Rackspace Technology, Inc. (RXT) Q3 2022 Earnings Report, Transcript and Summary

Good afternoon and thank you for standing by. Welcome to Rackspace Technologies Third Quarter 2022 Earnings Conference Call. [Operator Instructions] Please be advised that today’s call is being recorded. I would now like to hand the call over to Robert Watson, Vice President of Corporate Finance. Please go ahead.

Thank you and good afternoon. I am joined today by Amar Maletira, our Chief Executive Officer. Please note that we have made some changes to the supplemental earnings materials we provide, including a revised presentation and an Excel fact sheet. These materials as well as a replay of today’s call can be found on our Investor Relations website. Certain comments we make on this call will be forward-looking. These statements are subject to risks and uncertainties, which could cause actual results to differ. A discussion of these risks and uncertainties is included in our SEC filings. Rackspace Technology assumes no obligation to update the information presented on the call, except as required by law. Our presentation includes certain non-GAAP financial measures and certain further adjustments to these measures, which we believe provide useful information to our investors. In accordance with SEC rules, we have provided a reconciliation of these measures to their most directly comparable GAAP measures in the earnings release and presentation, both of which are available on our website. I will now share our third quarter financial results and then turn the call over to Amar for an update on the business. In the third quarter, both revenue and core revenue exceeded the high end of the guidance we provided on our Q2 call in August and reiterated on September 26, with the CEO announcement. Total revenue was $788 million, which represents 3% year-over-year growth on a reported basis and 5% growth in constant currency. We continue to experience material currency headwinds from our Europe business. Core revenue was $751 million, which grew 5% year-over-year on a reported basis and 7% in constant currency. Revenues in EMEA grew 8% in constant currency driven in part by the continued ramp of the BT contract, but declined 1% on an as-reported basis. Americas grew 3% and APJ grew 24% on an as-reported basis and experienced minimal FX impacts. Non-GAAP operating profit of $80 million also exceeded the high end of our third quarter guidance. This was down 36% year-over-year, primarily due to reduced gross profit from the ongoing revenue decline in our legacy OpenStack and managed hosting private cloud businesses. Non-GAAP operating margin was 10% and non-GAAP earnings per share was $0.10. Operating cash flow of $71 million and free cash flow of $52 million were positive for the seventh consecutive quarter driven in part by our continued focus on managing working capital. As a reminder, Q4 is a seasonally low cash flow quarter for the company. CapEx in the third quarter was in line with expectations with total CapEx of $31 million and cash CapEx of $19 million. CapEx intensity was 4% and 2%, respectively. For the full year, we expect to be within our target CapEx intensity range of 5% to 7%. We ended the third quarter with $249 million of cash and our $375 million revolver remained undrawn resulting in total available liquidity of $624 million at quarter end. Also note that the company recorded $464 million of non-cash impairment charges in the third quarter. The primary driver of these charges was a goodwill impairment in our multi-cloud segment. Additional details of these non-cash expenses can be found in our press release and SEC filings. And lastly, I will provide our guidance for the fourth quarter. This guidance reflects some caution related to an uncertain macroeconomic environment and continued foreign currency exchange headwinds. We expect total revenues in the range of $772 million to $782 million, core revenue in the range of $738 million to $746 million, non-GAAP operating profit of $65 million to $69 million and non-GAAP earnings per share of $0.04 to $0.06. I will now turn the call over to Amar.

