Rackspace Technology, Inc.

Good day and thank you for standing by. Welcome to the RACspace second fiscal quarter 2023 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 1 on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1 1 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Sagar Hebar, Head of Investor Relations.

Please go ahead. Thank you, and welcome to Rackspace Technologies' second quarter 2023 earnings conference call.

I am Sagar Hebar, Head of Investor Relations. Joining me on today's call are Amar Malik, 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 press release and presentation, both of which are available on our investor relations website. Please know that unless stated otherwise, all results are presented as non-GAAP, except revenues. I will now turn the call over to Omar for an update on the business.

Thank you, Sagar, and welcome to Rackspace. Fiscal second quarter 2023 exceeded our guidance for both revenue and EPS. This is the fourth consecutive quarter in which we exceeded our expectations. As we updated last quarter, we have reorganized the company and are focusing on a true business unit operating model and strategy, shifting to a more profitable business mix right-sizing our cost structure and building our product offerings to position Rackspace for long-term success. We are already seeing the benefits of organizing into two separate business units. Our increased focus in the private cloud business has resulted in solid pipeline expansion and bookings growth. In public cloud, we are starting to see some early positive signs in improved bookings mix, although it will take some time to work through this transition. The reorganization has also helped drive productivity improvements and optimize our expenses. I'm confident we have the right operating structure, people, and capabilities to achieve this turnaround. The progress achieved to date has been meaningful as our focus is on long-term, sustained, profitable growth. While we are making progress internally, overall market conditions are consistent with the first half of the year, with companies continuing to prioritize cost optimization. However, recently, generative AI has emerged as a top priority for companies as they're looking to understand how to leverage and benefit from this technology. The AI marketplace has propelled into a new era fueled by an unparalleled convergence of trends. Abundant computing and storage made easily accessible through cloud computing has unleashed innovation. At the same time, the volume and variety of data explosion have provided the foundation for cutting-edge machine learning and deep learning techniques to thrive, driving unprecedented and exciting opportunities for businesses across all industries. as a pure plate global multi-cloud solutions company rackspace unique proposition is our expertise and experience in building and operating an ai aware multi-cloud infrastructure and infrastructure aware ai solutions combined with our commitment to open source and the record dna of open innovation we are the right company at the right time to accelerate the adoption of ai to commercial mid-market and enterprise customers in june we launched foundry for ai by rackspace called fair a global spin-up dedicated to accelerating the adoption of responsible ai solutions across all industries with fair we have tapped into open innovation with our vast partner ecosystem For instance, we are combining forces with Google's AI Cloud Center of Excellence and expanding our partnership with AWS to help our customers realize AI's full potential. We also recently announced the launch of our hosted AI reference architecture powered by NVIDIA and Dell Technologies. This partnership gives Rackspace customers a simplified path to build, deploy, and operate enterprise AI solutions across public clouds and the Rackspace private cloud. In less than two months since the launch, we are already seeing significant early interest from existing customers and new prospects. We currently have nearly 250 leads or 50 opportunities in the pipeline and executing on three global generated AI projects. We're also using FAIR and its capabilities to transform Rackspace internal operations using AI. As an example, we launched Rackspace Intelligent Co-Pilot for the