and faster. Based in San Francisco Area. Cloudnexa – deploys and manages cloud infrastructure for AWS clients. Their cloud management as-a-service from with no upfront fees or long-term contracts, architecture and migration services included. Cloud Technology Partners – is an innovative cloud consulting and professional services firm serving mid-market, enterprise customers and software providers. Its consulting expertise includes migrating applications and data to the platform, developing cloud-native applications on AWS, and architecting, building and managing AWS deployments. Corpinfo – A leading technology firm providing Cloud Consulting Services, Infrastructure Solutions, and Managed Services. They use their experience to ensure that clients have the best technical solutions to solve their business challenges and deliver value for their organization. CSC - CSC leads clients on their digital transformation journey, providing innovative next-generation technology solutions and services that leverage deep industry expertise, global scale, technology independence and an extensive partner community. Logicworks – is an enterprise cloud automation and managed service provider that combines advanced automation and DevOps capabilities with 22+ years of legacy IT experience. Mobiquity - is a mobile computing professional services firm helping clients design, develop and deploy custom mobile solutions. Pariveda Solutions Inc: is a leading management consulting firm specializing in improving their clients’ performance. Provide strategic consulting services and custom application development solutions for mobility, cloud computing, data, portals and collaboration, CRM, custom software, enterprise integration and user experience needs of their clients. REAN Cloud – A cloud-native firm with experience supporting enterprise IT infrastructures and applications. Their key differentiator is their experience in implementing complex and scalable architectures, which support secure, compliant operations in highly regulated industries such as the Financial Services, Healthcare/Life Sciences, Education, and Public Sector verticals. Smartronix - is a global professional solutions provider specializing in cloud computing, application integration and development, software and hardware engineering, networking and system management, and cyber security. TriNimbus: Leading DevOps service provider with DevOps and Big Data Competencies. The team focuses exclusively on AWS and its surrounding ecosystem to support customers who are using the cloud to elevate their culture, environment and operations to the next level. Wipro – leading Information Technology, Consulting and Outsourcing company, that delivers business outcomes through its industry experience and a 360 degree view of 'Business through Technology' – helping clients create successful and adaptive businesses.
  • 34. In order to evaluate internal and external factors that influence RAX’s current strategic situation, a SWOT Analysis was prepared that describes positive attributes, tangible and intangible, that allow RAX to differentiate from competitors; characteristics of RAX that detract from the value offered or places the firm at a competitive disadvantage; reasons RAX is likely to thrive and issues beyond the company’s control that could put the business at risk.
  • 35. We assessed the importance of each factor to RAX as graphed in the Y axis for strengths and weaknesses. In regards to the opportunities and threats our Y axis shows the probability of becoming materialized. Through the SWOT Analysis graphs we concluded that RAX's most relevant weakness is how it is pricier than other managed cloud solutions. Nonetheless, this is directly related to RAX’s highly specialized workforce, a key strength, a main differentiation that can allow them to capitalize on the opportunity of operating within a rapidly growing industry. We have identified as a the likeliest threat the development of new technologies that reduce engineering complexity such as Open Compute Project, Open Network Linux, Dockers and containerization.
  • 36. In order to assess and understand RAX’s financial results and thus verify its earnings quality, we used the Beneish M-Score Analysis (1999) for earnings manipulation detection. The M-Score is comprised of eight different variables that identify either financial statement distortions or indicate a firm’s likelihood of earnings manipulation: DSRI = Days’ Sales in Receivables Index • GMI = Gross Margin Index • AQI = Asset Quality Index • SGI = Sales Growth Index • DEPI = Depreciation Index • SGAI = Sales, General and Administrative expenses Index • LVGI = Leverage Index • TATA = Total Accruals to Total Assets The M-Score can be calculated considering 8 or 5 indices as follows: • 5-variable Model: M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717 SGI + .107 DEPI • 8-variable Model: M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI -.172 SGAI + 4.679 Accrual to TA - .327 Leverage M-Score lower than -2.22 – The firm is not likely to be a manipulator. M-Score greater than -2.22 – The firm is likely to be a manipulator. Based on the M-Score Analysis conducted, RAX is not likely to be manipulating its earnings results.
