Rackspace breaks IPO drought

August 6, 2008: 9:58 AM ET

There haven't been many tech IPOs lately - only three this year, in fact. People here in Silicon Valley have certainly noticed  – this place thrives on venture capital, so in financial terms, the mood has been a little like a maternity ward going without any deliveries. Yes, entrepreneurs have still gotten rich selling out to big companies like Google and Microsoft, but without the same kind of cigar-passing glee that follows a Wall Street debut.

So it's fair to expect some buzz on Friday, when San Antonio hosting company Rackspace takes a bow. As tech IPOs go, the prospectus on this one reads like a pretty safe bet: the ten-year-old company logged net revenues of $362 million in 2007, and a profit (yes, profit!) of $17.8 million. It's offering 15 million shares at between $12 and $16 per share in a Dutch auction format (what Google used for its IPO), and it's backed by some great names in venture capital, including Sequoia and Norwest Venture Partners.

Sounds good, right? But there are also some red flags to watch out for. We'll get to those later.

Rackspace's game is hosting, which basically means its computers manage other companies' internal and external Internet presence. This can be anything as basic as handling e-mail, or as complicated as serving up an internal sales tracking system. It's no easy business – hosting companies need lots of powerful servers to put their customers online, buildings to hold the servers, and cash to pay the outrageous power bills. Even tech darling Apple (AAPL) had some trouble with hosting; its new MobileMe service, designed to manage e-mail, calendars and other functions, belly-flopped on its debut, losing customer e-mails and intermittently going on the fritz.

The folks at Rackspace (they call themselves Rackers) pride themselves on their ability to keep customers happy while shrewdly managing real estate and equipment costs, and commanding top-dollar subscription fees for their white-glove service. "Our Fanatical Support culture serves as a competitive advantage that has allowed us to establish our position as the world's leading hosting company," the Rackers brag in their prospectus.

For prospective investors, there's a lot to like about Rackspace. On the plus side, they've got healthy sales, growing profits, and a claim to some of the "cloud computing" and "software-as-a-service" mojo that, thanks to names like Salesforce.com (CRM), Amazon (AMZN) and Google (GOOG), are all the rage these days. From what I'm told, the cutting-edge companies that offer their services on top of Rackspace's system respect the way they run their business. And Rackspace executives say 15 percent of their annual growth comes from loyal customers who keep buying more services. That loyalty has formed the baseline for the company's 59 percent sales growth rate over the past four years.

"Rackspace is well-positioned as a provider of next-generation hosting services," said Bill McNee of Saugatech Research Services, a consulting firm. "The question is, what will they do to differentiate themselves in an increasingly crowded market?"

Which brings us to the red flags.

First, Rackspace is one of many hosting providers, and the field is getting more crowded all the time. Though the company has done a good job contending with competition from telcos like AT&T (T) and Verizon (VZ) and from others like Savvis (SVVS), The Planet and Terremark, the fight is about to get hairier. Big names like Amazon, Google, and most recently IBM (IBM), Yahoo (YHOO) and Hewlett-Packard (HPQ) have begun turning their attention to cloud computing, which is one of Rackspace's fastest-growing services. And as more big companies start looking to sign hosting contracts for their new online initiatives, who do you think they'll go with – Rackspace, or the big guys?

Second, Rackspace's hosting business is a bit like the real estate market, with similar pitfalls. Over the past few years, the demand for hosting services has outstripped supply, fueling meteoric growth in the category. In response, Rackspace and others have been massively building out data centers to serve new customers.  Like home builders during the housing boom, hosting providers are building out expensive data centers ahead of time, based on what they think demand will be later. If they're right, the hosting party continues. If they're wrong? Picture lots of big, expensive buildings with no tenants to help pay the rent.

Finally, one of those little things in Rackspace's prospectus bears mentioning – and it has to do with compensation. Specifically, bonuses. It's always interesting to see how a company goes about giving cash to its people, because cash awards are totally disconnected from stock performance. And if a company's board hands out too much of it, there's reason to fear that the executives (and employees) will end up marching to a different beat than the shareholders. So how does Rackspace handle cash bonuses? To start, the bonus range, between 40 and 70 percent of an executive's annual salary, isn't far outside the norm for public companies, which is good to see. Employee bonuses are also calculated on many of the same criteria that's used for bigwigs. From there, though, things get a little dicey.

The prime example came last year, when the company's equipment investments pinched profits. Figuring it wasn't fair for employees to suffer because the company had to make some long-term investments, the board tweaked the bonus calculation for the second half of the year. As long as profit levels held steady from one quarter to the next, everyone would get a full bonus. But then disaster struck: A wayward truck near Rackspace's Grapevine, Texas, data center crashed into a transformer, causing a power outage. Even though a backup system was in place, Rackspace had to take several servers offline and compensate customers for the resulting downtime. That meant a hit to Rackspace's profits, and thus its bonus pool – but the board decided to give full bonuses to everyone anyway, because their response to customer outrage was so "fanatical."

The right move? Maybe. You can't blame employees for a truck accident (though you could argue that a better backup system might have helped.) We'll just have to see how Rackspace management handles the inevitable disasters as a public company, and where the buck stops then.

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