enterprise, an engine designed to streamline and enhance the workflow of our knowledge workers. As we move into this rapidly evolving world of AI, we want to ensure we have an AI-ready workforce at Rackspace. We launched FAIR Learn, an innovative AI literacy program that combines the power of massive open online courses, or MOOCs, and digital credentialing to ensure the trackers across our entire company have the skills and knowledge to capitalize on AI. We launched FAIR Learn in late July to get our entire workforce AI ready in six months. In the first two weeks since the launch, we have 12% of our global workforce certified as AI ready. This demonstrates a key element of the Racker culture, the relentless commitment to continuous learning and the desire to deliver the best outcomes for our customers. Now turning to second quarter updates on our business units. In public cloud, we continue to implement our strategy of transitioning from low-value infrastructure resale towards higher-value added services. In Q2, we launched several new capabilities. For example, we initiated a tri-partner collaboration with AWS and Trend Micro to ensure a secure and streamlined AWS cloud migration delivered by Rackspace's Elastic Engineering offering. We also expanded our advisory offerings to help customers jumpstart their zero trust strategy, streamline migrations to Google Cloud, and expanded our investment in Azure landing zones. In addition, we released several new features supporting our modern cloud operations offerings for multi-cloud that range from architectural reviews to customer self-service options. We continue to evolve our go-to-market strategy, particularly in Americas, with a sharper focus on our market segmentation and product offerings. We also recently hired Vivek Khotra as our public cloud chief revenue officer, an experienced go-to-market leader with a strong track record of driving growth in digital and cloud services. While the public cloud services market remains challenging, we are seeing early signs of stabilization. We recently won a cloud strategy and implementation program with a leading international insurance company, as well as a cloud transformation project with a multinational beverage and retail company. We also extended our relationship for another five years with a large Canadian government financial services agency. Now turning to private cloud. Demand for private cloud solution remains robust. especially around workloads that may not operate efficiently in public cloud and applications requiring data sovereignty, especially in verticals such as healthcare, driving strong growth in both pipeline and bookings. We significantly expanded our private cloud new product releases this quarter. We enriched our VMware-based software-defined data center platform with enhanced management, security, data protection, and ransomware prevention. We scaled our private cloud storage and data freedom offerings to include block, file, and most recently object storage, rolling it out to an additional six data centers in the US and Europe. We also published a reference architecture for AI Cloud as part of our partnership with NVIDIA and Dell Technologies. Demand in healthcare has been strong, and we won businesses with two leading healthcare providers. one to host their core electronic medical record application and the other to build and operate their high-performance computer environment for genomic research. We expect the healthcare vertical to show solid growth in the second half of the year and into 2024. I'm pleased with the renewed focus on both innovation and go-to-market execution in our private cloud business. As I mentioned last quarter, we also hired two seasoned technology leaders who have hit the ground running Lance Weaver as the Private Cloud Chief Product and Technology Officer, and Maureen Sweeney as the Private Cloud Chief Revenue Officer. Now, let me wrap up by reiterating our top four priorities which we are focused on to turn around our company's financial performance. First, grow a public cloud services business at or above market rate. Second, reverse the decline in private cloud and position this business to capitalize on growth opportunities in an attractive market. 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.

