Rackspace Technology, Inc. (RXT) Earnings Call Transcript

Good afternoon, and thank you for standing by. Welcome to Rackspace Technology's First Quarter 2023 Earnings Conference Call. [Operator Instructions] Please be advised that today's call is being recorded. I would now like to turn the call over to Robert Watson, Vice President of Corporate Finance. Please go ahead, sir.

Thank you, and good afternoon. I'm joined today by Amar Maletira, our Chief Executive Officer; and Bobby Molu, our Chief Financial Officer. This quarter, we will begin reporting in our new operating segments, Public Cloud and Private Cloud. As we previously communicated, our prior Multicloud segment has been separated into its Public and Private Cloud components, and our prior Apps & Cross Platform segment has been merged into Public and Private Cloud based on the underlying nature of the products and offerings. Our prior OpenStack segment has been collapsed into Private Cloud. However, we will continue to provide visibility into OpenStack revenue. Please refer to our Investor Relations website for historical financials in the new segments, definitions of financial metrics and other supplemental materials to today's earnings announcement. As a reminder, certain comments we make on this call will be forward-looking. These statements involve 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 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 IR website. I will now turn the call over to Amar for an update on the business.

Thank you, Robert. Let me start by sharing some of our first quarter achievements. First, we delivered revenue and profit above the midpoint of our guidance for the first quarter. Meeting of commitments remains a priority. So I'm pleased we're able to achieve these results while navigating a challenging macroeconomic and industry environment. Second, we have now completed our first full quarter in our new two-business unit operating model. We're already seeing progress with increased focus in new offerings, demand generation and targeted verticalization. We have also identified new opportunities for cost efficiencies. Third, with the creation of these new business units, today, we have published 2 years of quarterly financials in our new segmentation. This also fulfills another one of my commitments to provide greater transparency. Fourth, I've completed the build-out of my leadership team with the appointment of two talented executives. Michael Bross has been named our Chief Legal Officer, a Rackspace veteran of 16 years. Michael has most recently been serving as an interim Chief Legal Officer, where he has clearly demonstrated the skills and leadership required to take on this role full time. And Kellie Teal-Guess has been named our Chief Human Resource Officer. Kellie brings over 30 years of experience in Global Human Resources with a strong background in strategy and execution, talent management, organizational design and change management. And finally, since the beginning of the year, we have added three highly accomplished technology executives, Anthony Roberts, Betsy Atkins and Tony Scott to the Rackspace Board of Directors. I'm very pleased that they have chosen to join our Board and look forward to working with them closely. So we continue to make progress on the objectives I established upon becoming CEO, realigning the company's operating model to better serve the attractive markets we operate in, build a seasoned executive team to drive our strategy forward and strengthening our Board. We're still in the early days of these changes, so it will take time for progress to be reflected in our financial results. Before I provide an update on the new operating segments, let me give my perspective on the market. There has been little improvement to the macro environment since we last spoke with you. Customers remain cautious, resulting in lengthening sales cycles and deferred decisions. Other companies in our industry are reporting the same trends. However, we still expect our market to enjoy strong growth over the long term as Multicloud is a key enabler of digital transformation and improving business outcomes. So we're using this flattening of the market to better position our company to capitalize once growth rebounds. Our customers know they need our help migrating and leveraging Multicloud. So our focus is on building the tools