  • 37.
  • 38. Below we present the rationale behind our main assumptions. Our revenue assumptions are detailed as part of the written report. Beta – In order to assess RAX’s level of systemic risk, we calculated a Beta by regressing its historical monthly returns from January 2011 to December 2015 against each of the following indices: S&P 500, NASDAQ and Russell 1000. Our calculations revealed that the NASDAQ has a stronger correlation with RAX based on the resulting R-Squared of 0.25, meaning that 25% of variation in returns can be explained by that of said index. Moreover, said regression resulted on a P- Value of 0.01%, the smaller the value the stronger the evidence that observations are significant in predicting RAX’s returns. On the other hand, the S&P500 resulted on a weaker R-Squared of 0.2% and P-Value of 0.02%. Nonetheless, in order to be conservative, we used the S&P500 due to its higher value for Beta. Cost of Debt - At the valuation date, the market value of RAX’s debt was $451.9M with a yield of 8.04% (average yield of 7.0%). For the computation of RAX’s Cost of Capital we assumed the current yield to be its Cost of Debt. Debt/Capital – We expect RAX’s current Debt / Capital ratio of 22.7% to move towards that of its peers (48.6%). Therefore, we assumed a target ratio of 30% throughout the forecasted period. Cost of Revenue – RAX’s Cost of Revenue is mainly comprised of fixed items such as employee-related expenses and data center operation costs. In addition, RAX incurs in variable costs including, but not limited to, power and bandwidth. For the purposes of our 10-year projection, we analyzed the historical behavior of this cost item as a percentage of revenue over the period 2011-3Q15. As a result, we observed RAX’s Cost of Revenue has been stable with a standard deviation of 0.8%. Therefore, we assumed the mean of this sample to be our Cost of Revenue as a percentage of sales throughout our 10-year forecast base case. We ran a regression for the Cost of Revenue historical values against Total Net Revenue resulting in a 0.06% P-Value. This reassures that Total Net Revenue is statistical significant for determining the Base Case Cost of Revenue percentage.
  • 39. Research & Development – RAX first disclosed its R&D related expenses in 2011. For RAX, this item includes costs for employee and consultants focused on the deployment of new technologies and the development/enhancement of proprietary tools. For our forecast, we analyzed the historical behavior of this cost item as a percentage of Net Revenue over the period 2011-3Q15. The mean value for this sample was 5.2%. We do not foresee changes in RAX’s R&D activities. Thus, we assumed the mean as RAX’s R&D expenses as percentage Net Revenue for the Managed Hosting business segment throughout our Base Case 10-year forecast. We ran a regression for the R&D historical values against Total Net Revenue resulting in a 0.41% P-Value. This reassures that Total Net Revenue is statistical significant for determining the Base Case R&D percentage. Selling, General & Administrative – For our forecast, we analyzed the historical behavior of this expense item as a percentage of Total Net Revenue over the period 2011-3Q15. However, we deemed periods 2013 and 3Q15 to be outliers and did not consider them for the purposes of this analysis. Excluding said periods from the sample, we observed a mean value of 31.4% with a standard deviation of 0.3%. We assumed the mean to be RAX’s Selling, General and Administrative expense as percentage of Total Net Revenue throughout our base case 10-year forecast. We ran a regression for the SG&A historical values against Total Net Revenue resulting in a 0.2% P-Value. This reassures that Total Net Revenue is statistical significant for determining the Base Case SG&A percentage. Depreciation and Amortization – For our forecast, we analyzed the historical behavior of this expense item as a percentage of Total Net Revenue over the period 2011-3Q15. As