Rackspace Technology, Inc. Q1 FY2022 Earnings Call

Good afternoon, and welcome to Rackspace Technology's First Quarter 2022 Earnings Conference Call. Today's call is being recorded. Kevin Jones, our CEO, and Amar Maletira, our President and CFO, are with us today. You can find the slide deck we will reference during the call on our IR website. On Slide 2, some comments we make will be forward-looking statements, which are subject to risks and uncertainties that may cause actual results to differ. We have included a discussion of these risks and uncertainties in our SEC filings. Rackspace Technology does not have any obligation to update the information presented on the call, except as required by law. Our presentation includes certain non-GAAP financial measures and additional adjustments to these measures, which we believe provide useful information for our investors. In line with SEC rules, we have provided a reconciliation of these measures to their most comparable GAAP measures in the earnings release and presentation, both of which are available on our website. After our prepared remarks, we will take your questions. I will now turn the call over to Kevin.

Good afternoon, and thanks for joining us. I'll discuss quarterly highlights and the strategic direction of our business. Then Amar will go into detail on the financial results. Turning to Slide five. Rackspace Technology benefits from secular tailwinds and a cloud market that continues to grow with no signs of slowing. In the first quarter, our cloud hyperscaler partners all grew year-over-year revenue by 35% to 50%, representing $10 billion of new cloud revenue in the first quarter alone. So cloud revenue continues to accelerate. The cloud revolution is in the very early stages, with winners still to be determined and plenty of whitespace to attack. Rackspace Technology remains well-positioned as the leading pure play multi-cloud services company. In the first quarter, our financial results were in line with our guidance and expectations, and we once again delivered solid growth, profitability, and cash flow. On the new business front, it was a very productive quarter. We renewed and strengthened our relationship with AWS and closed a major new deal with VMware to support their Global Edge offerings. We also just launched a new partnership with Nvidia, which I'll touch on in a moment. We closed the acquisition of Just Analytics and began introducing their products and services to our customers globally. Rackspace Technology was recognized as an industry leader in two major analyst reports published in the first quarter, including the ISD provider lens AWS ecosystem partners report, where we were named a leader in three quadrants, and the ISD index, where we were named a top 15 sourcing standout in the breakthrough 15 category for the Global, Americas, and EMEA regions. Turning to Slide six, revenue growth was solid, with total revenue up 7% and core revenue up 9% compared to last year's first quarter. Non-GAAP operating profit was $112 million and non-GAAP EPS was $0.22, both at the high end of our guidance range for the first quarter. As noted on the slide, our first quarter bookings put us on track to achieve our targeted $1 billion of new sales bookings in 2022. As we discussed with investors last quarter, Rackspace Technology and our Board of Directors have been carefully examining every area of our business, weighing the company's strategic options to increase shareholder value. I'd like to share with you how we're thinking about this. As Slide seven notes, we operate in two very different multi-cloud markets with different operating models, growth trajectories, and investment prospects. On one hand, public cloud is right in a long-term secular growth wave and is a services-centric capital-light product line where we can make smart investments to capture additional whitespace and growth opportunities. On the other hand, private cloud and managed hosting is in a low-growth market where we're focused on optimizing profit and free cash flow. Our strategy to maximize shareholder value is now coming into focus, and we are therefore considering reorganizing Rackspace Technology across these two markets. We are also exploring other strategic alternatives as noted in our press release; Amar will discuss this more in a moment. We will provide shareholders with details as well as the growth drivers, profit dynamics, and long-term financial model at an Analyst Day in September. On Slide eight, you can see how the development of our partner network is essential and different in each of these two markets. We have painstakingly built our partner network to add value across the two operations, and we work to strengthen these partnerships every quarter. On the left side of the slide in public cloud, long-term success starts with a strong relationship with the hyperscalers. We must act as a bridge between the needs of our customers and the hyperscalers as we onboard an ever-growing volume of new clients to the public cloud. In this vein, in the first quarter, we extended our strategic collaboration agreement with market leader AWS for an additional multi-year period, which serves as a strong validation of the value we deliver to AWS as an ecosystem to date. It is also essential in public cloud to provide customers with up-the-stack functionality once they've migrated to the cloud. Again, as an example, in the first quarter, we achieved premier partnership level with Snowflake, making us one of their top 30 partners in the U.S. On the right side of the chart, you see our key partners for private cloud and managed hosting. Here, strategic partnerships have served to provide upside through access to exciting strategic service adjacencies. As an example of the former, in the first quarter, we launched our new private cloud relationship with BT and started onboarding their customers to Rackspace Technology. As a reminder, the BT deal was the largest in Rackspace Technology’s history, with the potential for hundreds of millions of dollars of revenue. We are encouraged that even in the early going, we're seeing plenty of opportunity for further expansion of our relationship with BT. Earlier this week, we announced that we are now certified to deploy NVIDIA’s AI computing platform, and we've been named an advanced technology partner in the NVIDIA partner network. We are excited about this new partnership with a leading technology company, which we believe will help us grow private cloud and facilitate the development of highly compelling services for our customers. Now let's talk about the different ways we support our customers. On Slide nine, Carrier Global is a world leader in heating, air conditioning, and refrigeration solutions. After spinning off from its parent company, Carrier was looking to modernize their infrastructure and existing applications. We worked with Carrier to transform the IoT technology that powers all their connected thermostats and build a scalable, robust cloud-native platform that they can use as the basis for their entire connected device portfolio. After this modernization effort, Carrier reduced technical debt, increased security, sped up infrastructure provisioning time from 35 days to 30 minutes, and reduced infrastructure costs by 45%. On Slide 10, Provenir provides artificial intelligence-powered software to help the FinTech industry manage risk across identity, credit, and fraud. Provenir had multiple microservices deployed in Kubernetes clusters running in AWS but didn't have the capacity to quickly create monitors and dashboards. Rackspace professional services helped Provenir integrate their software with Datadog, resulting in enhanced visibility into their microservices and infrastructure, along with increased accuracy and consistency across multiple environments. More importantly, we built automation into the process, enabling Provenir to launch additional monitoring and alerts for its applications and infrastructure without having to write a single line of code. Now Amar will take you through the financials. Amar.

