Rackspace Technology, Inc. Q3 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to Rackspace Technology Third Quarter 2023 Earnings Webcast. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today. Please go ahead.

Thank you. And welcome to Rackspace Technology's third quarter 2023 earnings conference call. I am Sagar Hebbar, Head of Investor Relations. Joining me on today’s call are Amar Maletira, our Chief Executive Officer, and Bobby Molu, our Chief Financial Officer. 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 investor relations website. Please note that, unless stated otherwise, all results are presented as non-GAAP except revenues. I'll now turn the call over to Amar for an update on the business.

Thank you, Sagar. Fiscal third quarter 2023 results exceeded the midpoint of our revenue, operating profit and EPS guidance. Our two business unit operating model is now fully implemented, and our leadership teams are executing to their plans. Additionally, we remain committed to aligning our cost structure with our current needs. These measures continue to improve our operating efficiency and execution. As has been widely noted, the overall economic and demand environment remains uncertain. Organizations of all sizes and spanning various industries remain cautious on IT spending. Hence, we continue to see extended sales cycles and delays in customers' new initiatives. In response, we continue to focus on fine-tuning our organization, aiming for more effective execution of our current operations. We are strengthening and preparing Rackspace Technology to capitalize on an uptick in demand as and when it occurs. As mentioned in the last earnings call, we launched Foundry for AI by Rackspace (FAIR). Since launching in June, we have announced offerings with all three hyperscaler partners AWS, GCP, and Azure. Among the offerings is AWS FAIR Secure Landing Zone, a solution that assists our customers across diverse industries in securely harnessing this platform's native AI services. We also showcased our AI capabilities at the Google Cloud Next event to a positive response from customers. In addition, we continue to work with Dell and NVIDIA in implementing our private cloud AI reference architecture for customers requiring secure and performant private cloud landing zones. I'm pleased with the progress we have made. AI is a long-term secular trend. Gen AI is set to revolutionize every facet of companies and their operations. Its implementation promises to elevate business performance, improving productivity, enhancing business agility, and enriching customer experiences. Companies are presently navigating the initial phase of AI adoption, prioritizing the security, safety, and reliability of their deployments. Our FAIR initiative is distinctive in that it caters to both service and infrastructure requirements for AI, allowing for a safe, secure, and responsible deployment. We are confident in our strong position within this fast-evolving market. Now turning to updates on our business units. In Private Cloud, we continue to see traction in our vertical market strategy in industries such as healthcare and financial services across all regions. We maintained a sharp focus on building our pipeline, with approximately one-third of it consisting of new prospective clients. In healthcare, we won a multiyear contract to host and manage the industry-leading electronic health record application in a Private Cloud for a prominent children's hospital in the US Northwest. We won this new client due to our differentiated high availability solution, fanatical customer support, and years of experience in hosting and managing mission-critical workloads. We also entered into a multiyear contract with a leading US provider of home/medical equipment, consolidating two data centers into a Rackspace Data Center. This consolidation involves AS400 and other virtualized workloads, migrated and managed in Rackspace's Managed Hosted Private Cloud. In Financial Services, we signed a multiyear contract with a leading Asian bank to advance their cloud transformation initiative and support their growth agenda. Rackspace is enabling this complex transformation by providing a comprehensive private cloud solution that delivers business agility and financial flexibility for the bank. We also signed a deal with a leading payment technology company in the Americas for custom disaster-recovery-as-a-service, enabling full data replication and rapid recovery of their critical systems in the event of an outage or breach. In addition, we had nine product launches and enhancements across the Private Cloud portfolio in the third quarter, including Disaster Recovery Solutions and SAP HANA certifications for software-defined data center business and enterprise environments. We're also excited about multiple innovative offerings in our Private Cloud roadmap that are slated for release over the next two quarters. Here are a few examples. First is the Software-Defined Data Center Anywhere offering. This is Rackspace's VMware-based, turnkey Edge Solution for enterprise and mid-market customers that have sensitive applications and data locality and compliance needs. This solution allows customers to deploy compute where they need them, on-premises, custom colos, or in any data centers globally. The second offering is called Spot. Spot is a true compute market exchange service perfectly suited for a developer and cloud-native customer base. It is a Kubernetes cluster suited for preemptible workloads. This solution provides real-time market pricing, empowering customers to use compute capacity on demand. Now turning to Public Cloud, despite a challenging environment in Public Cloud, we saw good traction in pipeline and bookings in the third quarter. We continue to focus on more high-value services, making notable strides in attracting a wide range of customers and introducing new innovative offerings. On the customer front, we have established a partnership with a leading Fortune 500 biotech company committed to propelling medical innovation and enhancing patient outcomes across 100 countries worldwide. Serving as their preferred cloud infrastructure partner in AWS, we've expanded our involvement to encompass advisory and professional services, focusing on their multi-cloud strategy, technology modernization, and application migration utilizing our advanced global delivery model. This collaborative initiative is aimed at addressing customer needs more efficiently and expedite the implementation of digital products and services, ultimately leading to improved patient outcomes. For two of the largest multinational transportation logistics and warehousing companies operating out of Asia Pacific and the U.K. we are offering a broad range of cloud modernization services including modern operations. These new clients were a competitive win against some of the leading global system integrators. What differentiated Rackspace Technology was a business outcome-focused solution that drove business agility and operational efficiency for our customers. On the offerings front, we also launched nine Public Cloud offerings in the third quarter including full stack managed services for hybrid multi-cloud, allowing customers to manage their entire workload life cycle in hybrid and multi-cloud environments; a comprehensive managed security solution combining cloud-native detection and response with 24/7 cybersecurity experts; and a partnership with Google to launch Google-accelerated cloud migration, an exclusive rapid and cost-effective path for migrating virtual workloads to Google Cloud. Overall, it was a good quarter for both our Private Cloud and Public Cloud businesses on multiple fronts. We recently had a successful Industry Analyst Day in Boston. We presented our strategy and showcased our full suite of private cloud and public cloud products and service offerings. This was well received and positions us strongly as a hybrid multi-cloud and AI solutions company. Before I wrap up, I would like to welcome Thomas Cole as the newest member of our Board of Directors. Thomas has over 37 years of experience in banking. This is another example of how we are strengthening our organization with highly skilled and accomplished professionals. Now let me wrap up by reiterating our top four priorities we outlined at the start of the year, which we are focused on to turn around our company's financial performance. First, reverse the decline in Private Cloud and position this business to capitalize on the growth opportunities in an attractive market; second, grow our Public Cloud services business at or above market rate; third, build a highly efficient cost structure, and ultimately drive sustained growth in operating profit and free cash flow. With that, I will turn it over to Bobby.