result, we observed a mean value of 19.8% with a standard deviation of 0.7%. We assumed this mean value to be RAX’s Depreciation and Amortization expense as percentage of Total Net Revenue throughout our base case 10-year forecast. We ran a regression for the DNA historical values against Total Net Revenue resulting in a 0.01% P- Value. This reassures that these inputs have a statistical significance for determining the Base Case DNA percentage for the forecasted period. This reassures that Total Net Revenue is statistical significant for determining the Base Case DNA percentage. Cost of Revenue – The Cost of Revenue for this business segment will be mainly comprised of employee-related expenses, as well as reselling charges from Third-Party Cloud providers. In this regard, for the purposes of our 10-year forecast, we estimated these reselling charges to be equal to the projected Depreciation and Amortization expense of the Managed Hosting segment, 19.8% of its Net Revenues. This assumption is consistent with RAX’s management guidance as expressed during 3Q15’s earnings call. Furthermore, we expect the costs related to personnel to resemble RAX’s Cost of Revenue for Managed Hosting which translate to a 32.7% of Net Revenues. As a result, we estimate RAX’s Fanatical Support for Third-Party Clouds to deliver stable Gross Profit margins of 47.5% through 2025. Selling, General and Administrative – We considered RAX’s pre-IPO and IPO years to be an adequate proxy of the amount of resources that need to be allocated in order to best-position the new service offering. Therefore, we calculated RAX’s average Selling, General and Administrative expenses as percentage of Net Revenues for the three-year period 2006-2008 and assumed this value, 42.9%, for our 10-year forecast.
  • 40. Other considerations – This business segment is characterized for a high demand of human capital and lack of infrastructure needs. Therefore, in our forecast we do not expect RAX to incur in Depreciation and Amortization expenses or Capital Expenditures for Fanatical Support for Third-Party Clouds. This has been confirmed by RAX’s Leadership during its last earnings call. Accounts Receivable, net – RAX business is mainly based on a pay-as-you-use monthly model. Therefore, we assumed 30 days of sales outstanding to calculate its net receivables, slightly above RAX’s historical figures. Accounts Payable – Based of RAX’s number of days payable outstanding for 2014, which we assumed to remain constant throughout the forecasted period. Property and Equipment, net – Calculated based RAX’s Property and Equipment balance at the close of 2014, and the aforementioned assumptions for both CapEx and DNA. Accrued Expenses – Based on a fixed percentage of the Cost of Revenue forecasted for the Managed Hosting segment. Therefore, we calculated this ratio for RAX’s 2014 fiscal year and assumed this value, 11.5%, for our 10-year forecast. Other Current Liabilities – Based on a fixed percentage of the Cost of Revenue forecasted for the Managed Hosting segment. We calculated this ratio for RAX’s 2014 fiscal year and assumed this value, 5.6%, for our 10-year forecast.
  • 41.
  • 42. The Altman Z-Score, developed by Edward Altman, determines a company’s financial health. For publicly traded companies, this indicator is calculated as follows: (1.2*X1) + (1.4*X2) + (3.3*X3) + (0.6*X4) + (1.0*X5). Where: X1 – Working Capital / Total Assets X2 – Retained Earnings / Total Assets X3 – Operating Income / Total Assets X4 – Market Capitalization / Total Liabilities X5 – Sales / Total Assets Altman Z-Score below 1.80 – This is considered a distress zone indicating firm with a high probability of bankruptcy Altman Z-Score above 3.00 – This is considered a safe zone, indicating firms unlikely to a high probability of bankruptcy Based on the Altman Z-Score model, considering the financial information for the five year period 2011-2015, RAX has LOW probabilities of filing for bankruptcy.
