George Lambertson, analyst, george.lambertson@ubs.com, +1 212 713 9035, UBS FS Wealth Management Research 28 September 2010 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 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. 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 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. Source: UBS WMR, FactSet, prices as of 27 September 2010 This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 4. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
We believe that enterprise revenue growth at RAX is likely to be greater than our previous expectations due to: 1) increasing corporate demand for receiving 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 margin service level agreements to corporate customers (SLAs); and 4) likely increased channel distribution with new channel partners (current partners include 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. - 2
Investment Thesis Summary - Diversified Telecommunication Services UBS WMR Energy: Diversified Telco Svcs - Sector Outperform List CenturyLink Crown Castle Inc Equinix Qwest Communications Rackspace Hosting SBA Communications CTL CCI EQIX Q RAX SBAC 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. 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. 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. 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 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. 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 Frontier Communications Windstream Communications FTR WIN 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. 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 AT&T Verizon Communications T VZ Source: UBS WMR as of 27 September 2010 Note: Companies in BOLD represent High Conviction Calls. Please see the Appendix for definition. 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. 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. - 3
Appendix For a complete set of required disclosures relating to the companies that are the subject of this report, please mail a request to UBS Wealth Management Research Business Management, 1285 Avenue of the Americas, 13th Floor, Avenue of the Americas, New York, NY 10019. Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. Stock recommendation system: Analysts provide a relative rating, which is based on the stock s total return potential against the total estimated return of the appropriate sector benchmark over the next 12 months. Industry sector relative stock view system Outperform (OUT) Expected to outperform the sector benchmark over the next 12 months. Marketperform (MKT) Expected to perform in line with the sector benchmark over the next 12 months. Underperform (UND) Expected to underperform the sector benchmark over the next 12 months. Under review Upon special events that require further analysis, the stock rating may be flagged as Under review by the analyst. Suspended An outperform or underperform rating may be suspended when the stock's performance materially diverges from the performance of its respective benchmark. Restricted Issuing of research on a company by WMR can be restricted due to legal, regulatory, contractual or best business practice obligations which are normally caused by UBS Investment Bank s involvement in an investment banking transaction in regard to the concerned company. Sector bellwethers, or stocks that are of high importance or relevance to the sector, that are not placed on either the outperform or underperform list (i.e., are not expected to either outperform or underperform the sector benchmark) will be classified as marketperform. Additionally, when stocks that are not deemed to be of high importance or relevance to the sector are not expected to outperform or underperform the sector benchmark, they will simply be removed from the lists and will not be assigned a WMR rating. High Conviction Calls Sector analysts are required to have at least one "high conviction" outperform or underperform call for each sector they cover. Analysts have discretion over the selection of a recommendation as high conviction and the grounds for selection (e.g., greatest upside/downside to price target, most/least compelling investment case, etc.). The basis for each high conviction call is set forth in any research report identifying a recommendation as such. 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 p.a. Per annum (per year) UBS WMR UBS Wealth Management Research - 4
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