and services to meet them wherever they are in their digital transformation journey. Now let me turn to our new segments. With the two-business unit structure and the hiring of new leadership, we are prepared to better leverage the unique competitive advantages of each business. We're now engaging more closely with our customers and developing products and solutions that align to the specific market needs. We have a global footprint, flexible delivery model and the depth and breadth of capabilities, all strong competitive advantages that enable us to deliver differentiated value for our customers. And since we address both Public and Private Cloud, we can provide an unbiased point of view to ensure our customers achieve an optimal outcome. The Public Cloud business unit operates as a service-centric capital-light model. We engage deeply with customers to manage cloud complexity and deliver value-added cloud solutions in infrastructure, application, data and security through managed services, Rackspace Elastic Engineering and professional services engagements. D.K. Sinha, leader of the Public Cloud business unit, joined us mid last year and has been instrumental in shifting the organization from infrastructure resale to value-added services with an emphasis on customer partnership. D.K. and his team are driving our customer-first approach and developing strong relationships with both current and prospective customers. As an example, we recently helped a large North American University to containerize the PeopleSoft environment. And we also partnered with a large Asian customer to unify seven disparate data systems onto the Azure platform, enabling business insights for their stakeholders. We have built a service-oriented leadership team, and our focus is to continue to flawlessly execute our strategy to deliver industry-leading growth. Turning to the Private Cloud. This business is a technology followed capital-intensive model. We are one of the largest scale players in hosted Private Cloud and have a diverse set of offerings to address a broad set of customer segments and industries. Our strategy is to help customers efficiently and effectively move workloads from in-house data centers as well as workloads that may not operate efficiently in the Public Cloud. Rackspace Private Cloud solutions can help customers address these challenges. Brian Lillie joined us to lead the Private Cloud business unit last quarter and is improving our execution, management focus and accountability. He has already made management changes and recently hired a new Chief Product Officer and Chief Revenue Officer. I'm also delighted to see us innovating again in a business we have taken for granted for far too long. As an example, Brian, in collaboration with the CTO, Srini Koushik, has plans to launch a next-generation Private Cloud offering later in the year. This will take advantage of modern open source and cloud-native technologies, like Kubernetes and Containers. This will offer customers a full suite of Private Cloud offerings that span from bare metal to virtual machines to containers to serverless computing. Our strategy supports the secular trend of customers moving to a more capital-light model, migrating workloads out of the data centers to a managed solutions environment. Hence, this is just one of our initiatives to provide customers with a broader set of options in areas where they lack Multicloud capabilities. It will take time to show results, but Brian and his team are focused on growing the business and improving our execution. There is a bright future ahead for Private Cloud with an immense market opportunity. In summary, just 4 months into this new model, we are already seeing some of the benefits. First, each segment is more focused on identifying opportunities that they can leverage their unique competitive advantages to capitalize on the attractive growth market. Second, we have uncovered potential new operating efficiencies at both the business unit and corporate levels. And third, we have increased accountability across the company. As we have stated previously, our goal is to exit 2023 with a competitive cost structure and a strong pipeline backlog to drive profitable growth heading into 2024. I will now turn the call over to Bobby for an update on the financials before wrapping up with some closing thoughts. Bobby, over to you.