Thank you, Kevin. And thank you everyone for joining our call today. Slide 12 recaps our financial results for the first quarter. Revenue was $776 million, a 7% year-over-year increase. Core revenue was $735 million, up 9% compared to the first quarter of 2021. Non-GAAP operating profit was $112 million, which was at the high end of our guidance for the first quarter and was down 6% year-over-year, primarily due to the impact on gross profit from revenue decline in a legacy OpenStack and mature managed hosting. Non-GAAP operating margin was 14%, and non-GAAP earnings per share was $0.22, both at the high end of our guidance for the first quarter. Slide 12 shows the company's revenue mix in the first quarter by segment and by geography. Multi-cloud continues to represent the vast majority of our revenue at 83% of the mix and it grew 10% year-over-year. Apps and cross-platform, at 12% of total revenue, was down 3% year-over-year. As we have discussed previously, year-over-year comparisons in this segment were impacted by the discontinuance of a non-core product line in 2021. We lapped that strategic change in the second quarter. OpenStack declined 17% in line with our expectations. This segment now represents only 5% of total revenue. From a regional perspective, the Americas continues to represent 75% of our revenue and had 7% year-over-year growth. APJ grew at 32%, while EMEA grew 2% year-over-year. Excluding currency impact, EMEA growth would have been in the mid-single digits. On Slide 14, in the first quarter, operating cash flow was $65 million, and free cash flow was $45 million, an increase from $38 million in the fourth quarter. First quarter 2022 operating cash flow included the 2021 annual company bonus payout. Total CapEx was $31 million, and cash CapEx was $19 million with CapEx intensity of 4% and 2% respectively. We expect total CapEx intensity of 5% to 7% and cash CapEx intensity of 3% to 5% for the full year in line with our previous guidance. Cash at quarter end was $269 million, up $71 million year-over-year. On Slide 15, I want to remind investors that we have a strong balance sheet with no material debt maturities until 2028. In addition, all of our debt was refinanced in late 2020 and early 2021 at historically low rates with minimal financial covenants. At quarter end, total debt was $3.4 billion, and net debt was $3.1 billion. Our net leverage ratio of 4.3 times the adjusted trailing 12-month EBITDA is very manageable for a company with our growth profile. On Slide 16, we have guidance for the second quarter. We expect total revenue in the range of $780 million to $790 million. Core revenue in the range of $744 million to $752 million, non-GAAP operating profit of $93 million to $97 million, and non-GAAP EPS of $0.15 to $0.17. Now, let me provide you some additional color on our outlook. As I mentioned last quarter, we expect revenue growth to accelerate through the year. This is due to three main reasons. First, the ramping of BT-related revenue in the third and fourth quarters, which will bolster private cloud and managed hosting within the multi-cloud segment. Second, continued growth in managed public cloud, as we have a growing pipeline of large opportunities in the multimillion-dollar range that we expect to close in the second half of the year. And third, because of the investments we made in go-to-market, we have many new sales professionals that are ramping in the first half and who will become more productive in the second half of the year. Now with regard to operating profit and non-GAAP EPS, the second quarter will be impacted by $15 million to $20 million of investments that we're making to support growth acceleration in cloud services and the startup of a BT partnership. These investments are primarily in cost of revenue and some in operating expenses. They represent most of the divergence between our guidance and the constraints of estimates. Given the secular growth opportunity in the cloud market, we will prudently invest in long-term profitable growth. On Slide 17, to close, I would like to recap and summarize what Kevin said earlier. We offer services across both public and private clouds. We are the only pure play multi-cloud services company that is addressing both of these markets at scale. That said, the market has evolved rapidly in the last 18 to 24 months. We have been proactively evaluating all of our strategic options to take advantage of this opportunity. To that end, we have taken a number of actions. First, we completed an in-depth strategic review of the company. Second, we have a clearly defined strategy for the company across public cloud and private cloud managed hosting. Third, we are working on aligning our operating model and reorganizing the company to sharpen our focus in these two markets. Fourth, we are also working to align our financial models and plan accordingly. As we completed this strategic review, and also based on inbound interest for one of our businesses, we concluded that the sum of the parts valuation of Rackspace Technology could be greater than our current enterprise value. This is in part driven by the attractive growth profile of our public cloud offerings. Accordingly, we are evaluating strategic alternatives and options. We plan to share details on our strategy, operating organization, and long-term financial model at an Analyst Day to be held in September. With that, we'll take your questions.