  • 43. To identify a set of comparables for RAX, we screened all active companies registered in US exchanges under the SIC Codes below which we identified as the ones typically used for cloud companies and managed services providers. We also utilized cloud service providers’ rankings and awards as sources for the unfiltered list. Said screening was performed within three databases: Compustat©, Mergent© and OneSource©. The following set of criteria was used to weed out the companies from the original list:  Significantly different services  Financially distressed  Insufficient financial Information  Dissolved, bankrupt, privatized, merged or inactive  Significantly different functions  Significant government sales  Significantly different geographical markets  Insufficient description  Duplicate or related entities To deepen our analysis on comparability, we went through the details for each company individually, reading the Business Description section from the 10-K filing as well as the breakdown of revenues when disclosed. We only selected companies for our peer set that included outsourced infrastructure as one of their main sources of revenues and generated most of their sales in either US or UK. Our resulting list included 21 companies and REITs listed in US exchanges which service portfolio comprised one or more of the following services:  Cloud Infrastructure Outsourcing  Data Center Colocation  System Integrators / Data Center  Data Center Hosting With the final list of peers, we gathered data corresponding to standard financial metrics for each of the selected companies. When analyzing the data set, EBITDA showed the lowest dispersion thus we chose Forward EV/EBITDA as our valuation multiple.
  • 44. We used Forward EV/EBITDA as our independent variable and regressed it against the strongest underlying fundamentals of EBITDA which according to Damodaran are: (i) projected revenue growth, Estimated Annual Revenue Growth in the next 2 years, we used market consensus to capture as much information from the markets as possible; (ii) Debt/Capital, to consider differences in capital structure; and (iii) Effective Tax Rate. Our regression analysis was weighted based on market capitalization to account for the size of each company. We performed several sanity checks to our model and concluded that our regression could be used to predict the value of the multiple. In the first place, we assessed the statistical quality of the selected observations. For this we evaluated the existence of autocorrelation among observations by applying the Durbin-Watson method and resolved that there was a healthy independence among the chosen observations. Moreover, we confirmed no significant multicollinearity issue with the data. On the other hand, we assessed the significance of said observations for determining the Forward EV/EBITDA. Our model’s R-Squared stands at a healthy 0.645 which means that our measures of risk and growth explain 64.5% of changes in said ratio for companies in our sample. Furthermore, the significance level (P-Value) of 0.000 obtained shows that the regression model is a good fit of the data assuring a 95% confidence interval (Any value below .005 is accepted) and significance for each variable individually ranging from .003 to .045 (Any value below .05 is accepted). The "R-Squared" represents the coefficient of determination, which is the proportion of variance in the dependent variable (Forward EV/EBITDA) that can be explained by the independent variables (technically, it is the proportion of variation accounted for by the regression model above and beyond the mean model).
  • 45. The F-ratio in the ANOVA table tests whether the overall regression model is a good fit for the data. The table shows that the independent variables are statistically significant, meaning variation in the dependent variable’s results is explained by the independent variables as opposed to random chance (the regression model explains over 95% of variation with P-Value < .05) We tested for the statistical significance of each of the independent variables separately. With a P-Value lower than 5%, we concluded that the coefficients are statistically significant. The T-Value and corresponding P-Value are located in the "t" and "Sig." columns in the table below, respectively. Values in the “Sig.” column show that all independent variable coefficients are different from 0 and thus statistically significant Based on our model to predict Forward EV/EBITDA we arrived at a price for this methodology of $26.81 as follows:
  • 46. We performed a Monte Carlo Simulation to determine the possible outcomes of our financial model and their probability of occurrence. For this exercise we selected nine variables that we believe are of greatest impact for RAX’s Unlevered Free Cash Flow generation during the forecasted period. Five of these variables are directly related to the Managed Hosting segment while the rest pertain to Fanatical Support for Third-Party Clouds. For the Managed Hosting segment the Monte Carlo accounted for the following inputs: (i) OpenStack© Enterprise Adoption Rate [V1], (ii) Customer Gear Growth CapEx [v2], (iii) Cost of Revenue [V3], (iv) Selling, General and Administrative Expenses [V4], and (v) Depreciation and Amortization [V5]. Similarly, for Fanatical Support for Third-Party Clouds the following variables were considered: (i) Third Party Cloud Growth Rate [V6], (ii) RAX’s market share [V7], (iii) Cost of Revenue [V8] and (v) Selling, General and Administrative Expenses [V9]. For all of the aforementioned variables we assumed a triangular probability distribution. Therefore, we defined a most likely value to occur, a minimum value and a maximum value. The minimum and maximum values for V1, V6 and V7 were established based on our market analysis and insights from industry research firms. For the rest of the variables, to determine the minimum and maximum we used the Base Case value +/- two standard deviations (95% confidence interval) except for V2 for which we assumed the Base Case value +/- one standard deviation (67% confidence interval). After running 1 million simulations, we observed a probability of 54.03% of obtaining a target price per share consistent with our BUY threshold of 30% upside. Moreover, considering the 70% weight assigned to the DCF Analysis, we observe a probability of 35.8% of obtaining a target price per share that downgrades our recommendation for RAX. The Histograms below show the distribution of the resulting values of the simulation considering both a 100% and 70% weight for the DCF Model within the target price.
