Return of the Rack
"So I'm back up in the game / Running things to keep my swing"
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Mark Morrison’s Return of the Mack is an all-time song. It’s one of those jams that you can just put on and instantly sink into a very specific vibe. The ironic thing is that I don’t think I have ever really read the lyrics, but I understand very deeply the emotions and feelings Morrison is trying to convey: he’s back, and there’s nothing you can do about it.
What if I told you this was a good allegory for the upcoming Rackspace Technologies IPO? Would you think that I was just fishing for correlations in order to make the pun in the title of this blog work? You might be right, but it doesn’t change the fact that Rackspace has returned, and their timing couldn’t be more interesting.
If you are unfamiliar with Rackspace, you should know that it’s a pre-dotcom-bubble founded company, started in 1997 as an internet service-provider. After a couple of pivots, twists, and turns, the Company realized that a lot of it’s potential clients were more interested in “outsourced-hosting” services and started building a business around that. After receiving some funding from Sequoia and Norwest, among others, and moving it’s headquarters to Texas, the Company went public for the first time in 2008. The IPO got beat up (it was August 2008, after all), and lost 20% of it’s value at the end of the first day of trading. And after a rocky couple of years, Apollo announced they were taking Rackspace private in 2016. Of course, it’s more complicated than that, but those are the spark-notes.
So after all of that, Rackspace dropped their S-1 at the beginning of July, announcing that they would be returning to the world of public equities, this time, bigger, better, and stronger (right?). Also, during a time when Cloud stocks are hotter than ever.
WisdomTree Cloud Computing Fund:
The above year-to-date chart may look rather pedestrian during any other year, but in 2020, a 55% return is pretty dang good. Especially if you consider that the index dumped off a decent chunk from an all-time-high two weeks ago (right around the time Rackspace dropped their S-1). Now, to be fair, these are not necessarily “cloud” companies per-say, really just “cloud-enabled” companies. But the point still stands.
So what has changed since the company was last public, other than friendlier public markets? Well, let’s take a look at the S-1.
First, the first sentence of the second paragraph of the Our Business section pretty much sums up the market demand for cloud companies: “Cloud technology—the on-demand availability of compute, storage and networking—has revolutionized how companies manage their infrastructure and applications, providing businesses with greater flexibility and lower costs compared to legacy technologies.” That’s the basic gist of why everyone is so psyched about cloud computing - whether you have noticed it or not, cloud computing is as ubiquitous as personal computers and smart phones. Actually, scratch that: Cloud Computing, Personal Computer and Smart Phones are all ubiquitous because of each other. The advances in cloud-computing have driven the past decade+ of technological software innovation. And Rackspace has certainly been a part of that story.
One of the other nice things about cloud technologies? The unit economics. The Company’s revenue per employee for 2018 and 2019 were $372K and $375K, respectively. This is particularly impressive when you consider one of Rackspace’s big pitches: their world-class customer service (let’s get to that in a second). Now, I am not a paying customer myself, so I can’t speak to it, but they do devote a lot of resources to that core area.
Since the Company’s go-private event, they claim to have improved their go-to-market strategy by offering multicloud products instead of single point solutions. But what the heck does that mean? If we are reading between the lines, it basically means that the company has become a services provider - a consulting firm - instead of a technology provider. They still have plenty of technology backing their main products up, but the Company’s competition is more IBM and Accenture and less AWS and Azure.
Rackspace is also targeting larger, enterprise-size companies. This is an interesting point, because no matter how you slice it, Rackspace’s addressable market is enormous ($500bn+). But by going after whales, they can provide more consulting services because, in theory, the implementation of cloud products and tools becomes more complicated. Not a revolutionary thought or anything, but does back-up the idea that the company has moved toward a consulting model.
Of course, whenever there is a huge market like this, there is bound to be some competition. But still, the Company should be experiencing some significant tailwinds, even before you factor in the world’s even further acceleration to cloud due to COVID-19. 2017, 2018, and 2019 should be pretty strong years.
However, from a topline perspective, Rackspace didn’t do much to write home about. The Company’s revenue growth rate over the past three years has relatively stalled out. To put it in perspective, when the Company was acquired in 2016, it reportedly had more than $2 billion in annual revenue. So if we are being generous, the Company has managed to improve revenue by $500 million since it was acquired. Although impressive, that seems rather paltry considering current cloud-trends. I thought there was a cloud bull-market going on?
The Company’s operating income paints a similarly confounding picture, with upside-down economics in 2017 and 2018, until eventually turning a corner in 2019. Of course, the 2018 figure is largely due to an impairment of goodwill of $295 million. This goodwill charge is due to writing down the Company’s Private Cloud Services component due to decreased earnings and missed budgets.
The company takes one of it’s biggest bottom line hits in interest expense, which is almost entirely responsible for the Other Expenses line item. This has to do with Rackspace’s massive debt load, which we will get to in a second.
The Company, like many massive LBO’s, still has mountains of debt. Which is not always such a big problem, but they also don’t have mountains of cash or strong cash flows. The Company, as of 3/31 has $125 million of cash on hand, with over $5.7 billion of long-term liabilities (most of which is debt from the Apollo acquisition or on-going operations)
So what are some of our takeaways here? Rackspace has reoriented itself as a services firm - it’s solutions are all service / consulting heavy. When you look up Rackspace competition, it’s a bunch of consulting firms that pop up. Rackspace is not a competitor of AWS or Google Cloud - Rackspace is a service provider for those platforms. So while their gross margins are relatively strong, their SG&A expenses are that of a consulting firm, which is not super-desirable for a company trying to pitch itself as a tech-wave-to-ride.
But the companies getting the best multiples are technology companies that could fit into the cloud computing index. And that’s exactly what Rackspace is trying to convince the market that it is - a tech company, not an IT installer. While that may be a reach, it certainly is both. This is a story we see a lot these days, with companies utilizing traditional business models masquerading as tech mavens.
But this isn’t some VC-backed upstart selling this story. It’s a PE-backed, debt laden monster who doesn’t have a good growth story to sell. For these reasons, it’s going to be a tough road ahead for Rackspace and I am dying to see if they can figure it out.
From a few weeks ago, Turner Novak’s interview with Patrick O’Shaughnessy was incredible. The Invest Like the Best podcast has been on a hot streak recently and I cant recommend this one enough. A couple of my favorite topics:
The rise of TikTok - probably some of the best conversation I have heard about one of the biggest social media platforms that has torn through 2020. I don’t think I have heard anything so well put on the topic all year.
The story of Pinduoduo - more on that in the next link.
Fantasy Draft Portfolio - I have heard about his paper venture portfolio before, but it was cool to hear him rehash it now that he is actually managing a venture fund of his own.
The rise of Pinduoduo is a fascinating story - at the start of the year, I think I had a very small understanding of Pinduoduo. As far as I was concerned, it was an Alibaba clone, eating up ecommerce market-share in China. Boy was that off-base - the company has a radically unique ecommerce business model, gamifying small purchases at a massive scale. While I am still not sure I fully comprehend their model, I am definitely blown away by their growth, market position, and positive annual cash-flows (!).
Blake Smith, a startup founder based in Cincinnati, wrote about why someone should start a business in Cincinnati. I think what he says can be applied to a lot of different cities in the region (Columbus, Cleveland, Indianapolis, etc). This is simple and straightforward: start a business in Cincinnati because the culture and environment is super founder-friendly. My experience of investing in startups in the region over the past couple of years would bolster his points.