Rackspace Technology, Inc.

Good day and thank you for standing by. Welcome to the Rackspace Technology third quarter 2023 earnings webcast. At this time, all participants are in a listen-only mode. After the speaker's presentation, there'll be a question and answer session. To ask a question during the session, you'll 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 today's conference is being recorded. I would like to hand the conference over to your speaker today.

Sagar Habar, please go ahead.

Thank you and welcome to Rackspace Technologies' third quarter 2023 earnings conference call. I am Sagar Hebar, Head of Investor Relations. Joining me on today's call are Amar Malatera, 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 In accordance with SEC rules, we have provided a reconciliation of these measures to the most directly comparable GAAP measures in the earnings press 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 will 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, and so 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, or 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, performant private cloud landing zones. I'm pleased with the progress we have made. AI is a long-term secular trend. GenAI 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 a vertical market strategy in industries such as healthcare and financial services across all regions. We maintain a sharp focus on building a pipeline with approximately one-third of it consisting of new prospective clients. In healthcare, we won a multi-year contract to host and manage the industry-leading electronic health record application in a private cloud for a prominent children's hospital in the U.S. 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 multi-year contract with a leading US provider of home medical equipment, consolidating the two data centers into a Rackspace data center. This consolidation involves AS400 and other virtualized workloads, migrated and managed in Rackspace's managed host state private cloud. In financial services, we signed a multi-year 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 the 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, customer colo, or in any data centers globally. Second offering is called Spot. Spot is a true compute market exchange service perfectly suited for 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 towards 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 on AWS, we have 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 empowering them to address 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 UK, 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 lifecycle in hybrid and multi-cloud environments. a comprehensive managed security solution combining cloud-native detection and response with 24-7 cybersecurity experts. We also partnered 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 services 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 gap 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 gap 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 a 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 non-cash impairment charges, primarily as a result of the decrease in our market capitalization. Additional details of these non-cash 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, gap revenue of $433 million, also at the high end of our guidance, was 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 a 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 resale profit, was $130 million, down 4% sequentially. Gross margin for our public cloud segment was 11% of GAAP revenue, up 1 percentage point sequentially. Gross margin was 37% of net revenue, up 3 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 1 percentage point sequentially, and 17% of net revenue, up 4 percentage points sequentially. Now, on to our Q4 guidance. we expect the fourth quarter gap revenue to be approximately $710 to $720 million. Total operating profit is expected to be $46 to $48 million, and loss per share of 3 to 5 cents. From a segment perspective, we expect private cloud revenue of $284 to $289 million, and public cloud revenue of $426 to $431 million. Our tax rate is expected to be 26% and other income expense of approximately $57 to $59 million in expenses. The share count is expected to be around 221 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. I will now turn the call over to Sagar.

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.

Thank you, ladies and gentlemen. If you have a question or a comment at this time, please press star 1-1 on your telephone. If your question has been answered or you wish to move yourself from the queue, please press star 1-1 again. We will pause for a moment while we compile our Q&A roster.

Our first question comes from Ramsey's LSL with Barclays. Your line is open.

Hi. Thank you for taking my question tonight. 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? Are clients increasingly open to that approach? Maybe how can you support that strategy going forward?

Yeah, thanks, Ramsey. Great question. So the focus on selling services is left, right, and center 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 are reorganized across two BUs and with 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 local market aligned across verticals in public cloud. We also have aligned it very close to the hyperscalers so that we can go drive more migration, modernization services along with our hyperscalers. We have also changed our sales resource mix. We have forced underperformers in sales. We continue to hire services and business outcome-focused sales execs we launched a number of new offerings in services, Ramsey. In the last nine months, close to 30 new offerings. In the last quarter itself, we launched nine new offerings. One of that was managed services for both hybrid and multi-cloud environment. So a lot of changes, a lot of structural changes that are taking hold. Now, what we see in public cloud services is we 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. Newer 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 during when the macro environment is uncertain. So we continue to work with our customers, helping them plan for new initiatives so they will 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 intra-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 see, look at the pipeline, both from public cloud and private cloud perspective, our pipeline is growing. It has sequentially grown. So the top of the funnel looks great, but I think the decision-making cycles have basically extended, and that's extended the sales cycle. So the conversion from pipeline to bookings is taking more time, and because customers are very, very cautious on their IT spend, And given the macro environment, which remains uncertain, I think we always typically see services business are very cyclical. So that's what we're seeing. So sales cycles are getting extended. Decision making is taking more time. But the top of the funnel looks okay. It's just 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 Franklin then without Raymond James, your line is open.

Great. Thank you. Um, can you walk us through how many new logos you signed up in, in public cloud and private cloud? Um, that's my first question. And, uh, follow up question. Um, you recently changed your sales comp for public cloud and drive a little bit better engagement in various services. How has that gone in the third quarter and how has that tracked? Thanks.

Yeah.

So let me just give you some color on our bookings generally, and I will also answer your question on 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. You know, 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 and infrastructure within public cloud, how it's standing 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 our 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 multi-year deals, anywhere between three to seven years. It is very sticky. It's quite lumpy too, hence we are very thoughtful in making sure that we close deals that are a win-win for both 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 doubled down on. And what we're seeing is healthcare vertical is a significant contributor to the broken pipeline. And just, which is now, you know, sort of aligned to our overall vertical strategy and focus. Regarding the sales comp changes, well, it is, you know, sales comp changes we made to make sure 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. Typically, it takes some time. But as I mentioned earlier, in my earlier remark and 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 getting sort of extended and sales cycles are getting elongated. But it is, I think, 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, Mike. One moment for our next question. 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 growth margins and operating margins. Can you talk about the drivers of the margin improvement between, say, mixed cost efficiencies, other things that you're doing internally? And then my second question would be, you know, you've announced your own generative AI solution partnership with HyperScale. How are you thinking about the timeline that it takes for generative AI services to have a meaningful or even just modest impact on your bookings and or revenue? Thank you.

