Rackspace Technology, Inc. Q2 FY2021 Earnings Call

Good afternoon, everyone, and welcome to Rackspace Technology’s Second Quarter Earnings Conference Call. As a reminder, today's call is being recorded. Kevin Jones, our Chief Executive Officer, and Amar Maletira, our President and Chief Financial Officer, are joining us today. The slide deck we will refer to today can be found on our Investor Relations website. On slide two, certain comments we make on this call will be forward-looking. These statements are subject to risks and uncertainties which would 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 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 respective and most directly comparable GAAP measures. These reconciliations are in the tables included in our earnings release and slide presentation, both of which are available on our website. After our prepared remarks, we will take your questions. I’ll now turn the call over to Kevin.

Good afternoon, and thanks for joining us. I'll discuss quarterly highlights and touch on some customer case studies, and Amar will go into detail on the financial results. As shown on slide five, we delivered a solid second quarter: revenue and non-GAAP earnings per share were at the high end of our prior guidance, and non-GAAP operating profit exceeded the top end of our guidance. Our new product launches from earlier this year, Rackspace Elastic Engineering and Rackspace Services for VMware Cloud, are off to a good start with some early wins already on the board. The turnaround in cash flow resulting from our working capital and cash management transformation programs has been remarkable. This quarter, we began paying down debt with the repayment and retirement of our accounts receivable financing facility. The strong cash flow we are generating will enable us to continue making progress on reducing our leverage ratio toward our stated targets. Turning to slide 6, total revenue was up 13%, and core revenue was up 17% compared to last year's second quarter. Non-GAAP operating profit was up 4%, and non-GAAP EPS was up mid-teens at 14%, in line with revenue growth. Through sales bookings in the second quarter were $258 million, a 6% increase compared to the first quarter. This year, we are calibrating new sales bookings to drive both revenue growth and initial sold margin. We believe approximately $1 billion of new sales bookings in 2021 will enable us to drive double-digit revenue growth while optimizing profitability, and we're all on track to meet that goal with just over $500 million of bookings in the first half of the year. On slide 7, I want to touch on the transformation that we announced in late July. Over the past 6 months, we've taken a hard look at every aspect of our business in light of the acceleration of digital transformations and continued migration of our business from mature products to growth products. Through this process, a few things became very clear: we had to free up resources and continue to invest in new solutions, expand our delivery capabilities to meet demand for those new solutions, and help employees in our mature businesses develop high-demand skills for growing areas. The actions we announced in July accomplish all of these goals. As part of this initiative, we are providing Rackers, including those impacted by the restructuring, the ability to re-skill and retrain for high-demand areas in cloud, including elastic engineering and cloud professional services. Net net, we believe the transformation and restructuring initiatives announced in July positioned Rackspace Technology extremely well to compete and win in the growing cloud technology solutions industry. As I've done in past quarters, let me share some case studies of how Rackspace Technology is helping customers innovate in the cloud. On slide 8, let's talk about Pure Storage, a $6 billion market cap technology company. Pure Storage serves over 8,000 customers with its storage as a service offering, helping them run their operations seamlessly across multiple clouds. As containers became more practical, Pure Storage took notice and looked for a world-class partner who could move fast to build reference architectures on Google Anthos and Kubernetes. The partnership with Rackspace Technology enabled Pure to hit an aggressive 90-day timeframe for the initial product launch. Pure Storage now has reference architectures that they can confidently present to prospective customers, delivering the benefits of leveraging Pure Storage on Google Anthos. Slide 9 features a case study from Bright Skies, the company we acquired in Germany in the fourth quarter of 2020. Bright Skies recently helped a major international produce company transition its European operations from company-owned data centers to the cloud. Our solution included an entire service package that started with a cloud readiness assessment, a feasibility study and budget plan, and technical workshops to define the target architecture. On an accelerated three-month timeline, 100% of those virtual machines were moved to Microsoft Azure. Today, they'll benefit from having this data in the cloud with less complexity, increased productivity, and most importantly, reduced costs. Now, Amar will take you through the financials.