Thanks, Amar. I will cover the total company results for the third quarter, then share some details on our segment performance followed by our Q4 guidance. We maintain our commitment to enhancing the efficiency of both businesses as part of our disciplined financial strategy. We've effectively managed working capital and bolstered liquidity, notably through a more detailed focus on collections and the implementation of a new accounts receivable securitization program. Additionally, we will continue to identify additional cost reduction opportunities in areas that do not align with our current strategy. Now looking at the results for the quarter. Total company GAAP revenue of $732 million was at the high end of our guidance, down 2% sequentially and down 7% year-over-year driven by declines in both private cloud and public cloud. Total net revenue was $430 million, down 4% sequentially and down 12% year-over-year. Gross profit of $162 million was 22% of GAAP revenue and 38% of net revenue. We remain on track, with our prior guidance for sequential quarterly operating profit improvement for the remainder of 2023 off of the second quarter trough. For the quarter, operating profit was $46 million at the high end of our guidance, up 17% sequentially. This was down 43% year-over-year primarily due to revenue declines in our private cloud business unit, operating margin was 6% of GAAP revenue and 11% of net revenue. Loss per share was $0.04, which was within our guided range of $0.04 to $0.06 loss per share. In the third quarter, we recorded approximately $214 million of noncash impairment charges primarily as a result of the decrease in our market capitalization. Additional details of these noncash expenses can be found in our SEC filings. Cash flow from operations was $267 million and free cash flow was $239 million in the third quarter. Our reported cash flow includes cash received through the new AR securitization. Normalizing for the AR securitization, cash flow from operations would have been $61 million and free cash flow would have been $34 million, in line with our expectations. Let me provide a little more insight on the AR securitization we executed at the end of September. The primary objective of this securitization was to bolster our already solid liquidity position and allow us to opportunistically take advantage of the dislocation in our debt pricing. In the third quarter, we deployed $30 million of cash to opportunistically repurchase another $85 million of our senior unsecured notes in the marketplace. Through October year-to-date, we have repurchased a total of $274 million of senior unsecured notes using $96 million of cash at an average price of $0.34 on the dollar. We believe the combination of this facility and these buybacks is positive for shareholders, allowing substantial discount capture on our debt and increasing our available liquidity to $653 million, including $278 million of cash on our books. We continue to monitor and assess further opportunities to deploy capital in accretive, downside-protected ways for shareholders. Total CapEx for the third quarter was $28 million, with a CapEx intensity of 4%. We continue to expect CapEx in our typical 5% to 7% CapEx intensity range for the full year. Turning to our segment results. For Private Cloud, GAAP revenue for the third quarter was $300 million, which was at the high end of our guidance. This includes legacy OpenStack revenue of $31 million. Total Private Cloud revenue was down 4% sequentially due to customers rolling off old generation private cloud offerings. Private Cloud gross margin was 38%, up one percentage point sequentially driven by cost reductions offsetting the impact of revenue declines. Segment operating profit was $85 million at an operating margin of 28%, essentially flat quarter-over-quarter. In Public Cloud, GAAP revenue of $433 million was also at the high end of our guidance, essentially flat quarter-over-quarter primarily due to consumption-driven growth on infrastructure resale volumes, offset by declines in services. Public Cloud services revenue was down 4% sequentially, given the tightening of discretionary spending. We expect our pivot to a stronger services-led focus to pay dividends as the macro environment improves and our go-to-market strategy matures. Public Cloud net revenue, which includes our Public Cloud Services revenue and infrastructure resell profit, was $130 million, down 4% sequentially. Gross margin for our Public Cloud segment was 11% of GAAP revenue, up one percentage point sequentially. Gross margin was 37% of net revenue, up three percentage points sequentially, driven by utilization and efficiencies from cost savings. Segment operating profit in Public Cloud was $22 million, which was 5% of total segment revenue, up one percentage point sequentially and 17% of net revenue, up four percentage points sequentially. Now on to our Q4 guidance. We expect the fourth quarter GAAP revenue to be approximately $710 million to $720 million. Total operating profit is expected to be $46 million to $48 million and loss per share of $0.03 to $0.05. From a segment perspective, we expect Private Cloud revenue of $284 million to $289 million and Public Cloud revenue of $426 million to $431 million. Our tax rate is expected to be 26% and other income and expense of approximately $57 million to $59 million in expenses. The share count is expected to be around 221 million to 223 million shares. We expect full year cash flow from operations and free cash flow to be positive on both a reported and normalized basis.