Let me take the first question on the margins and the expansion and the gross margins. So, yeah, that's right. So we talked about the fact that we are taking on a lot of cost reduction this year as a result of the macro headwind. And 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 bug, we also have 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, given the macro environment, that wasn't coming through, and we were experiencing an underutilization. So as part of our cost reduction, we took some actions there. We've improved utilization. As a result, you'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 reductions, 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. And for us, AI and Gen AI is a net new workload that didn't exist before. So it's a massive time expansion for us. And what we did to capitalize on this trend, which we believe is a secular trend that will accelerate very rapidly, we launched Foundry for AI by Rackspace, or FAIR, way back in June. And since, as we launched FAIR, we ring-fenced a part of the organization, we spun up the organization with resources within the company. We had a lot of resources who were very well-versed with AI, and we saw good traction in the last six months. Let me give you a little bit of a color on what, from a bookings perspective, where we landed. The interest in Gen AI has increased. We roughly have about 900 active leads in our pipeline, and this is 2x what we saw when we reported last quarter. We were close to about 100 qualified opportunities broadly across all three regions, Americas, Europe, and Asia-Pac. We won about 10 deals. Now, these are pure Gen AI deals, which are paid engagement after we launched FAIR. And most of these deals are in what we call it the ideation, which is a discovery and incubation phases. And the deal sizes tend to be smaller as expected, since we are in early phases of generic adoption. So when we start moving into what we call it the industrialization of production phase, which will involve both fine tuning and inferencing the models, we expect this to scale. so uh you know as i mentioned in my uh prepared remarks we work with all three hyperscalers to launch joint ai solutions on public cloud and we have one deals across all the three hyperscalers we are also working on implementing the private ai cloud reference architecture collaborating with both dell as well as nvidia so early stages early phases uh so to speak uh probably it will take time but you know most important thing for us is to go get the thought leadership, which will lead to more mind share, which will lead then finally to wallet share. And we can help customers wherever they are in the AI journey. Today, it's all about consulting services. It's all about building and helping them building those applications. Ultimately, it has to work on certain infrastructure. And the landing zones can be the public cloud or private cloud. And that's where the real monetization happens. And now, it really started really started driving park leadership in this place. So I would say still more to come, and we're just in the early innings, so to speak.

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

Yes, good evening. Two questions. Pricing and competition for both public and cloud, what are you 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 more of their workflow to the cloud, things like that, before they can even take advantage of Gen AI? Thank you.

Yeah, let me, so was the first question around pricing?

Correct, pricing and competition.

Yeah, pricing competition. So listen, I think in public cloud, you know, we play in markets. So let me give you a little bit of a color on the markets we play in so that you get an understanding of who we compete against, right? So we address all three market segments, enterprise, mid-market, and commercial. In enterprise, we are very focused, you know, because enterprise is where you find a big GSIs, global system integrators, and we are very focused. We pick 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 a sweet spot. Mid-market is customers with between $300 million to about $3 billion in revenue. You don't have a large GSI call 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 that's where we have built a big business. And commercial is, you know, $300 million and lower. It's also a sweet spot for us. So when you take a look at competition, we see, you know, depending on which market we play, we see competition in that market. Obviously, you know, services business right now has a cyclical headwind And so, and everybody is chasing the same business, but it's more important for us to remain engaged with the customers so that when the demand returns, we'll go and capture the demand. That's how we are approaching this. Okay. Now talking about AI and your, your question around ideation and whether the customers are ready for incubation. And that's a great question, by the way, because right now I think a lot of customers are looking for use cases. In fact, we are also very surprised that some of the customers already have use cases. So we actually go into the incubation phase with this customer, where we help them to pick what we call as the large language models, whether it is an open model or it is a proprietary model. We'll help them to architect the data and then make sure that we train these models on the data. So instead of data coming to AI, AI applications are going to the data so that we can go But the real monetization will happen in the industrialization and the production phase, as I mentioned earlier. That's when I think you have to create massive data lakes. But what we are seeing is currently customers are using the existing data and running what we call as co-pilots. So we have created many intelligent co-pilots for enterprise. We call it ICE, I-C-E. And this is where we are winning a lot of deals. In fact, we have created a lot of intelligent co-pilot for enterprise, even internally at Rackspace. And we ran a big AI readiness program at Rackspace. You know, five months ago, we decided and took a very bold step in making sure that we get entire 6,500 of our employees AI ready. And we said we should be AI ready by in 12 months. To be honest, in the last four or five months since we implemented it, we have about three-fourths, 75% of our 6,000-plus employees workforce is AI-ready. So a lot of things to come here, and this is what we are also going and helping our customers. So a lot to do here. I think this is an early phase, but it's a good question.

Excellent. Thank you very much.

And I'm not showing any further questions this time. I'd like to turn the call back over to Sakhar 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 email us at ir.ragspace.com. Have a great evening, everyone.

Ladies and gentlemen, that's include today's presentation. You may now disconnect and have a wonderful day.