Thank you, Robert. I’m excited to lead Rackspace Technology into its next chapter as a customer-first, cloud-first company. Since being appointed CEO, I’ve been focused on having an honest dialogue with our customers, partners and employees. It is clear that our customers need our help, and they want us to win and we have a world-class partner ecosystem and talented employee base who is ready to serve them. I remain confident in our strategy and firmly believe we are implementing the right operating model to execute on the market opportunity in front of us. As I shared during my September 26 investor update, it is critical that we quickly improve our execution focus and accountability across the organization. So let me share some early actions and progress. First, I know we need to rebuild our credibility as a team. I’m pleased that in the third quarter, we delivered revenue and profitability above our guidance. Looking ahead, we followed our normal guidance process, but we are adding some caution to reflect the uncertain macro outlook. We intend to build a track record of meeting and beating expectations. Second, I’ve made a few changes to my executive leadership team and will continue to evaluate additional adjustments to position our organization for success and ensure alignment with our go-forward operating model and priorities. Third, I’m pleased that Shashank Samant will be stepping up as the Lead Director for our Board. Shashank is a dynamic seasoned executive who specializes in the digital technology services business and the cloud market. Shashank, most recently, served as President and Chief Executive Officer of GlobalLogic, a Hitachi Group company. Under his leadership, GlobalLogic scaled to $1.5 billion in sales as a leading brand in the digital transformation space. In early 2021, GlobalLogic was acquired by Hitachi at an enterprise value of $9.6 billion. Prior to GlobalLogic, he held leadership positions at Nest, IBM and HP. The entire company will benefit from his increased engagement and broad experience in cloud and digital businesses. And lastly, we continue to make good progress on our realignment into a two business unit structure and are on track to begin operating in this new structure on January 1, 2023. Looking ahead, we know that 2023 will be a transition year with a lot of heavy lifting. We have already realized significant cost efficiencies over the last 2 years. We’ll continue to streamline expenses where we can, but we are now repositioning Rackspace for profitable growth. This is my mandate from the Board. To Rackspace’s advantage, we addressed two distinct markets with strong unmet demand for the innovative solutions and services we provide. As we have stated many times before, we expect the demand across our multi-cloud offerings to remain strong, but we have to step up our execution and focus so we can seize it. Public cloud operates in a hyper-growth market with significant white space. For Rackspace to achieve our goals in this market, we must sharpen our solutions development focus by launching value-added and operationally scalable services. We are making progress. We will continue to make organic investment so we can move even faster. Going forward, we will not lead with infrastructure resale. We’ll lead with higher value solutions and services in public cloud and with a deeper customer engagement. Our new operating model will ensure that we emerge from 2023 with a public cloud organization focused on the high-value opportunities in this wide open market space. In hosted private cloud, including bare metal managed hosting the market opportunity is more significant than many may appreciate today. We estimate that over 60% of workloads are still in customer data centers and many will move to either public cloud or hosted private cloud over the next few years due to cost advantages, reduced operational complexity and fewer resource constraints among many other factors. We find that many of these workloads are better suited for hosted private cloud. Examples include workloads in regulated industries such as government and healthcare, legacy applications that are too expensive to be refactored for public cloud and data and performance-intensive workloads. And Rackspace is uniquely positioned to win in the private cloud market. We have a well-known brand with deep experience in private cloud, a global data center footprint, cutting-edge technology and IP and strong partnerships with key ecosystem players such as Dell and VMware. And while we are still in the early innings of a push to revitalize and arrest the declines in our managed hosting and private cloud business, we are seeing early signs of progress. For instance, we recently signed one of the largest hosted private cloud deals in the history of the company. This is a multiyear commitment that provides a glimpse into the promising market opportunity in private cloud. We are also launching industry-specific private cloud offerings, for example, in healthcare, which are already driving good pipeline generation. And finally, in September, we launched the Rackspace accelerated migration program. This industry-leading program is designed to help customers move their workloads from on-prem or colo facilities into Rackspace private cloud. It has been several years since we have seen this much activity and traction in private cloud. It’s an encouraging trend, which we are working hard to capitalize on with new and innovative solutions. Before I conclude, I just want to remind everyone on what gives me the confidence that we will turn this company around. First, we operate in two multibillion-dollar markets: Private cloud and public cloud, and both are growing. As I often say, we are in a great neighborhood. Second, our core revenue base is over 90% recurring. It includes a large diverse customer base with more than half of the Fortune 100 companies. We truly have a phenomenal base of customers who need our help and want us to succeed. Third, we have roughly 7,000 dedicated Rackers with more than 11,000 technical certifications who collectively make up our unique Racker culture. Rackspace is truly a great place to work, and we will continue to invest in our people. Fourth, we have strong, deep relationships with world-class partners in both public and private cloud. We continue to strengthen our long-standing relationships while also developing partnerships in new cutting-edge cloud technologies. And finally, we have a well-respected brand in the tech market based on our long history of innovation. In closing, there is a lot of work ahead of us, and the path will certainly not be easy, but I truly believe the actions we are taking will position our business for sustained growth, profitability and success in the years to follow. I look forward to sharing more on our strategies and financial aspirations in the future. And with that, we will take your questions.

Thank you. [Operator Instructions] Our first question comes from Kevin McVeigh with Credit Suisse. Please go ahead.

Great. Thanks so much and congratulations on the results from Amar. Obviously, there is a lot going on in terms of the transition. I wonder, can you give us a sense, as you think about 2023 and you reposition the business across the two new segments, are you starting at the same base of revenue? Or should there be some shrinkage? And if you look at the goodwill impairment, it looks like it’s about 15% of the goodwill on your balance sheet. Is that a proxy for the adjustment on the revenue? Or is there any way to think about just the base of revenue and then maybe some sequencing on margins, just so we can get a couple of goalposts. I know it’s still a little bit early, but just try to frame that a little bit.