Thank you, Bobby. Let us begin the question-and-answer session. We ask everyone to limit discussion to one question and one follow-up. Please go ahead.

Our first question comes from Ramsey El-Assal with Barclays. Your line is open.

Hi. Thank you for taking my question. I was wondering if you could comment on how the shift towards selling value-added services versus infrastructure has been going. What was value-added services growth in the quarter? Or are clients increasingly open to that approach? Maybe how can you support that strategy going forward?

Yes. Thanks, Ramsey. Great question. So the focus on selling services is at the forefront of what we're doing in the Public Cloud business. We have made a lot of structural changes in the company. As you know, we reorganized across two BUs with a focus on both public and private cloud and within Public Cloud we are very much focused on selling higher value-added services. We have also aligned our go-to-market accordingly. Similar to Private Cloud, we also have our go-to-market aligned across verticals in Public Cloud. We have also aligned it very close to the hyperscalers, so that we can drive more migration and modernization services along with our hyperscalers. We have also changed our sales resource mix. We have forced out underperformance in sales. We continue to hire services and business outcome-focused sales executives. We launched a number of new offerings in services, Ramsey. In the last nine months, we launched close to 30 new offerings. In the last quarter itself, we launched nine new offerings. One of those was managed services for both hybrid and multi-cloud environments. So a lot of changes, a lot of structural changes that are taking hold. Now, what we see in Public Cloud services is that, like most of the services companies in the ecosystem, there is a cyclical headwind in Public Cloud Services business. And what we are seeing is customers are very much focused on cost optimization projects, which we are working with them very closely. We are capturing those cost optimization projects. New initiatives in services are getting delayed. But as I always tell our salespeople, during good times and bad times, you have to stay close to the customer, but you have to stay close to the customer when the macro environment is uncertain. So we continue to work with our customers, helping them plan for new initiatives so that we'll be ready when we can go capture that demand when it returns. So I feel good about the structural pivot that we are making from low-margin infrastructure resale to higher-margin services. Now you will see our services business has declined year-on-year as well as sequentially and that's a result of the cyclical headwinds that we are seeing generally in the services business.

I see. Okay. And I also wanted to ask you for a little bit more commentary on the sales delays which you might be seeing out there, which is consistent with many of your peers. Are you seeing delays in signing new work or delays converting bookings to revenue, or maybe on both sides?