Thank you, Omar. I will cover the total company results for the second quarter, then share some details on our segment performance, followed by our Q3 guidance. In addition to the benefits Ammar described in our shift to the 2BU model, as mentioned in the last earnings call, we have uncovered opportunities for further efficiencies in both businesses. We've also been able to more tightly manage working capital, specifically driving a more granular focus on collections. We continue to pursue other cost reduction opportunities while balancing that with investment in the market opportunity ahead of us. Total company gap revenue of $746 million was above the high end of our guidance, down 3% year-over-year. Total net revenue was $447 million, down 10% year-over-year, with declines in both public and private cloud. Growth profit of $163 million was 22% of gap revenue and 37% of net revenue. On our last call, we indicated that operating profit this year will try from the second quarter with sequential quarterly profit improvements anticipated for the remainder of 2023, driven primarily by cost reduction and some improvement in mix. We are on track. We reduced overhead with SG&A down 7% year over year and 3% sequentially. Given this, operating profit was $39 million, also above the high end of our guidance. This was down 60% year over year, primarily due to revenue declines in our private cloud business unit. Operating margin was 5% of gap revenue and 9% of net revenue. Loss per share was $0.06, which was better than our guided range of $0.07 to $0.09 loss per share. Cash flow from operations was $38 million, and free cash flow was $14 million in the second quarter. These results were in line with expectations due to our strong working capital management. In second quarter, we deployed $47 million of cash sourced from our revolving credit facility to opportunistically repurchase another $142 million of our senior unsecured nodes in the marketplace. Through July year to date, we have repurchased a total of $222 million of senior unsecured nodes using $77 million of cash. We continue to monitor and assess further opportunities to deploy capital in a creative downside protected ways for shareholders. Total capex for the second quarter was $45 million with a capex intensity of 6%. We continue to expect capex to be lower for the next couple of quarters and end up in our typical 5% to 7% capex intensity range for the full year. Turning to our segment results. For public cloud, gap revenue of $435 million was up 3% year-over-year driven by our infrastructure resale business, partially offset by declines in services. Public cloud net revenue, which includes our public cloud services revenue and infrastructure resale profit, was $135 million, down 7% year-over-year. Services revenue was down 5% year-over-year, given the tightening of discretionary spending and customer optimizations. We expect our pivot to a stronger services-led focus to pay dividends as the macro environment improves and we mature our go-to-market. Gross margin for our public cloud segment was 11% of gap revenue, down 5 percentage points year-over-year, and 35% of net revenue. Margin compression was driven by lower volumes across both services and infrastructure resale. Segment operating profit in public cloud was $17 million. In private cloud, gap revenue for Q2 was $311 million, which includes legacy OpenStack revenue of $32 million. Year-over-year, total private cloud revenue was down 11%. The private cloud segment revenue decrease resulted from customers rolling off old-generation private cloud offerings, expected decline in legacy OpenStack offerings, as well as the impact from the December hosted exchange ransomware incident. Private cloud gross margin was 37%, down 10 percentage points year over year. And segment operating profit was $87 million, at an operating margin of 28%, down 10 percentage points. The margin compression reflects the fixed costs associated with revenue runoff in this business, partially offset by cost efficiencies. Overall, the quarter was in line with our expectations and consistent with our plan to improve our cost structure and transform our business mix to higher margin revenues over time. During this transformation, we will continue to invest in innovative technologies and key market verticals, as well as focus on cash management and continue to drive efficiencies. Now onto our Q3 guidance. We expect the third quarter gap revenue to be approximately $722 to $732 million. Total operating profit is expected to be $43 to $47 million and loss per share of four to six cents. From a segment perspective, we expect public cloud revenue of $428 to $433 million and private cloud revenue of $294 to $299 million. Our tax rate is expected to be 26% and other income and expense of approximately $58 to $60 million in expenses. The share count is expected to be around 215 to 217 million shares. As we noted last quarter, we expect Q3 cash flow from operations and pre-cash flow to be positive.