Yes. Kevin, good to hear your voice. Thank you for the question. You’re absolutely right, Kevin. It is difficult, as you can imagine, right, to provide guidance for the full year given the number of macro and micro changes that we’re experiencing, right? But let me give you some color. First, there is, as I mentioned in my prepared remarks, there is a macro uncertainty, which may lead to sort of longer sales cycles as well as a slowdown in decision-making in 2023. Second, to improve our execution, we are making some tough choices here and also implementing operational changes over the next couple of quarters that will position the company for sustained profitable growth. Now this will be reflected in our numbers. So these choices, Kevin include deemphasizing infrastructure resale and shifting the mix of our pipeline and bookings to higher-value services and solutions. So this takes time. But as you can imagine, it is the right thing to do for the business. It will involve refocusing our go-to-market organization and in some cases, also rebuild in certain areas. And more importantly, we also have very, very targeted investments in solutions development, such as industry verticals. So as we get to the end of 2023, Kevin, we will start to see the benefits of our reorganization and also our execution focus. And we are seeing some really encouraging pipeline development in bookings, but it is still early and the business that we can close, as you know, can take about 6 or 9 months to materialize into revenue. So with that said, although the outlook for the last – next four quarters is really tough, even the near-term is tough. But based on what we are seeing, for example, macro-uncertainty, as I mentioned earlier, which might result in potentially longer sales cycle, operating model changes that may lead to some disruption, the deemphasis on infrastructure resale that I mentioned earlier as well as some continued FX headwinds. We expect Q1, which is seasonally down quarter because you have some usage-based volumes in our managed public cloud seasonally goes down. We expect revenue to be sequentially down between 1.5% to 2% as a result of all those factors that I mentioned. Does that help, Kevin?

It helps a lot. And then just maybe just this is a two-part, but I’ll ask it. I mean, really nice to see Shashank. It sounds like not only elevated to the Board but buy $2.5 million of stock, which is a really nice signal. Is there any way to think about the bookings, Amar, just for Q4 just within the context and, again, very helpful on the sequencing of the revenue for Q1?

Sure. So on bookings for Q3, let me give some color here, Kevin. I’m actually very pleased to see a favorable mix shift in the bookings to more of a higher value and higher-margin business away from infrastructure resale. So as you know, infrastructure resale bookings come at low margins, so this shift in focus to higher-margin services and solution bookings was by design. And so I’m pleased that we are making that shift. In fact, the public cloud services bookings were up year-on-year and included about 17 new public cloud services customers and also a large expansion deal with a major media and communications company in Europe. So, very pleased with that. Of course, the base of the public cloud services business is smaller compared to our infrastructure resale. So our focus is on growing the services booking space more quickly and on the private cloud side, as I mentioned in my prepared remarks, and I’ll give some color there, we had a strong – very strong bookings quarter, which was largely driven by this large private cloud deal, and I will talk a little bit more about it, but we continue to gain traction and build pipeline in private cloud as we improve our focus there. Now on the – since you asked about the bookings question and I referenced the large private cloud deal, let me give you some color there so that you understand the dynamics here. This private cloud deal is one of the largest deal in the history of the company and is over a couple of hundreds of millions of dollars of TCV over 5 years, in fact, with the customer and the technology sector. We offered a very compelling value proposition to the customer. These were stable storage-intensive analytics-heavy workloads, which were better suited to operate in a private cloud environment. In fact, Rackspace was able to offer a solution that significantly lowered their cost while delivering improved performance in both storage and compute. So this is particularly a large opportunity, Kevin, but it is a representative of the types of deals we will begin to see in our managed hosting and private cloud business as a result of multiple things. We have a very strong brand in this market, great market presence. We have the scale, and we will also see an increased focus with our two-business unit structure.

Very helpful. Thank you, Amar.

Thank you. Our next question comes from Amit Daryanani from Evercore. Please go ahead.

Hello. Thanks for taking my question. I have two as well. I guess, first one, I was hoping if you folks could just talk about when you look at your debt stack in debt structure right now, maybe just talk about how much of is floating versus fix and then more importantly, given the compression in margins that we’ve been seeing, could you just talk about what are some of the covenants and the leverage metrics that we should be aware about would rely to those?