So I think that's a great question. I think what we are seeing here is the pipeline. If I look at the pipeline from both a Public Cloud and Private Cloud perspective, our pipeline is growing; it has sequentially grown. So at the top of the funnel looks great. But I think the decision-making cycles have extended, and that's extended the sales cycle. So the conversion from pipeline to bookings is taking more time and because customers are very cautious on their IT spend and given the macro environment, which remains uncertain. I think we typically see services business are very cyclical. So that's what we are seeing. So sales cycles are getting extended. Decision-making is taking more time, but the top of the funnel looks okay. It's just that the conversion of pipeline to bookings is taking more time.

I see. All right. Thank you very much.

Thanks.

One moment for our next question. Our next question comes from Frank Louthan with Raymond James. Your line is open.

Great. Thank you. Can you walk us through how many new logos you signed up in Public Cloud and Private Cloud? That's my first question. And a follow-up question: You recently changed your sales compensation for Public Cloud to drive a little better engagement in various services. How has that gone in the third quarter? And how is that tracking? Thanks.

Yes. So let me just give you some color on our bookings generally and I will also answer your question around the new logos. So given the macro backdrop, Frank, we had a fairly good quarter from a bookings perspective with over 200 new customers across both Public Cloud and Private Cloud. Public Cloud bookings actually grew sequentially. So this also answers some of the questions that Ramsey had about the top of the funnel and how we are seeing the services and how it's panning out. In Private Cloud, we did see two large deals slip into our December quarter, and we anticipate to close these deals in this quarter. So we do expect Q4 or a December quarter to be a strong quarter for Private Cloud bookings. And just as a reminder, as you guys know, large Private Cloud deals are typically multiyear deals, anywhere between three to seven years. They are very sticky; it's quite lumpy too. Hence, we are thoughtful in making sure that we close deals that are a win-win for both the customers as well as Rackspace. So feeling good about the bookings overall and how it might pan out in Q4 for Private Cloud. From a pipeline perspective, we see growth in both Private Cloud and Public Cloud. And as you know, we are using a vertical strategy. Healthcare is the first vertical that we double down on. What we are seeing is that healthcare vertical is a significant contributor to the growth in pipeline, which is now aligned to our overall vertical strategy and focus. Regarding the sales compensation changes, we made changes to ensure that we pivot our sales focus from low-margin business to higher-margin business, which is mainly services, and that's working well. It is working through the system. It typically takes some time. But as I mentioned in my earlier remarks and in response to Ramsey's question, the top of the funnel looks good. The conversion, especially in the services business, is taking time as decisions are often drawn out, and sales cycles are getting elongated. However, it is driving the right behavior. That's the key for us: driving the right behavior in our sales organization to pivot to higher margin services.

Okay, great. Thank you very much.

Thanks.

Our next question comes from Bradley Clark with BMO. Your line is open.

Hi, thank you. I want to ask about the margin performance. For the first time in a number of quarters, you sequentially grew both adjusted gross margins and operating margin. Can you talk about the drivers of the margin improvement between, say, mix, cost efficiencies, and other actions you're taking internally? And my second question would be you've announced your own generative AI solution partnership with Hyperscaler. How are you thinking about the timeline that it takes for generative AI services to have a meaningful or even just a modest impact on your bookings and/or revenue? Thank you.

Yes, let me do the first question on the margins and the expansion and the gross margins. So that's right. We talked about the fact that we are taking on a lot of cost reductions this year as a result of the macro headwind. We've seen that play out. We've talked about the fact that we'll see operating profit improvement on the back of cost reductions, and that's exactly what we've executed. Just to give you a little color on Public Cloud, we've also mentioned that we had staffed up in our delivery organization for an expected demand at the beginning of the year. But given the cyclical headwinds and the macro environment, that wasn't coming through and we were experiencing underutilization. So as part of our cost reduction, we took some actions there. We've improved utilization. As a result, we're seeing that flow through in the gross margins. Also, in the OpEx you'll see improvements there as well. This quarter flowing through from the cost actions we've taken. So a lot of it is on the back of cost reduction, and you'll see that as well in Q4.

