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Why Blue Harbour Sees Value in Rackspace

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NEW YORK ( TheStreet) -- Hedge fund Blue Harbour Group believes managed cloud company Rackspace is undervalued and can buy back a significant amount of stock as the company distinguishes its business model from larger competitors such as Amazon Web Service . Blue Harbour began buying Rackspace shares in May and accumulated shares through July and August after Rackspace said it hired Morgan Stanley to run a strategic review for the company.

While Blue Harbour believes Rackspace's business would be complementary to a handful of acquirers over the long-term, it also thinks the company's standalone prospects in the cloud computing market present a value to investors. Blue Harbour expects Rackspace will generate $2 billion in recurring revenue by 2015, indicating a return to steady revenue growth amid a change in strategy that emphasizes the company's service, in addition to its cloud infrastructure capabilities.

Rackspace, after failing to win cloud hosting market share from Amazon Web Service amid a pricing battle, is working to re-emphasize its customer service, in a move that may underscore its differentiated offering to smaller businesses without a large IT infrastructure. Earlier in 2014, Rackspace changed its pricing to split infrastructure and service costs for customers. That change appears to have buoyed Rackspace's recent earnings and its outlook for coming quarters.

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Improving fundamentals at Rackspace and a more clear communication of strategy to investors may help the company improve its valuation. Currently, Rackspace is trading at about six times forward earnings before interest, taxes, depreciation and amortization (EBITDA), while competitors (according to Blue Harbour) such as Equinix trade at multiples of over 10x EBITDA. Historically, Rackspace has traded at around 10x EBITDA.

Blue Harbour has lobbied that the company use its balance sheet to buy back shares while they are undervalued. The fund accumulated a 6.4% stake in Rackspace shares through July and August and met with management to express its views on buybacks before filing a 13D on Monday. Blue Harbour is currently Rackspace's fourth largest shareholder, according to Bloomberg data, while hedge fund Third Point Management recently disclosed an over 5% stake in the company.

Rackspace carries $340 million in cash on its balance sheet and the company generates roughly $600 million in EBITDA. Wells Fargo analysts said on Tuesday they believe the disclosure of Blue Harbour and Third Point's stake, in addition to strong third quarter guidance is improving investor sentiment on Rackspace after years of underperformance.

Rackspace appears poised to adopt a more shareholder friendly capital structure, Wells Fargo said, while noting the company may be able to repurchase as much as $900 million in stock, or 20% of its equity value.