Wealth Management Research
28 September 2010
US Equities Telecommunication Services
Rackspace - cloud growth; raising price target
■
We are raising the price target for
Rackspace
Hosting
(RAX)
to USD
27 from USD 23, primarily due to our expectations for stronger and
greater than previously expected revenue contribution from Enterprise
customers and cloud hosting services.
■
We believe that an expanding suite of cloud services like "Windows for
the Cloud", which doubles RAX's addressable cloud market, should help
to accelerate cloud revenues.
■
We think that the announced inclusion of RAX in the S&P MidCap
400 Index by 1 October 2010 should create increased demand from
index funds and from managers that use the index as a benchmark. We
would expect this to increase liquidity in the stock, which could attract
additional investor interest.
WMR S&P Telecommunication Services Sector Allocation
Moderate Underweight
Strong enterprise customer and cloud hosting revenue growth
We are increasing our price target for
Rackspace
Hosting
(Outperform) from
USD 23 to USD 27, primarily due to our expectation for an accelerating
revenue growth contribution from Enterprise customers and cloud services.
We also have a more positive view on the company’s capital efficiency in
light of increased 2Q 2010 free cash flow growth generation. We believe
that this may help to allay some investor concerns regarding margin and cash
flow pressures due to investments in growth. Rackspace is solely devoted to
dedicated hosting (physical data center) and cloud hosting (data services over
internet). Managed Hosting and cloud hosting accounted for 88% and 12%
of 2Q 2010 total revenues, versus 89% and 11% in 1Q 2010, largely due to
accelerated sequential quarterly 2Q 2010 growth in cloud hosting revenues.
Most of RAX’s current installed customer base is small- and medium-sized
businesses, but RAX’s increasing suite of cloud service offerings is leading to
rapid growth in large enterprise customers that are particularly focused on
cloud services.
Rackspace Hosting (RAX) Outperform
Price (USD) WMR Target Upside / (Downside) 52 Week High 52 Week Low 24.34 27.00 11% 24.70 15.15 Key Metrics 2011E P/E(x) Dividend Yield (%) Total Assets ($M) Total Equity ($M) 44.25 0.00 668.6 349.4
Consensus Forecasts(Fiscal Year End) 12/2009 12/2010E 12/2011E
Sales ($M) 629.0 772.5 929.5
Net Income ($M) 31.8 47.5 73.0
EPS 0.24 0.36 0.55
Book Value per Share 2.82 3.32 4.11
P/E(x) 101.4 67.6 44.3
ROE(%) 9.8 13.0 15.2
Consensus Rating Distribution Buy Hold Sell
87% 13% 0%
Price Target Rationale
Rackspace, Inc. provides managed hosting solutions. It offers Web servers, application servers, virtualization, email solutions, database and security services, and storage & backup services. The company was founded in 1998 by Dirk J. Elmendorf and Patrick Condon and is headquartered in San Antonio, TX.
The valuation is based on RAX trading at 10.8x (10x previously) 2011 EV/EBITDA target multiple applied to WMR estimated 2011E EBITDA of USD 335 million. Risk factors include larger financially stronger competitors like Amazon, potential difficulty in hiring employees with technical expertise required for its service business model, and near term margin pressure due to investments in growth.
We believe that enterprise revenue growth at RAX is likely to be greater than
our previous expectations due to: 1) increasing corporate demand for
receiv-ing dedicated and cloud services from the same provider; 2) expansion in
RAX’s suite of cloud service offerings, with the recently launched “Window
for the Cloud” offering doubling RAX’s addressable cloud market (previously
limited to Linux operating system workloads); 3) the offering of higher
mar-gin service level agreements to corporate customers (SLAs); and 4) likely
creased channel distribution with new channel partners (current partners
in-clude XO Communications and Ingram Micro). In light of RAX’s sequential
2Q 2010 cloud revenue growth of +21% versus +13% in 1Q 2010, solid 2Q
2010 bookings, and 8% higher cloud revenues per customer, we expect 2H
2010 and 2011 growth to be greater than our previous expectations and in
the 24-25% range year-over-year.
We think that RAX’s ability to offer both dedicated managed hosting and
cloud services allows it to differentiate itself from Amazon, which focuses
exclusively on Cloud services with very limited service support. About 15-20%
of RAX customers use both dedicated hosting and cloud hosting services (vs.