Thanks, Amar. Our first question comes from Bryan Keane at Deutsche Bank. Ramsey El-Assal, you're up next.

Hi, guys, I just want to ask about the margin profile. I know we talked about 14% to 15% EBIT margins for the year. Just any update on that Amar, and then on gross margins as well. What's the outlook there?

Thanks, Bryan. So Bryan, as noted in last quarter's call, we're going to continue to guide the street one quarter at a time. Now, if you look at our Q2 guidance, the midpoint of our guidance implies that the operating margins in Q2 of about 12%. But also keep in mind, as I mentioned in my prepared remarks, within our second quarter, we do have growth investments of about $15 million to $20 million that impact operating margins by about 200 basis points, which implies that our operating margin excluding these investments will be approximately 14%. So Bryan, long-term, I do see operating margins in the low to mid-teens. And so that's what a long-term outlook is. Let me just give you some color on the gross margin since you asked that question. Now, when you look at our Q2 investments of $15 million to $20 million Bryan, most of these investments are primarily in cost of revenue, to deliver additional services growth in the second half. And these investments are primarily in building out our delivery capability in both professional services and elastic engineering. And so including these investments in our Q2, gross margins will be in the 28% to 29% range. But if I again, exclude these investments, we will still be in the 30% range for Q2.

Got it. And just to follow up on the strategic review, it sounded like there was an inbound inquiry that came in, which business was that that got that inquiry? Is that a smaller piece of the business, a larger piece? Just trying to get a sense of what that business unit was? Thanks so much.

Hey, Bryan, it's Kevin. I'll address the strategic question. Currently, we can't share specifics due to the ongoing nature of our discussions, both internally and externally. As I mentioned earlier, we're focusing on two markets that are very edge practice, and we're organizing our efforts around them. However, I can assure you that all strategic alternatives are being considered. We are assessing all options, including the current interest we've received for one of our businesses, and we will share more information as it becomes appropriate based on developments.

Ramsay El-Assal from Barclays, you are up, and Frank Louthan, you're on deck.

I was wondering if you could give us some color on the demand environment, just given the more kind of challenging macro backdrop. Are you seeing any impacts out there on client decision-making? Any color here will be helpful?