Okay. Hey, Amit. Good to hear your voice. By the way, you’re not coming across very clear, but I got the gist of your question, you wanted to – basically is how our debt structure looks fixed versus variable and the covenant on it, right? So let me start with the covenant first. We have minimal debt covenants after the debt refinancing we did in early 2021. So when I arrived here in November 2020, we took advantage of the very favorable debt market and refinanced our debt in 2021. All of these debts are not due for another 6 or 7 years. We have two – there is a senior secured note, which is at 3.35%, fixed. We have a term loan B, which has a variable component to it. And then we have a non – sort of non-secured note, which is at 5.375%, so a wide variety of the debt structure. I think I’m not sleeping – I’m not losing any sleep so to speak, servicing this from an interest expense perspective. And as you know, based on the rates right now, it’s a very attractive pricing right now on the debt side. So minimal debt covenants, a wide variety of interest expenses on this, but overall, I think it is very manageable interest expense, given that most of this debt is – two of those notes are actually fixed interest rates. Does that help?

Yes. No, that is really helpful. Thank you for that. If I can just follow-up, when I look at the December quarter guide, right, maybe just something on the more near-term side, you started talking about flattish revenues on a year-over-year basis, I think, right, on total numbers. Maybe just talk about how much of the FX headwind are you seeing in the December quarter numbers on a year-over-year basis? And then how macro impacting you in the December quarter, I am wondering if seeing deal push-outs, deals having delayed. Just any clarity on kind of the macro and FX and how that’s impacting December quarter would be helpful?

I think you’ve covered just key points there, Amit. So, let me start with the macro, right. So, we took a revenue haircut primarily in services and also a bit in the usage-based volumes that come to our managed public cloud business, mainly due to macro outlook, okay. And the macro outlook, as you know, when you take a look at what’s going on from a demand environment, etcetera, all companies in the cloud ecosystem are being cautious about the demand environment. And rightfully so, given the tough macro outlook, in fact, the hyperscalers are cautioned that the growth rates are slowing, although they are still growing double digits. And we do believe that customers will maintain their current IT spend on mission-critical projects, but slow down spending on lower priority less critical projects. And this, of course, varies by customer and verticals. But broadly speaking, Amit, customers will be focused on cost optimization as well as on projects that have a faster payback period. And I have done this for a long time and I have gone through these cycles multiple times, and it’s not unusual to expect some of the changes in the size and scope of the deals, longer sales cycles and also a slowdown in decision-making. So, we have factored those in when we guided. So, typically, you would see as the revenue either be flattish or go up sequentially, we have guided to a sequential decline in revenue because of that. FX continues to remain a headwind. It was, I think 2 percentage points of headwind in Q3. We are also taking a look at our October numbers that are coming in now. I don’t have any color right now. But we have factored in that FX headwind. It’s very difficult to predict, but we did factor in some of these FX headwinds. And we did that in Q3 too. So, we are not changing the way we guide when it comes to FX.

Prefect. Thank you.

Thank you. [Operator Instructions] Our next question comes from Tien-Tsin Huang with JPMorgan. Please go ahead.

Hey. Thanks so much and good to have a track record here from the – with these results. I wanted to ask if you don’t mind on – also on bookings and because we have been hearing a lot through this results season, how clients as well as vendors are being more careful around the gross profit dollars or margins around new contracts, new award activity? How – are you seeing that manifest itself in some way in your business? Are you may be seeing a shift and need to spend a little bit more in terms of capital intensity to win work? I am just curious if you are already seeing that, and that’s a factor with your selectivity on winning business on the bookings side.