Thank you, Amar. I will cover the total company results for the first quarter, then share some details on our segment performance, followed by our Q2 guidance. Total company revenue of $759 million was down 2% year-over-year and slightly above the midpoint of our guidance. Non-GAAP net revenue is a metric we are introducing that applies net accounting to Public Cloud infrastructure resale revenue. For clarity, non-GAAP net revenue includes all revenue from our Private Cloud business unit, Public Cloud services revenues and only the profit component of Public Cloud infrastructure resale. We believe non-GAAP net revenue provides investors with the visibility to the true margin profile of our business. Please refer to our Investor Relations website for more details and definitions. For the first quarter, total non-GAAP net revenue was $460 million, down 9% year-over-year, driven by continued declines in Private Cloud, which, as a reminder, now includes legacy OpenStack. Non-GAAP gross profit of $179 million was 24% of total revenue and 39% of non-GAAP net revenue. Non-GAAP operating profit was $51 million, slightly ahead of the midpoint of our guidance. This was down 55% year-over-year primarily due to revenue declines in our Private Cloud business unit. Non-GAAP operating margin was 7% of total revenue and 11% of non-GAAP net revenue. And non-GAAP loss per share was $0.02, within our guided loss per share range of $0.01 to $0.05. Cash flow from operations was negative $2 million and free cash flow was negative $14 million in the first quarter. These results were in line with expectations due to our strong working capital management, which largely offset the impacts of the company bonus payout and a large vendor prepayment. We ended the quarter with a cash balance of $174 million and remain laser-focused on cash flow generation. Total CapEx for the first quarter was $72 million, while cash CapEx was $12 million. CapEx intensity was 9% and 2%, respectively. CapEx for the quarter was higher than recent quarters, driven in part by capital requirements for a new customer we signed in Q3 2022. With regards to this customer, as we began to execute in Q1, we became concerned about the viability of the arrangement and ultimately, it did not materialize as anticipated. The capital purchase is fungible and will be redeployed to other business requirements. As such, you should expect CapEx to be lower for the next few quarters and remain in our typical 5% to 7% total CapEx intensity range for the full year. Additionally, in the first quarter, we recorded $543 million of noncash goodwill impairment charges as a result of the January 1 reallocation of goodwill due to the business unit realignment and the decrease in our market capitalization. On to our segment results. Now that we are operating in our new segments, Public Cloud and Private Cloud, we will no longer report the Multicloud, Apps & Cross Platform and OpenStack segments after this quarter. Please refer to our Investor Relations website for historical financial information in the new segment and our earnings presentation for an estimate of our Q1 2023 revenue in the prior segments. For Public Cloud, revenue of $445 million was up 7% year-over-year, driven primarily by our infrastructure resale business. Public Cloud non-GAAP net revenue, again, this includes our Public Cloud services revenue and infrastructure resale profit, was $146 million, up 1% year-over-year. While revenue growth in services was 3% in Q1, it will take some time for the business to reach sustained growth in line with the market as we pivot to a services-led motion. Gross margin for our Public Cloud segment was 12% of total revenue and 37% of non-GAAP net revenue. Segment operating profit in Public Cloud was $25 million, which was 6% of total segment revenue and 17% of non-GAAP net revenue. In Private Cloud, total revenue for Q1 was $314 million, which includes legacy OpenStack revenues of $34 million and was down 12% year-over-year. The Private Cloud segment revenue decrease resulted from declines in our Private Cloud offerings and legacy OpenStack as well as the impact from the December hosted exchange ransomware incident. As a reminder, the hosted exchange e-mail business represented less than 1% of the total company revenue and roughly 2% of Private Cloud revenue. Private Cloud gross margin was 40% and segment operating profit was $93 million at an operating margin of 30%. Given the continued widespread attention in the macro environment and financial sector disruption, I would like to reiterate some important points regarding our balance sheet and capital structure. First, we have a solid debt structure with favorable terms, which was less impacted by the recent run-up in interest rates. Over 70% of the debt is either fixed or hedged and the average interest rate on our total debt was 5.5% for the first quarter. We have no funded debt maturities until 2028, and we have no maintenance covenants, which gives us significant flexibility and runway as we execute our transformation plan. Second, Rackspace has nearly $550 million of liquidity comprised of $174 million of cash on the balance sheet and a $375 million undrawn revolver. It is worth noting that our revolver commitments are provided by some of the largest global financial institutions, and we have no exposure to the U.S. regional banks that have recently faced challenges. And finally, in the first quarter, we opportunistically spent $10 million of cash to repurchase $23 million of our senior unsecured notes in the marketplace at a deep discount. These transactions were at an average price of approximately $0.43 on the dollar and will result in $1.2 million of annual interest expense savings. We will continue to monitor and assess further opportunities to deploy capital and drive shareholder value. As Amar noted in his prepared remarks, 2023 will be a transformational year, and we believe our performance will reflect that. We will continue to focus on preserving cash and optimizing our expenses. We know it will take time for the transformation to drive improved financial performance, but we expect to begin seeing sustained progress in 2024. And with that backdrop, here is the guidance for Q2. We expect total revenue in the range of $725 million to $735 million. From a segment perspective, we expect Public Cloud revenue of $430 million to $435 million and Private Cloud revenue of $295 million to $300 million. Non-GAAP operating profit of $33 million to $37 million. Non-GAAP loss per share of $0.07 to $0.09. Additionally, non-GAAP other expense of $57 million to $59 million. Non-GAAP tax rate of 26%. Non-GAAP share count of 214 million to 216 million. And as we noted last quarter, we expect Q2 cash flow from operations and free cash flow to be positive. Lastly, we expect Q2 operating profit to be the trough with sequential profit improvement anticipated for the remainder of 2023, driven primarily by cost reduction and some improvement in mix. I will now turn the call back over to Amar for some closing comments.