Sagar, over to you. 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.

As a reminder, if you'd like to ask a question at this time, please press star 1 1 on your touchtone telephone. To withdraw your question, please press star 11 again. Our first question comes from a line of Kevin McVey with Credit Suisse. Kevin, your line is now open.

Great. Thanks so much, and really congratulations on the results given the transformation. Hey, I don't know where best to start. Amor, you talked about the generative AI, and it seems like that's a massive opportunity. Is there any way to frame what that could mean to the enterprise overall? Did that contribute to the beat? I mean, I know there was a series of product introductions intra quarter, but just a really, really strong beat and maybe help frame the puts and takes on the beat. And again, if the generative AI impacted that or if there's a way to think about what that can mean to the enterprise longer term.

Okay. Thanks, Kevin. And thanks for the question. And Bobby will cover the beat in the quarter. I would say Generative AI did not contribute to the beat, and Bobby will go through the details there for you, Kevin. Generative AI can be a massive opportunity for us, Kevin. You know, when you take a look at Generative AI and AI in general, it is all workload. We are a multi-cloud solutions company, and we are very workload-centric. So what Generative AI does is it gives us an opportunity to go after this massive workload You know, generative AI is going to be very pervasive. It's going to impact all businesses, all functions, and, you know, the amount of workloads that will get created will be absolutely massive. Now, think about generative AI the way we think about it is, you know, in three layers, right? One is the infrastructure layer. The second is application or data, and the third is application. So, when you think about the infrastructure layer, It has compute, it has storage, and it has networking. And when you look at compute, it has both the GPUs as well as CPUs. For example, we believe that all the training models will run on GPUs, but when it comes to inferences, where most of the monetization will happen, it will be a combination of both CPUs as well as GPUs. Storage is also very important because data has to be stored. And networking component also is critically important because there will be ultra-low latency and you have to improve the performance of the network. And we have about two decades of experience in optimizing infrastructure for any workload. So we are very well positioned to build an AI-aware infrastructure. both on the private cloud side and also partner with the public cloud, hyperscaler partners on the public cloud side. Data is another big opportunity for us as well as for the industry. Now you can do all the plumbing you, you know, with the infrastructure, but if you do not have water flowing through the plumbing, in this case data, it is useless. So we have a sizable data practice. We can help customers to, you know, basically migrate data, create the right data architecture, We can also help them in data reclassification. So good opportunity there. And third, of course, Kevin, is application. It's picking those right models, foundation models to train. And since we have good experience in building AI workload-aware infrastructures, we also have experience in building an infrastructure-aware AI applications. So it really helps us from that perspective. You know, we have a lot of experience in multi-cloud, and we believe that this is a net new workload that will not run in on-prem, and most of it will run in a multi-cloud infrastructure where it's public or private, and that's where we are going to capture it. You know, when you look at our strengths, you know, we have 20,000 customers in commercial, mid-market, and enterprise that we can tap into. We have our 6,500 employees. 6,000 of them are technologists. With 10,000 plus certification, as I've mentioned in my prepared remark, we have launched AI Learn. About 12% of our workforce is AI ready in the last two weeks or so. And we have an ambitious goal in getting everyone AI ready in the next six months. And more importantly, I think we also have the partner ecosystem. And we continue to add to that partner ecosystem with announcements that we have made. So we feel very, very confident that if this takes off, which we believe will, it will definitely be a positive for Rackspace. Now, we are not counting on this to turn around the business. I want to be very clear. Our turnaround plans are based on the market opportunity we have in public and private cloud, excluding AI. We have a very good plan that we are executing on, and I'm very pleased with where where we landed in Q2. So talking about the beat, let me turn it over to Bobby so he can go over where we outperformed.

Thanks, Ammar. So Kevin, the beat was primarily in our private cloud business, where essentially we were able to push out runoffs from customers on old generation private cloud offerings. And then we also had a bit of conservatism built into the model as well. The public cloud business came in line with our estimates, even though as the macro environment was pretty much constant from Q1. So overall, I'd say we were pleased with our execution in the quarter and the beat that we had.

That's great. And then just one quick follow-up because you've just done a really, really opportunistic job of retiring some of that debt. But if I look at the cadence, if my math's right, it looks like you committed about $10 million in the first quarter or retired – $10 million, you committed $23 million of capital in the first quarter, $142 million in the second, and then $57 million after the second quarter. I guess, Bobby, is there any way to think about what the potential capacity is to take down even more of those senior unsecured? Just, again, really, really nice. Use of capital, particularly given where, and it looks like your average is somewhere around $0.35 to $0.30 to $0.43 is where you've been taking that debt down.

Correct, correct. Look, Kevin, we were opportunistic with that, right? So our priorities, you know, our capital allocation priorities remain unchanged. As Mark mentioned, right, our party is around investing the business organically, and that's what we're focused on. We were opportunistic in what we did this quarter. You know, we saw the debt trading at very attractive rates, and so we executed on exactly what you just talked about. Could we be doing that again in the future? Possibly. But we're more focused on the operations. If the debt continues to trade at those levels and it's attractive, we'll look at it. But we also want to maintain our liquidity, right? It's a tough macro. So we want to be conscious of that. We want to make sure we have dollars to invest back in the business and turn around the business. So that's really our focus. And that's kind of what we're out looking for the rest of the year. Congrats again.