So, I think – thanks, Tien-Tsin for the question. So, there are two parts of our business, right. We are a multi-cloud provider, Tien-Tsin. We have public cloud and then also we have private cloud. And I can tell you, let me – public cloud demand continues to remain strong. I do believe that as we go through this process, the demand in multi-cloud will remain, but it may start moving to the right. And we have seen that happen in down cycles, not with multi-cloud business but in other businesses. And to be honest, to the extent that market is taking a pause, it comes at a good time for us to go complete the reorganization exercise, etcetera, and get ready when the customers return to normal spending levels and we will be prepared to capture the demand with newer offerings in an operationally realigned organization. So, for us, on the public cloud side, customers are looking for cost optimization. You have heard that multiple – most of the hyperscalers are talking about it. We have also seen that. And so we do have cost optimization services that we deliver today. We are going to expand those offerings. We are going to lead with those offerings so that we start building relationship with the public cloud customers who need help on optimizing their spend on public cloud. But the services business, the demand still remains. But the sales cycles will be longer, as you know, to go and as you are making the pivot from say infrastructure resale to services. It takes time for us to build the services pipeline, but it’s all doable. And the focus will help us to start building those pipelines fast. So, on the public cloud side, I feel – I think we have a good opportunity to pursue. On the private cloud side, many had thought that the private cloud was – I will just give you an example. I have been in the job for 45 days, and I have been on the road for 40 days out of those 45 days, talking to customers, partners and employees. And the biggest surprise for me, Tien-Tsin, is there is an ample demand signals out there. The issue is we have not been listening carefully. We need to better listen to those demand signals and you would be surprised how much of opportunity there is in the private cloud space, which has been underestimated by the company as well as the market. And so I feel that if we are focused on a couple of industry verticals, for example, regulated industries like healthcare, on the commercial side, industries like technology, I think we are going to do quite well in private cloud. So, stay tuned, we are going to launch a lot of offerings in this area in the next 6 months to 12 months or even before that. But we are separately seeing traction in private cloud and public cloud remains strong despite the slowdown in growth from the hyperscale aspect.

Got it. Thanks for that. I appreciate the hard work as well. Thanks.

[Operator Instructions] Our next question comes from Nate [indiscernible] with Deutsche Bank. Please go ahead.

Hi guys. This is Nate on for Bryan. I just wanted to ask about sort of gross margin expectations in fourth quarter and sort of the right way to think about modeling margins into next year. So, I think at the end of the last earnings call, you had snuck in some comments and you expected gross margins around 26% in the fourth quarter and mid-20s for fiscal ‘23. Just wanted to check in to see if there is any update to that thinking or if those numbers still hold?

Yes. So, Nate, thanks for asking the question. Now given the mix of the business, Nate, that we are projecting in Q4 after taking the haircut, etcetera, we still expect the gross margins to be between 25.5% and 26% for fiscal Q4, okay. So, that is actually not changing. Now, when it comes to gross margins for fiscal 2023, you see, Nate, my mandate from the Board is to turn this business around and align it to the strong growth markets that we address today. So, I months not going to manage to an arbitrary near-term targets since I am driving a transformation. So, in 2023, we are going to make some tough decisions and set us up well for 2024. And as I mentioned to Tien-Tsin, the demand signals remained strong. And to the extent that the market is taking a pause, it comes at a good time for us to complete this whole reorganization that we aren’t taking today. And so just as a reminder, right, our gross margin pressures are almost entirely a function of the mix of the business. And so as we turn the business around, as we stabilize the private cloud business, start growing the services component of our public cloud, we will see improvements in our mix that will drive gross margin accretion. But similar to revenue, it is difficult to know exactly how the mix will play out in the next few quarters. Now I can also tell you, from an OpEx standpoint, we plan to keep it roughly flat year-on-year, and we will continue to monitor it. So, we have a good – very tight control on our expenses, we have cost efficiency programs that we are running that will continue to run, and we will keep a tight lid on the expenses as we go through this tough macro environment and also the micro changes that we are making in the company.

Got it. That’s very helpful. And then just my follow-up was on BT. So, is there any updates or color you can give beyond sort of the high-level comments that were given in the prepared remarks. So, I think last quarter, you had mentioned it was sort of ramping slower than you had hoped for, but it seems like maybe that’s turned around. So, any way to quantify that impact or any sort of broader qualitative color you could give on BT would be great.

So, let me give some qualitative color here on BT. So, when you look at the BT deal, and probably we have explained this in the past, we have two distinct phases in the BT deal. First is the customer onboarding phase. We are currently operating in the first phase onboarding over 200 marquee customers. We have made some good progress on transitioning customers since our last update last quarter. The second phase is I call that as a transformation phase, where we can transform the customers’ environment by moving them to the Rackspace private cloud solutions. And this will create significant value for them as well as for us. And when we talk about our partnership with BT, we have a great partnership with BT. Both the companies BT and Rackspace are working well together. We are aligning our product and solution roadmaps. We will collaborate on bringing the best value to the market through this newly developed joint solutions that we are launching.

Appreciate the color. Thank you.

Thanks.

Thank you. I am showing no further questions at this time. I would now like to turn it back to Robert Watson for closing remarks. End of Q&A:

Thanks Andrea and thank you everyone for joining us. If we didn’t get to your question or you have a follow-up, please send us an e-mail at ir@rackspace.com. Have a great evening everyone. Thank you.

Thank you for your participation in today’s conference. This concludes the program. You may now disconnect.