0% of RAX's customers in early 2009). We view RAX’s Open Stack offering,
which provides the code to allow any developers to create application service
offerings for Rackspace’s cloud platform, as a medium-term positive. We also
think that additional 2011 revenue upside could come from this year’s launch
of cloud services by Rackspace in Europe. On the other hand, we expect the
growth in revenues from the company’s installed base of customers to slowly
recover and be dependent on the economy.
Raising Rackspace price target to USD 27 from USD 23
The new price target reflects an 10.8x 2011 EV/EBITDA target multiple (10x
previously) applied to WMR estimated 2011E EBITDA of USD 335 million.
We think Rackspace's current 2011 EV/EBITDA of 9.7x, which compares with
its 7.6x peer group average, is inexpensive in the context of a substantially
stronger growth outlook at RAX vs. its peer group.
Investment Thesis Summary - Diversified Telecommunication Services
UBS WMR Energy: Diversified Telco Svcs - Sector Outperform List
Company
Ticker Investment Thesis Summary
CenturyLink CTL
We expect CTL to benefit from merger synergies with Embarq and strong Price/FCF per share growth. We also expect the company to benefit from the announced merger with Qwest as a result of operating, strategic, regulatory, and financial benefits.
Crown Castle Inc CCI Our Outperform on Crown Castle is based on strong secular growth drivers, increased financial flexibility, and the likelihood of increased 2H2010 share buybacks that could serve as a catalyst for stock appreciation.
Equinix EQIX
We think that Equinix has a strong value proposition based on a first-to-market global presence with large data centers and substantial carrier/networks. We think that strong demand and Equinix's differentiated business model should allow it to continue to drive double digit EBITDA and EPS growth. Valuation appears relatively inexpensive at 12.5x trailing EV/EBITDA vs. its 5 year average of 25.8x.
Qwest Communications Q
Our Outperform on Qwest is based on their strong track record of restructuring and free cash flow generation and our expectation of enterprise revenue growth. It is also based on the announced acquisition of Qwest by CenturyLink at USD 6.02 per share (price may fluctuate based on share ratio) that is expected to close in the next 9 months.
Rackspace Hosting RAX
Rackspace has a differentiated business model which includes dedicated and cloud hosting and a focus on customer service, a solid long term track record, and a strong revenue growth profile. Cash flow and profit growth should be strong, supported by large enterprise and cloud growth opportunity and gradual cyclical rebound in small business demand.
SBA Communications SBAC
Our Outperform on SBAC is based on reduced debt leverage and extended maturities, financial flexibility for share buybacks or tower acquisitions, strong free cash flow growth, and potential for above-average near term growth based on its smaller size relative to peers.
UBS WMR Energy: Diversified Telco Svcs - Sector Underperform List
Company
Ticker Investment Thesis Summary
Frontier Communications FTR
While the dividend appears sustainable, we consider company forecast merger cost synergies to be difficult to achieve and expect the stock to be under pressure until the closing of the merger and a tapering off of expected selling of Frontier shares by Verizon shareholders.
Windstream Communications WIN
We expect strong cable broadband and telephony competition and wireless competition, risk of increasing capital expenditures on its network as the company seeks to increase business revenues, expect low single-digit declines in revenues, and see significant exposure to the potential reduction in Universal Service Fund subsidies.
UBS WMR Energy: Diversified Telco Svcs - Sector Marketperform List
Company
Ticker Investment Thesis Summary
AT&T T
We are more positive on AT&T based on improving fundamentals resulting from a gradual recovery in enterprise employment and spending, new wireless data plans with tiered pricing, strong iPhone sales, lowered investor expectations, and an over 6% dividend yield.
Verizon Communications VZ
We believe that the outlook for Verizon's stock has improved due to gradually increasing enterprise employment and spending, likely stabilization in wireline margins due to cost cutting measures, and a near term rebound in wireless net contract subscriber additions and data plans due to its 2010 fourth generation buildout to 100 million homes.
Source: UBS WMR as of 27 September 2010
Appendix
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Terms and Abbreviations
Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition
1H, 2H, etc. or 1H07,
2H07, etc.
First half, second half, etc. or first half 2007,
second half 2007, etc.
1Q, 2Q, etc. or 1Q07,
2Q07, etc.
First quarter, second quarter, etc. or first quarter
2007, second quarter 2007, etc.
2007E, 2008E, etc.
2007 estimate, 2008 estimate, etc.
EV
Enterprise value = market value of equity,
preferred equity, outstanding net debt and
minorities
Appendix
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