Thank you, Kevin.

Our next question comes from the line of Bradley Clark with BMO.

Hi, yes. Thanks for taking my question. I know you discussed that generative AI didn't contribute to the revenue beat in the quarter, but is there anything you can talk about related to bookings or customer conversations related to generative AI, and specifically What are you thinking in terms of timing or obstacles that organizations have to go through, particularly on the data side, before they can really start implementing large-scale Gen AI projects? Thank you.

Sure. Thank you very much, Bradley. I think, listen, as I said, I mentioned to Kevin, we are very optimistic about the opportunity ahead for us with generative AI. Now, the deals that we have been closing are modest in size from both revenue and bookings perspective. But that's what we expect, right? General AI is at its infancy. It's evolving very rapidly. We are at a very early phase, which we call it the discovery and the incubation phase, probably. is ideation phase where we basically have consulting services and workshop with our customers identifying the use cases. We have identified in all what 512, 513 use cases in the last two months across multiple functions and across multiple industries, roughly around 12 domains. So that's the early phase. Once we identify the use cases for the customers, the second phase we call as the incubation phase, where we help the customers look at different foundational models, look at whether they have the right data architecture, and help them also work out the integration with their current processes. So that's the incubation phase. So most of the projects that we are seeing are in those early phases of discovery, or ideation and incubation. I think when this moves into what we call as industrialization, which is moving into the production phase, that's where we will start seeing the scaling in terms of the deal sizes, et cetera. And that's the area where there's a lot of monetization. That's why we are so excited about it because ultimately these workloads, it's workloads and workloads have to run on infrastructure. And there will be a massive requirement of infrastructure across compute, storage, and networking. And that's what we are very good at doing. Listen, I think we have in less than two months, just to give you a little bit of more color here, as I mentioned in my prepared remarks, we have roughly about 250 leads in the pipeline. We have qualified opportunities that are over 50. And we have closed three deals across multiple industries. And in fact, we are closing two more deals by the end of this week. So very good traction. I think the key hurdle for any customer is identifying those use cases. And, you know, general AI, as foundation as it is, it is going to impact every single function. So there'll be massive number of use cases. So identifying those use cases, then the biggest challenge is do they have the data ready? And the third challenge is where are they going to run both their and the training models as well as inferences? And that's where we believe it's going to be on multi-cloud infrastructure, both public cloud as well as private cloud.

Appreciate all the insight. Thank you.

As a reminder, if you'd like to ask a question at this time, that is star 1 1. Our next question comes from the line of Frank Luthan with Raymond James.

Great. Thank you very much. I just wanted to check, was there anything sort of one time in the quarter that helped the revenue? Just curious about that relative to the sequential guide. And then separately, can you give us an idea of what sort of number of bookings or the percentage of bookings from new logos? And where are you as far as bookings coming in that are more AI-centric these days? Is that a material part of your bookings these days? Thank you.

Frank, let me take the one-time question. No, there were no material one-timers. This was really around what I just said around private cloud business, where we were essentially being able to push out the runoff from customers that are on some of our old generation private cloud offerings. And then we did have a little bit of conservatism built in that I mentioned. So that's essentially what drove that beat. There was nothing material in terms of a one-timer.

Yeah. So in terms of bookings, Frank, you know, I'm quite pleased with how the quarter panned out. We had a good quarter given the macro backdrop, as well as with all the changes we are making internally from a reorg perspective. You know, if you look at our second quarter bookings, we were up sequentially in both the businesses, private cloud as well as public cloud. In private cloud, our increased focus with this 2BU structure has also resulted in a strong sequential growth in bookings. And it's mainly coming in from international, but we do expect that trend to continue even in Q3. We also saw a strong growth in private cloud pipeline. In fact, it was significant growth. In particular, we are experiencing solid interest in one of our key verticals, such as healthcare, Now, in public cloud, we did improve bookings sequentially. So we did see a double digit growth also in bookings in the second quarter with an uptick in services bookings. As you know, we are moving towards the higher margin services business and shifting away from infrastructure. Now, this all takes time, but we remain focused on making that shift. And our customers, many of our customers in the public cloud side are also focused on cost optimization. So as you think about Q3, we expect another quarter, next quarter, to be a sequentially growth quarter for us in bookings across the company.