  • 47. Finally, from the Monte Carlo, we concluded that the variable with the highest impact within our model is V7, contributing to 30.7% of the variability in our price target as shown in the graph below. Therefore, RAX’s equity value could be diminished if not able to capitalize of its current and future partnerships with third party cloud providers. Independently from the Monte Carlo, and holding all growth variables unchanged, we performed a Sensitivity Analysis on the key inputs underlining the discount rate and Terminal Value computations. Specifically, we tested the RAX’s Terminal Growth Rate and WACC. Terminal Growth Rate – For our DCF Analysis to deliver a price estimate for RAX with at least a 30% upside, the Terminal Growth Rate must be equal to or greater than 0.69% (a decrease of 66% from the Base Case value). However, considering the 70% weight we assigned to our intrinsic valuation model, the Terminal Growth Rate would need to decrease from 2.02% to 0.16% for us to change our recommendation to a HOLD. Furthermore, even with a terminal 0.0% our recommendation would not turn into a SELL. WACC - For our DCF Analysis to deliver a price estimate for RAX with at least a 30% upside, the WACC must be equal to or greater than 10.09% (an increase of 8%). However, considering the 70% weight we assigned to our intrinsic valuation model, the WACC would need to increase from 9.36% to 10.35%% for us to change our recommendation to a HOLD. Furthermore, a WACC greater than 13.43% (an increase of 43.5%) would be necessary to turn our recommendation to a SELL.
  • 48.
  • 49. During the first half of 2014, after RAX’s former CEO Lanham Napier retired, the company was rumored to be an acquisition target for large Telcos and tech companies including IBM and HPE. Based on this event, and considering that the cloud computing industry is characterized by a high M&A activity, we decided to conduct a brief research of the industry’s M&A track record. Sept. 15, 2015 – Accenture (NYSE: ACN) entered into an agreement to acquire Cloud Sherpas, a leader in cloud advisory and technology services specializing in Google, Salesforce and ServiceNow. The move will further strengthen Accenture’s position as a cloud services provider and enhance its ability to provide clients with cloud strategy, technology consulting, and cloud application implementation, integration and management services. May 26, 2015 - Storage giant EMC Corporation announced the acquisition of cloud computing management software and IaaS provider Virtustream for $1.2B. The acquisition could help the company expand its presence in the growing cloud computing domain and improve its range of offerings. Sept. 11, 2014 - HPE announced a definitive agreement to acquire Eucalyptus, a provider of open source software for building private and hybrid enterprise clouds. Since introducing HPE Helion in May 2014, HP shares in private cloud grew and was ranked as the leader in the Forrester Wave report for Private Cloud Solutions. HPE expects the acquisition to close in the fourth quarter of its fiscal year 2014. Terms of the deal were not disclosed. Oct. 16, 2014 - Ericsson (NASDAQ:ERIC) announced its acquisition of Redwood City, CA-based Sentilla Corp., a provider of IT infrastructure intelligence software. The deal was aimed at enhancing Ericsson’s ability to help service providers support IT organizations that are struggling to overcome new network complexities introduced by mobility and the cloud. Aug. 19, 2014 - Datapipe, a global provider of cloud and managed services and a Leader in Gartner’s Magic Quadrant for Cloud Enabled Hosting, announced its acquisition of managed hosting and cloud company Layered Tech. The acquisition was aimed at fueling Datapipe’s continued growth and leadership in delivering managed cloud services, as well as its expansion into the Government sector with FISMA and FedRAMP compliant Federal cloud offerings. Jan. 27, 2011 - Verizon Communications Inc. (NYSE: VZ) paid $1.4B to acquire Terremark Worldwide Inc., an operator of data centers, in an effort aimed at selling more computing services to business customers. The deal came as telecom operators are moving deeper into selling processing power, data storage and software hosting services over the Internet as their landline businesses shrink. The acquisition could help VZ secure more cloud computing deals and compete with companies like Amazon.com Inc. SOURCE: Companies’ press releases