Thanks, Bobby. As I mentioned last quarter, 2023 is a transformation year, and we expect performance to be choppy. This is reflected in our guidance, but as Bobby noted, we do anticipate Q2 being the low point from an operating profit perspective. We are fortunate to operate in growing markets and are working hard to improve our execution across the board. We are focused on four priorities to turn around our company's financial performance. First grow our Public Cloud services business at or above market. Second, stem the decline in Private Cloud offerings, excluding OpenStack. Third, build a highly efficient cost structure. And lastly, drive sustained growth in profit and free cash flow. We are making progress, but we have a lot of hard work ahead. We have a good strategy, a solid plan and a strong team. So I'm confident we'll get this done. And with that, we'll take your questions.

[Operator Instructions] Your first question comes from the line of Frank Louthan from Raymond James.

Can you just give us a little more color on what's in the Public and the Private Cloud? I assume that OpenStack and Apps & Cross Platform are in Private Cloud. And the relative profitability there, how should we think about that? And how quickly you can sort of exit those businesses and then look for other opportunities for Private Cloud?

Yes. So Frank, thanks for the question. So in -- so your question is around what's in the Private Cloud segment, or both Private and Public Cloud?

Well, kind of how you divided them up and just what we should think about -- the difference in profitability.

Yes, absolutely. So Frank, the Private Cloud segment includes both Private Cloud, which includes managed hosting, and we also included OpenStack, which shares the infrastructure with Private Cloud and is also managed by Brian Lillie. Some of the Apps & Cross Platform that pertains to Private Cloud is also included in the Private Cloud segment. So Private Cloud segment addresses the private cloud market and vice versa, Public Cloud segment has infrastructure resale that we do across all the three hyperscalers and the services for Public Cloud, that includes services for infrastructure, application, data and security, both in managed services, elastic engineering and professional services. So those are two segments. Now from a profitability perspective, Public Cloud, when you look at gross margins, and we have provided the gross margins to you in the segment financials. So it's operating at around 36% gross margins in Public Cloud on a net basis, which is using gross profit as a percentage of net revenue. And Bobby defined what net revenue is in his prepared remarks. Overall, the gross margins on a gross basis was about close to 12%. So on a net basis, it was about 36%. Now the reason why we provided that metric to you so that you can really understand the underlying gross margins of the business after excluding the impact of the infrastructure resale gross margins, which basically dilutes the gross margins. As you know, gross margins for infrastructure resale is very low. On the Private Cloud side, the gross margins that we posted in Q1 is about 40%. So as you can see here, we have given a lot of transparency in our financials now. This is how we are going to manage the business internally. So we have two leaders managing Public and Private Cloud, and this is, however, we're going to report externally to the Street.

All right. That's great. And just a follow-up on the trough in the Q2 profitability. So you said it's going to improve sequentially mostly from cost cutting. What else can you give us -- what gives you the confidence that this is the trough and we're going to be moving forward from there?

Yes. Frank. So look, we provided guidance here in terms of Q2 being the low point. We're pretty confident about that because we've got some significant cost actions underway -- in its way. As we segmented the business into these two BUs, we talked about that, we've uncovered some significant opportunities to take cost out, which we're executing on. And we've kind of doubled down on that for the second half as we've seen kind of macroeconomic environment kind of stall. So we're pretty confident or very confident that we will see sequential improvement in Q3 and Q4 going forward. At the same time, we will see a little bit of mix improvement, too, that should help us. So that's what gives us confidence.