So, let me take the Gen AI question. First of all, thanks for the question. This is a very exciting space for Rackspace. As you know, we are a very workload-centric company. For us, AI and Gen AI represent a net new workload that didn't exist before. So, it's a massive TAM expansion for us. To capitalize on this trend, which we believe is a secular trend that will accelerate rapidly, we launched Foundry for AI by Rackspace (FAIR) back in June. Since launching FAIR, we refocused part of the organization, we spun up the organization with resources within the company. We had a lot of resources who are well versed in AI, and we saw good traction in the last six months. Let me give you a little bit of color on bookings perspective where we landed. The interest in Gen AI has increased. We roughly have around 900 active leads in our pipeline. This is 2x what we saw when we reported last quarter. We were close to about 100 qualified opportunities, probably across all three regions: Americas, Europe, and Asia Pac. We won about 10 deals. Now, these are pure Gen AI deals, which are paid engagements after we launched FAIR. Most of these deals are in what we call the ideation, which is the discovery and incubation phases. The deal sizes tend to be smaller as expected since we are in early phases of Gen AI adoption. When we start moving into what we call industrialization or production, which will involve both fine-tuning and inferencing the models, we expect this to scale. As I mentioned in my prepared remarks, we worked with all three hyperscalers to launch joint AI solutions on Public Cloud and we have won deals across all the hyperscalers. We are also working on implementing the private AI cloud reference architecture, collaborating with both Dell and NVIDIA. These are early stages so to speak; it will take time, but the most important thing for us is to gain thought leadership, which will lead to more mind share that will lead then finally to revenue. We can help customers wherever they are in the AI journey. Today, it's all about consulting services. It's all about building and assisting them in building those applications. Ultimately, it has to work on specific infrastructure and the landing zones can be either Public Cloud or Private Cloud, and that's where the real monetization happens. We've already started driving thought leadership in this space. So I would say there is still more to come and we are just in the early innings.

One moment for our next question. Our next question comes from Matthew Roswell with RBC. Your line is open.

Yes. Good evening. Two questions. I guess first pricing and competition for both Public and Cloud where you're seeing this quarter, and how has it changed over the last couple of quarters? And then following up on the AI conversation, are you finding as you go in and do these ideation deals that clients often need to sort of do preliminary work, for example, move market that workflow to the cloud, things like that before they can even take advantage of Gen AI? Thank you.

Yes. What was the first question about pricing?

Correct, pricing and competition.

Yes, pricing competition. Listen, I think in Public Cloud we play in markets. Let me give you a little bit of color on the markets we play in so that you get an understanding of who we compete against. We address all three market segments: enterprise, mid-market, and commercial. In enterprise, we are very focused, because enterprise is where you find the big GSIs (global system integrators). We are very focused. We think about 50 accounts and we have a selective penetration strategy in enterprise. So we don't go head on with the GSIs. When it comes to mid-market, that's our sweet spot. Mid-market includes customers with revenues between $300 million to about $3 billion; you won't find large GSIs calling on these customers. These customers have the same complexity and challenges that an enterprise CIO will have. This is a sweet spot for Rackspace. This is where we want to expand and where we have built a significant business. Commercial includes customers $300 million and lower. It's also a sweet spot for us. When looking at competition, we see competition across the markets we play in. Obviously, the services business right now is facing cyclical headwinds, and everybody is chasing the same business. However, it's more important for us to remain engaged with customers, so that when the demand returns, we'll go and capture the demand. That's our approach, okay? Now, talking about AI and your question around ideation and whether customers are ready to incubate, that's a great question because right now I think many customers are looking for use cases. In fact, we are surprised that some customers already have use cases. So, we actually go into the incubation phase with customers where we help them to pick what we call 'large language models', whether it's an open model or a proprietary model; we will help them to architect the data and ensure that we train these models on the data. Instead of data coming to AI, AI applications are going to the data, so that we can go. However, the real monetization will happen in the industrialization and production phase, as I mentioned earlier. That is when you have to create massive data lakes. What we are seeing is currently customers are using the existing data and running what we call 'co-pilots'. We have developed many intelligent co-pilots for enterprise. We call it ICE, and this is where we are winning many deals. In fact, we have created many intelligent co-pilots for enterprise even internally at Rackspace, and we ran an extensive AI readiness program at Rackspace. Five months ago, we made a significant effort to ensure that all 6,500 employees are AI-ready. We aimed to be ready in 12 months. To be honest, in the last four to five months since we implemented it, about 75% of our workforce is AI-ready. So, there are many advancements to come here, and this is what we are also helping our customers with. So, there is a lot to do. I think we are still in the early phases, but it's an exciting opportunity.

And I'm not showing any further questions at this time. I'd like to turn the call back over to Sagar for any closing remarks.

Thank you everyone for joining us. If we did not get to your question, or if you have a follow-up, please e-mail us at ir.rackspace.com. Have a great evening everyone.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.