Does that help, Frank? Yeah, and with that on the cost optimization, are you seeing anything going the other direction where are any segments of your business looking to cost optimize to pull back on some services? or is it more coming to you to try and save money that way?

Yeah, I think cost optimization also plays to a strength. We have cost optimization offerings that are helping public cloud customers in their cost optimization. We have 2,000-plus public cloud customers. They have a good view of their usage. We can't predict the usage, but we know where they are using their infrastructure, so we do help in cost optimization, and so that is also helping customers. But let me give you an overall color on the demand environment. I think when we look at the demand environment across, you know, it's not gotten worse. It's consistent with the first half of the year. Different dynamics in public versus private cloud. Frank, in public cloud, as we talked about, customers continue to optimize their cloud infrastructure spend. Cloud services spend typically lag infrastructure, so we continue to see softness in services demand. And we are not the only company seeing that. Every company in the services ecosystem is seeing the same challenge. However, we have started seeing, you know, better engagement from our customers. We believe that demand will recover in the next two to three quarters. And when it does, we will be there to capture it. As we are continuing to see an increase in engagement, we also fine-tuned our go-to-market specifically in America's Now, in private cloud, the dynamics are a little bit different, Frank. You know, customers are looking to move out of the data centers, reduce their CapEx and OpEx investments, and also looking at moving workloads that are not operating efficiently in public cloud. And this has created a little bit of, you know, sort of a momentum for us, and it's a tailwind. And given our focus, you know, we are showing up in many opportunities that we never had before. So this is overall good for a private cloud business. So two different dynamics. I can also give you some color on verticals because we are focused on three verticals as we reorganize the business and we'll expand it in the future. Those three verticals, healthcare specifically, as I mentioned, solid momentum in healthcare, as customers are grappling with, you know, the reduction in the revenue per patient and the cost per patient going up. So they are trying to do more with less. And these are mainly regulated workloads, which are moving out of the data centers, and we are capturing it in a private cloud hosted environment. We also have a vertical in private equity. We basically serve about 18 funds, about 150 port core companies. And we are seeing good traction and momentum in the private equity vertical, too, where most of the private equity firms are driving value acceleration. And the third vertical, which has been a positive surprise for us, is a public sector vertical in the U.S. That's a vertical that beat their bookings target for first half. They grew their bookings year on year. And we expect their bookings actually to actually sequentially grow from Q2 to Q3.

Great.

That's good color. I really appreciate it. Thank you.

Our next question comes from a line of Rayed Al-Fayoumi with Bank of Hope.

Good afternoon. Congratulations on a good quarter. I have two questions. One relates to the overall amount of debt. Just wanted to get some color on on your finance leases and on your operating leases, and if that exposure is still about the same. As of Q1, it was about $534 million for both of those. If that was reduced at all.

That is about the same. Those are the right estimates. Not materially reduced from Q1 with respect to that.

Thank you. My other question is a little hypothetical, but I was wondering if you ever expect further equity support from some of the lead owners, say, Apollo. Do you ever factor that in as far as your ongoing planning?

So, you know, listen, I think I cannot disclose that, but, you know, listen, at the end of the day, we are a publicly traded company. So your question is whether we'll get any further equity support from our sponsors. Is that the question?

Can you hear us? I think we lost him there. Yeah. Let's go to the next question.

Liz, we can take the next question. Is there any other questions?

We have no further questions in queue at this time.

Thank you, Liz. If we did not get to your question, or if you have a follow-up, please email us at ir.racphase.com. Thank you, everyone, for joining us, and have a great evening.

This concludes today's conference call. Thank you for participating. You may now disconnect.