So if I can just build on that, Frank, if I may, right? I think the other question is, for us, what are the early indicators of progress, right? As we go segment, the two businesses -- our entire business into two business units. I'm focused on three indicators as a measure of a successful turnaround of this company. First, in Public Cloud, I'm keeping a close watch on our services growth and how the mix of the business is changing from low-margin infra to a high-margin services business. As you know, since building a services backlog typically, it takes around 6 to 9 months, and that's what process we already initiated. I expect fiscal '23 to be a very low growth year for services with growth acceleration in fiscal 2024. So that's the first indicator. The second, in Private Cloud, I'm very focused on making sure that we arrest the decline in revenue, excluding the impact of OpenStack. So we have initiatives in place to both grow the bookings and backlog, while also actively reducing the churn. And in Private Cloud, as you know, given the long sales cycle and time it takes to implement the solution, I do expect better performance starting in 2024. And just to give you a little bit additional color here, Frank, every percentage point of improvement in revenue growth adds roughly about $7 million to $8 million of incremental profit due to the high fixed costs and the positive operating leverage we have in the Private Cloud business. And the final metric, both Bobby and I are very much focused on, is making sure that we go drive cost efficiencies. As you know, as we split the business into two business units, we have uncovered additional operating efficiencies that we can go drive and also on the cash flow side, focus on cash flow generation and preservation. These are things that Bobby and I will be keeping a close tab on.

[Operator Instructions] Our next question comes from the line of Kevin McVeigh from Credit Suisse.

And appreciate the additional disclosures. Amar or Bobby, any way to think about what free cash flow should be for 2023 and EBITDA associated with that? And what type of macro environment? I mean, you're pretty comfortable with the current environment. Like what type of macro outlook are you assuming as you work your way through this transition?

Yes. So Kevin, look, for free cash flow, like we said in our Q4 earnings call back in February, we did anticipate Q1 cash flow to be slightly negative. But we do expect positive cash flow from operations in the remaining quarters, and we do expect free cash flow to be margin positive for the full year. From an EBITDA perspective?

So I think -- so on the EBITDA perspective, Kevin, we expect EBIT to trough this quarter in Q2 and then from there sequentially, improve. Now we don't want to provide the EBITDA forecast for the full year, both revenue and EBITDA forecast. I would like to give you an outlook one quarter at a time, given the uncertain macro environment and also given the transformation that we are driving. So we need some room here to go change the mix of the business, Kevin, to two more of services compared to infrastructure resale. So there are a lot of moving parts here. So we'll guide you one quarter at a time. But as Bobby mentioned, we expect free cash flow to be marginally positive. And we landed in a good place in Q1, given all the onetime cash expenses that we had in Q1.

And then from a macro perspective, just on that point there, Kevin. Look, we -- it's a tough macro right now, right? So our assumption is it remains tough and the market doesn't get -- the macro doesn't any better either. That's kind of our assumption going to these -- sorry, Q2 guidance and then as well into our full year cash flow and free cash flow guidance.

Great. And then it looked like you took the opportunity to acquire some senior notes, about $23 million. Should we expect more of that over the course of the year? Or just any thoughts around that?

Yes. So Kevin, look, our debt is trading at high discounts. So we do see that. But -- anyway we did purchase $23 million of unsecured bonds at the $10 million that you talked about. When it comes to repurchasing debt, I mean, we will consider it, but our priority is investing in the business so that we can pivot to profitable growth going forward. That's our priority. Our capital allocation priorities haven't changed, and our top priority remains investing in the business. So...

And if I can just add to that, Bobby, very well said, we also want to be prudent about maintaining liquidity, Kevin, given the uncertain macro environment and also our ongoing transformation. So we will balance all those things, investing organically, as Bobby mentioned, being opportunity if we have to, but also making sure that we maintain sufficient liquidity given the transformation and the macro outlook.

The next question comes from the line of Ramsey El-Assal from Barclays.

This is Ryan Campbell, on for Ramsey. I was hoping you could provide a little additional color on the bookings pipeline. What dynamics are you seeing from current clients versus new logos? And then from a sales perspective, has your approach changed in order to accelerate the shift to higher-value services?