Yes, sure thing. So let me take that one, Amar. I'll talk a little bit about the economic environment in general, and then I'll sort of transition into the demand environment that we're seeing. I would say just kind of upfront, while there are near-term headwinds in the economy, such as supply chain disruption and the war in Ukraine, we do not see any recessionary pressure in this business. Our hyperscaler partners grew cloud revenue by a record amount, over $10 billion in the first quarter. So cloud is really only accelerating, even in the challenging economic environment we've seen so far this year. Now if the economy does slip into recession, we think that multi-cloud becomes even more of a must-have for customers because it helps customers save money, quickly scale up, or scale down and change their business model. We saw this in early 2020 when the economic slowdown caused by COVID resulted in the acceleration of demand for digital services and multi-cloud. So that's the broader macroeconomic picture and how it relates to our business. Now, if I just look at the demand environment, let me give you a little bit of color on how I see the demand environment. Now we'll start out with the market. The market, Ramsay, really is very strong. We believe that at this point, only 10% to 15% of workloads have been moved to the cloud, so there's many years of growth runway ahead. Our view is that will result in lots of opportunities for migrations, integrations, and managed services. First, multi-cloud continues to be really the overwhelming choice for customers that are moving to the cloud. As the hyperscalers continue to innovate, they're innovating at such a pace that choice is now really abundant in the market for customers. Customers need firms like Rackspace Technology to help them make the right decisions for their cloud environment. That's another piece. We see lots of desire for innovation beyond infrastructure into the apps and data layers of the IT stack in particular. The other thing we're seeing is industry specialization is becoming a trend in a lot of areas. From a geographic perspective, demand for multi-cloud services continues to pick up pace all over the world, particularly in Europe, the U.K., Asia and South Pacific, Latin America, and of course, the United States. So that's the market. Now, from a customer perspective, it's quite interesting. I was just with a large healthcare CEO last week, and they're a big customer for Rackspace Technology and a multi-cloud customer. The CEO told me, thank goodness Rackspace handles cloud for us; the complexity of multi-cloud really is mind boggling. Rackspace takes all that off his plate. The other thing he said, and I keep hearing this over and over from other customers, is data. Data is becoming a huge differentiator in healthcare, and customers are saying we want to increase the pace of innovation, both in cloud-native data and cloud-native apps. We hear this from customers in a lot of industries now that data and apps innovation is important to them and is a focus of how they're becoming more competitive. Finally, just to wrap up from a partnership perspective, right now, the demand for the hyperscalers' products continues. The demand for cloud continues to be amazing; AWS, Google, and Microsoft are adding giant amounts of sales and revenue every quarter. It's unlike anything I've ever seen in my career. When I talk to my friends at Dell and VMware, there's big demand from customers for private cloud and multi-cloud as well. Our partners all tell me, we need Rackspace Technology to help make sure these customers have the very best services partner and help them on their cloud journey. Overall, Ramsay, it's a very strong demand environment, and we are extremely encouraged by the opportunity.

Our next question comes from Frank Louthan with Raymond James. And Bradley Clark, you're on deck.

So maybe going a little more detail on the dip that you're forecasting here for the operating income in Q2, what's causing that sequential decline? And then, if you don't end up selling the whole company, give us a little bit of color on what the reorg looks like? What sort of things will you be adjusting going forward in areas you think need some more help? Thanks.

I'll take the first question, and Kevin could you take the next one? So Ramsay, in terms of the dip, the sequential dip in our operating profit, we did about $112 million in Q1. It's going down to about $95 million in Q2, that's the midpoint of our guidance. That's mainly the investments that we're making, Frank, in our business. If you take a look at the investments in, I'll give you some additional color on where we're making those investments. The investments are in three areas, right? First, we're making investments, as I mentioned earlier, to expand delivery capacity for professional services and elastic engineering across all three cloud platforms; this includes AWS, GCP, which is Google, as well as Microsoft Azure. Second, we're also making some investments, Frank, in our go-to-market organization. Third, we are making some investments, which are mainly startup investments as we ramp our BT accounts. BT is expected to reach full run rate revenue by the end of the second half. As I mentioned earlier, most of these investments are in cost of revenue in Q2, and this is what's basically creating the decline in operating profit going from Q1 to Q2. That's mainly the reason.

Very good. And the second question you had, Frank, around how we're going to kind of reorganize and manage the business and the company? Just a little bit of backdrop; we operate, I would say, a very attractive multi-cloud market, right? It spans across both public and private clouds. As we talked about, we're the only pure play multi-cloud services company that's addressing both of these markets at scale. That being said, when you look at the market and the markets evolved, it's evolved pretty rapidly in the last 18 to 24 months, and we have a public cloud business that is significantly scaled from 18 months ago. We've been proactively evaluating all of our strategic options to take advantage of this public cloud market opportunity and sharpen our focus. Public cloud and private cloud have very different business dynamics as we talked about on the call. They also require different skill sets and levels of investment demand. For developing a plan to best align our resources with these findings, what we're going to do, Frank, at this Analyst and Investor Day in September, we'll provide additional details on what this looks like both from an operational and financial standpoint on a go-forward basis. But hopefully, that gives you some color.

Bradley Clark from BMO Capital, you're up next. And Matt Roswell after that.