Thank you, Kevin, and thank you everyone for joining our call today. Slide 11 recaps our financial results for the quarter: revenue was $744 million, an increase of 13% year-over-year. Our core business grew 17% year-over-year to $698 million. Non-GAAP operating profit was $119 million, up 4% year-over-year. Non-GAAP operating margin was 16.1%, down 1.5 percentage points year-over-year, but within our mid to high teens range. Non-GAAP earnings per share was $0.24, up 4% from last year. Slide 12 shows the company's revenue mix in the first quarter by segment and geography. Multicloud continues to represent the vast majority of our revenue at 82% of the mix, and it grew 17% year-over-year. Apps and cross-platform, representing 12% of total revenue, grew 16% year-over-year, driven by growth in application services coupled with strength in our data and security services businesses. OpenStack, a legacy business, declined 20% in line with our expectations and now represents only 6% of total revenue. From a regional perspective, the Americas continue to represent 75% of revenue and grew 12% year-over-year. APJ grew at 39%, while EMEA grew 13% year-over-year. As shown on slide 13, Q2 was another good quarter for cash flow. GAAP cash from operations was $106 million, bringing first half cash from operations to $209 million. Free cash flow, defined as GAAP cash from operations minus cash CapEx, was $77 million, up from $66 million in Q1. This brings total free cash flow for the first half to $143 million. As expected, total CapEx in Q2 was $82 million, with total CapEx intensity at 11%. This was due to the renewal of large enterprise license agreements. The accounting treatment for these renewals requires us to recognize enterprise licenses as CapEx in the period the deal is signed. Cash CapEx was $29 million, and cash CapEx intensity was 4% in the first quarter. For fiscal year 2021, we expect cash CapEx intensity in the 4% to 6% range. Total cash at quarter-end was $215 million, and we had $375 million of unused revolving credit lines. We paid down $56 million of debt, including $50 million for the repayment and termination of the accounts receivable financing facility. On slide 14, we have guidance for the third quarter. For the third quarter, we expect revenue in the range of $750 million to $760 million, core revenue of $705 million to $715 million, non-GAAP operating profit of $118 million to $122 million, and non-GAAP earnings per share in the range of $0.23 to $0.25. Non-GAAP other expenses are expected to be between $50 million and $52 million, and we anticipate a non-GAAP tax expense rate of 26%. We expect non-GAAP weighted average shares of $213 million to $215 million. For the fourth quarter, we expect revenue to grow approximately 2% sequentially, and operating profit and EPS to be flat sequentially. With that, we'll take your questions. Joe, please go ahead and queue up the audience for Q&A.

Hey, guys, can you hear me? Sorry, I just want to make sure I was unmuted. So I had a question; you're targeting $1 billion in bookings for the full year, which suggests flattish absolute dollars for the second half of the next two quarters. So there are two questions. First, can you remind us how that's going to translate into double-digit revenue growth for the second half of the year? It looks like the midpoint guidance suggests a deceleration a bit in the third quarter and fourth quarter. And secondly, you clearly refined the strategy of what you're letting into that funnel. Could you remind us of some of those changes and why that's beneficial for you guys longer term? Thank you.

Let me get started here, and Kevin can add additional color. When you look at our revenue growth, it is driven by multiple factors. First, we have a high base of recurring type revenue, which drives good visibility into the future, and that's factored into our guidance. Second, we are executing revenue-related initiatives that are less visible to the street, mainly focused on things like the acceleration of revenue realization and reduction in contract renewals. We need to roughly deliver $1 billion in bookings to continue driving double-digit revenue growth in '21 and '22. If you look at our fiscal '21 guidance, we anticipate double-digit growth in revenue. Based on our guidance, our core revenue in Q3 will grow roughly about 13% and in Q4, it will grow about 10% plus, depending on what you model for your OpenStack business. Therefore, when examining the $1 billion, you will see that revenue growth continues, and we are looking at the full revenue growth for the full year with expectations of delivering approximately 13% to 14% growth, significantly higher than what we delivered last year.

I would just add to that. Dan, when you review the second half for bookings, I expect third quarter bookings to be lighter than the $250 million run rate to reach that $1 billion total number, due to seasonality and summer holidays in specific parts of the world. However, we anticipate a rise in Q4 to balance out at that $1 billion number. As Amar mentioned, achieving that number is essential to sustain double-digit revenue growth, which is incorporated into our guidance as well. Regarding the second part of your question about the type of business we are calibrating, we've been working to calibrate new business bookings alongside initial sold margin. This has proven to be a positive development for the company, allowing us to be more selective and strategic about the deals we pursue. As we continue to grow our professional services business and our cloud-native application development business, including multi-cloud managed services such as the elastic engineering recently launched, this is our primary focus. Amar, do you have anything to add?

I think you said it, Dan. The focus is on securing high-quality bookings that will drive not only double-digit revenue growth but also improve margin profiles and expansion opportunities within those accounts.

Tien-tsin, you’re up next. Jim Breen, you are on deck.

Hopefully I’m unmuted now. Can you guys hear me? I appreciate the question here. Just on the margin side, as we've been focusing on the supply side of the equation, the industry's talking about the war for talent and wage inflation. I'm curious if you're seeing that, and how much of that is a factor in some of your margin outlook. I know you're in some hot areas around cloud, so I just want to check if that is a focus area or if it’s influencing your thinking on margin compared to previous discussions.