  • 50. In order to gauge market sentiment on RAX, we used a variety of tools like Heckyl and Cityfalcon, as well as standard ratios. According to Heckyl proprietary research, sentiment dipped mid-january when the stock was being dragged down with the market by worries of a slowdown. We have seen so far how the sentiment has rebounded and is now trending upwards into positive territory again (above 0) Source: Heckyl Cityfalcon’s data points out to an uptick in the number of stories, including a downgrade by Zacks research on their stock recommendation. Nonetheless, sentiment on RAX has been recovering slightly despite a bigger peak later that contain positive news such as RBC and Cowen Capital reiterating BUY recommendation. Source: CityFalcon Among analysts, the consensus seems to be that the stock is still a BUY, despite recent downgrades by investment firms. Out of 20 analysts in the Dataset, at least 60% rates the stock as an either BUY or OUTPERFORM with 25% rating the stock as SELL or UNDERPERFORM. Source: Heckyl
  • 51. Capital IQ also shows a similar situation, with most analysts hovering around the 30 mark for RAX as a target price with a steep drop back in August 2015 due when the stock price was closer to the 50s. Source: Capital IQ Of the 11 publicly disclosed analysts’ recommendations on Capital IQ: 1 advised a SELL, two more a HOLD and 8 issued a BUY on RAX. Source: Capital IQ Another trend worth noting is that 80% of hedge funders tracked by Heckyl have been adding to their positions on RAX while the other 20% have been either reducing their positions or dumping the stock all along. Source: Heckyl Target Price Recommendation Evercore ISI 33.00 E Hold (3) Analyst Schildkraut, Jonathan A. Schildkraut, Jonathan A. FBN Securities, Inc. 31.00 E Sell (5) Analyst Seyrafi, Shebly Seyrafi, Shebly Jefferies LLC 33.00 E Hold (3) Analyst McCormack, Michael McCormack, Michael JMP Securities 55.00 E Outperform (2) Analyst Walravens, Patrick D. Walravens, Patrick D. Morningstar Inc. 32.00 E Buy (1) Analyst Summer, Rick Summer, Rick Needham & Company - Hold (3) Analyst - Kugele, Richard Oppenheimer & Co. Inc. 43.00 E Buy (1) Analyst Horan, Timothy K. Horan, Timothy K. Pacific Crest Securities-KBCM 45.00 E Buy (1) Analyst Bowen, Michael George Bowen, Michael George Raymond James & Associates 48.00 E Buy (1) Analyst Louthan, Frank G. Louthan, Frank G. Wells Fargo Securities, LLC - Buy (1) Analyst - Powell, Gray William Blair & Company L.L.C. - Buy (1) Analyst - Breen, James D.
  • 52. But still, the float for the stock has been increasingly negative, meaning a possible trend reversal and the selloff of the stock. We attribute this partially to recent turmoil affecting the overall markets, but investors are starting to short the stock signaling a bearish view on RAX. For the last six month short interest ratio has been on a rollercoaster, but steadily increasing the last few months. We assessed the overall sentiment of the market for the stock as improving and this should reflect in a better short ratio over the next few months. n this graph we can see that for the 50 day moving average the stock has a $52.50 stock price resistance. We can also see that the stock has broken its support of $27.00 and is now trading at $19.53. The graph shows the trailing twelve months with its Bollinger Bands and with two overlays, the 200 day moving average and 50 day moving average.