I have two parts here. But I want to ask the incremental investment in the June quarter focused around expanding delivery capability and the BT account more broadly. As you know, you potentially win other large deals mentioned as multi-million dollar opportunities in the pipeline in the second half? How do you think about the incremental investment that these large deals are going to take? And the idea that with every one of these deals, there's more incremental investments that are already in the model? Are you investing more so ahead of time, so that this $10 million to $15 million becomes less and less over time? And then, part two of the question, I wanted to ask about pricing, and in an inflationary environment with higher wage inflation, the operating environment may be different than some other services company, but are you having pricing complications with your customers to potentially offset some higher wages and expenses, and if so, any comments you can make on the strategy there? Thank you.

Yes. So let me take the first one. Bradley, thank you very much for asking the question. To give you a little bit more specifics on investments, you're absolutely right; we are making investments ahead of demand that we are seeing mainly in cloud services. As you know, there's a lot of demand in cloud services. So this $15 million to $20 million of investments we're making in Q2 will also carry forward into Q3 and Q4, but it will be run rate costs, and it will be supported by incremental revenue, right? So you've got to build ahead of the demand; that's what we are doing. Now, as we see more growth opportunities, we may prudently make additional investments to capture further growth. These investments will primarily be in cost of revenue to build capability in advance of the services demand that we are seeing in cloud. We will continue to update the street if there's any change to our investment outlook per se, right? It's a very dynamic market. We see a lot of demand as Kevin talked about, and it is very prudent for us to continue investing and capturing that demand because, as you know, services is a very sticky business, and we have a very high recurring revenue base too. So these are the kinds of investments we'll make to continue driving profitable growth in the business. Regarding your second question about pricing, that's a very interesting question. If you look at and I will have Kevin jump in here too, we are not encountering significant pricing pressure from customers in the markets we play in, in cloud services, whether it is application migration, or modernizing those applications, or even data migration and data ops; these are very hot areas of the market today. It is sometimes very difficult to find skills in those markets. So we do not see a lot of pricing pressure. We do not have a very labor-intensive model, so to speak. Our key differentiator is combining labor with automation, and we have talked about it at length in the past, that we have driven about 75% of automation in our workflows. That's the reason why we do not see a lot of pressure in terms of pricing and labor costs because we are not a very labor-intensive model. Kevin, do you want to add anything here?

I think you said it really well. So, Bradley, we don't have nearly as many employees as a lot of firms out there in the market, so we don't have that same exposure to the labor inflation that's happening in the broader economy. We definitely don't see any pricing pressure, per se. Where it makes sense for delivering more value and making that case, we certainly are having those conversations. But in general, it's not as much of a factor in our business, particularly because we're very automated; we've got 75% of our multi-cloud transactions automated. We have the highest automation in the industry, driven by technology in an automation-driven business, if that makes sense.

Our next question comes from Matt Roswell at RBC Capital Markets. Go ahead, Matt.

I was wondering, follow-up on the investments, and I apologize for this, just wondering if you would be willing to kind of bucket how much of them are going into the three areas: cloud investment, go-to-market, and for BT? And I think you just said we should kind of expect the same level into the third and fourth quarter. When would you expect to see revenue return on the investment?

Let me address the last question first. The revenue return on investments is typically quick, occurring within three to twelve months, usually around three to six months. This fast return is essential as we need to establish our delivery capability prior to providing services to our customers. Regarding the investments, as I mentioned, the majority are in cost of revenue, approximately 75% to 80% of these investments fall into that category. The remainder is in operational expenses, with 75% to 80% of the investments allocated to hiring professional services resources for elastic engineering, among other areas. OpEx investments are primarily directed towards expanding our go-to-market efforts and initiating our BT environment.

Thank you. If I could sneak in a quick one: How should we think about cash conversion in the second quarter?

So, I will just talk about cash conversion in general. As you know, we had a very strong cash flow year in 2021, with all the improvements we drove, and those improvements are very sustainable. Long-term, we expect cash flow from operations to track to anywhere between 60% to 70% of our operating profit. For example, in Q1, our operating cash flow was quite solid at $65 million, which was about 58% of our operating profit. But also keep in mind, the first quarter is typically the seasonal low for cash flow, as it is a quarter in which we pay employee bonuses. There was a big cash payout from an employee bonus perspective. I would say, if you're tracking to 60% to 70% of our operating profit for conversion to cash flow from operations, I would say the quality of earnings is very high-quality earnings. Our cash CapEx is also going down; cash CapEx should be anywhere between, say, 3% to 5% of our revenue, and that CapEx intensity continues to go down, which means our free cash flow margin should be really good. This is a comment overall for fiscal '22.

Thanks, Matt. We haven't had anyone else queue up, so we'll shut it down there. I want to thank everyone for joining us. If you have a follow-up, please give me a shout at ir@rackspace.com, and we'll talk to you soon.