Do you want to start with that one, Amar, regarding margin? I'll add a few comments on the talent war afterward.

Absolutely. When examining our margin, gross margins are declining due to a mix shift in our business. This consists of two components: the ongoing decline in our legacy OpenStack business, which we no longer actively market, and the mix shift within our multi-cloud segment from mature to growth products. Growth products have lower initial gross margins, but also lower CapEx and OpEx intensity. Regarding your question about gross margins being affected by the war for talent, we have already incorporated that into our guidance. We have made room in our model to invest in the business. However, we are in a transient phase, and we believe this will continue for another four to five quarters. During this time, we expect our gross margins will bottom out in the low 30% range. Once gross margins hit this bottom, we expect to inflect positively with improved mix shifts leading to higher value cloud services. We are already observing good traction in our land and expand strategy. Consequently, we have significant confidence margins will improve with higher value products. Notably, our cumulative bookings in managed public cloud engagements are growing double digits, with healthy expansion in gross margins. In Q3, we expect gross margins to fall between 32.5% and 33%. We have modeled prudently for these reasons related to the mix shift occurring in the business. We're onboarding more managed public cloud customers, with 31% growth in new logos in the first half of 2021 compared to the first half of 2020, indicating a substantial increase in public cloud onboarding. This is contributing to the gross margin declines. Nonetheless, we have integrated all these factors into our guidance as we project for the second half. Specifically regarding talent, I believe it is already considered in our guidance, and we plan to continue investing in business areas of high growth.

In terms of workforce talent, we are certainly observing an uptick in activity across our industry and customers noting similar trends regarding talent competition. Nonetheless, we are well-positioned to navigate through this. Our business is primarily technology and automation-driven, requiring fewer employees compared to larger systems integration companies and global managed services providers. We still accept less than 2% of applicants at the company. That said, as Amar highlighted, we are closely monitoring this industry-wide trend and taking a proactive approach.

Thank you, you answered my operating margin and gross margin question as well. I'll seize the floor. Thank you.

Jim Breen from William Blair, you're up next. Ramsey El-Assal from Barclays is on deck.

Thanks. Can you provide more color on guidance for profitability? It seems that your full year guidance given last quarter was over $500 million in non-GAAP operating profit, but it looks like we might be a bit below that. So what’s changed over the last quarter? Secondly, could you talk about the revenue being down sequentially this quarter in the Apps and Cross Platform segment? Can you provide insights on that lumpiness?

Certainly, Jim, let me address the guidance question first. I know I've touched on some aspects in my previous comments, but let's break it down. Our revenue guidance reflects our expectations for continued sequential growth in both Q3 and Q4, with double-digit growth projected for core and overall revenue for 2021. This is included in our fiscal 2021 guidance. In terms of profit guidance, that reflects low gross margins anticipated in the second half of 2021. I may be repeating this, but I want to provide transparency: we are witnessing a mix shift impacting gross margins. This includes a decline in the legacy OpenStack business that we no longer actively market and a transition within our multi-cloud segment from mature to high-growth areas. We've factored these shifts into our prudently modeled gross margins, expected between 32% and 33% for the second half. Following the restructuring we announced on July 21, we’ve aligned our OpEx to meet the new gross margin profile while continuing to invest in growth offerings. Our projections suggest we are in a transient phase for the next four to five quarters and anticipate gross margins will bottom around the low 30% range. By the end of fiscal 2022, we expect growth in higher-value cloud services to lead to an inflection point. The legacy OpenStack product is declining in our revenue mix, already down to 6%, and we expect the transition within multi-cloud will soon be more than 80%. Significant expansions in our newer accounts with higher margin services often take time, but this is a long-term strategy for us. Does that clarify things, Jim?

Yes, that's great. Could you also provide insights into revenue down a little bit this quarter within the Apps and Cross Platform segment? Thanks.

In Q2, our Apps and Cross Platform did experience a year-over-year growth of about 16%, which is quite healthy. However, it decreased approximately 5% sequentially. Additionally, as part of our restructuring, we exited a small, non-strategic line of business in application services which explains most of the sequential downturn from Q1 to Q2. We anticipate this segment will continue delivering revenue in the $90 million to $93 million range in both Q3 and Q4, while growing at a healthy rate.

Our next question comes from Ramsey El-Assal with Barclays. Ramsey, are you there? I think we've lost Ramsey. So there are no further questions in the queue. With that, we'll call it a wrap. Again, if you have follow-up questions, you can reach out to me at ir@rackspace.com, and have a good evening.