Rackspace Technology, Inc.

Thank you for standing by. My name is Prila and I will be your conference operator today. At this time, I would like to welcome everyone to the Rackspace Technologies second quarter 2024 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question, this time seem to press restore followed by the number one on your telephone keypad. If you would like to withdraw your question, please press restore. followed by the number one again. Thank you. I would now like to turn the conference over to Sagar Hebar, Head of Investor Relations. Please go ahead.

Thank you, and welcome to Rackspace Technologies' second quarter 2024 earnings conference call. I'm Sagar Hebar, Head of Investor Relations. Joining me on today's call are Amar Malatira, our Chief Executive Officer, and Mark Marino, 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 RSAC filings. Back-based 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 the most directly comparable gap measures in the earnings press release and presentation, both of which are available on our investor relations website. I will now turn the call over to Omar for an update on the business. Thank you, Sader, and welcome everyone to our earnings call.

Results in the second quarter exceeded the high end of our guidance for revenue, profit, and EPS. This marks the eighth consecutive quarter in which we have either met or exceeded our guidance. We continue to execute to our plan and focus on advancing our three strategic priorities. First, we are making steady progress on our operational turnaround. I will cover this in detail later in my prepared remarks. Second, we are repositioning Rackspace as a forward-leading innovative hybrid cloud and AI solutions company. We are now well-placed to catch the next big secular waves of both hybrid cloud and AI. And third, we are right-sizing our capital structure to support long-term and sustainable profitable growth. We have ample liquidity and flexibility to focus on our operational priorities. We further improved our capital structure in the second quarter through opportunistic repurchases of a debt. Over the next two to three years, from a market perspective, we anticipate an exploration in digital transformation spending driven by the ongoing transition to hybrid cloud as well as AI. We see customers taking a more strategic approach to their use of both public and private cloud with a notable shift towards a more hybrid environment. In the realm of AI, we are winning business and helping leading companies prepare for AI and Gen AI applications. The first step to AI starts with data and we are seeing strong demand in data services and solutions partially driven by AI. Now let me get into our business performance starting with private cloud. Private cloud gap revenue of $260 million was down 3% sequentially in the quarter and within our guided range. We are working both to accelerate the pace of new wins and slow the rate of revenue runoff. Bookings were slightly down sequentially driven by deal lumpiness. We see our new private cloud strategy gaining traction. Our pipeline was up over 35% year-over-year with strength across all regions. Within our pipeline, we are seeing large opportunities as enterprises develop a better understanding of which workloads fit in private cloud versus public cloud versus on-prem. While those larger deals typically have longer sales cycle, they align with our key objective of building a solid book of business from long-term commits of high-quality recurring revenue. One of our marquee private cloud engagements is with Seattle Children's Hospital. Leveraging our healthcare cloud solution, we migrated their Epic Health Records platform onto Rackspace's fully managed private cloud. Additionally, Seattle Children's made strides in pediatric research with the launch of cutting edge high performance computing. Rackspace collaborated with Dell to design and implement this system that leverages the power of blazing fast NVIDIA A100 GPUs. Rackspace is hosting and managing this high-performance compute environment for the hospital. Another large U.S. healthcare payer awarded us similar EPIC migrate and operate managed services contract that enables payer-provider collaboration. I expect to see continued growth in healthcare. We are leading with Epic Hosting as a service, but building a foundation for customers to consolidate more of their data center footprint with Rackspace. We see similar opportunities in other regulated industry verticals. For example, we're also seeing traction in our banking, financial services, and insurance vertical. In our December quarter last year, A large UK retail bank chose Rackspace's software-defined data center solution for their mission-critical banking applications. We're in the midst of this implementation, and a customer is already experiencing significant improvement in transaction response times for their ATM and point-of-sale applications. This is yet another good validation of our differentiated solutions in private cloud. From an offerings perspective, in Private Cloud, we launched 16 new and enhanced 17 other products and solutions in the quarter. Overall, Private Cloud is still navigating a challenging transition, but our strategy is being increasingly validated through recent wins, a growing pipeline, and positive customer feedback. We are positioning Private Cloud for durable and profitable growth, in what we believe to be an underserved $50 billion total addressable market. Now, moving to public cloud. Public cloud gap revenue of $425 million was up 1% sequentially, exceeding the high end of a guided range due to better than expected performance in both services and infrastructure resale. Overall bookings grew double digits year-over-year and low single digits sequentially. I'm particularly pleased with our services bookings, which represented 70% of total public cloud bookings for the quarter, growing high single digits year-over-year and sequentially. I attribute that success to a shift in our go-to-market strategy of leading with services combined with better execution. We're seeing particularly strong market demand for data services, specifically in data engineering. There are bookings in the quarter more than doubled year over year. Our strategic positioning in data services, driven by both digital transformation and AI, is clearly paying off. Additionally, we have become much better in attaching services to our infrastructure resale deals. 85% of our largest infrastructure resale deals this quarter also had services attached. We also started offering Rackspace Elastic Engineering services through AWS Marketplace. Some notable customer wins demonstrate the progress of our go-to-market strategy of leading with services. For instance, we were selected to implement a digital transformation program for a large media company, rewriting a major customer-facing application and migrating it onto one of the hyperscalers. Rackspace is supporting the strategic multi-year effort with a skilled, multidisciplinary team. For a major consumer web company, we are deeply engaged across several service offerings in professional services, platform support, and security, driven by a strength in delivering full-stack services and our deep cloud expertise. I'm very encouraged by the success we have seen in public cloud and believe that the progress we have made across various initiatives will lead to even stronger performance going forward. We continue to target attractive opportunities with a winning mindset, positioning ourselves for ongoing success. Now, when it comes to AI, we continue to take an optimistic long-term but realistic short-term approach. Our fair initiative is developing innovative new ways to help our customers on their AI journey with over 40 engagements. We are closely partnering with hyperscalers and we are one of the select few global AWS AI partners. As noted previously, we are driving strong growth in data services, helping customers take their first step towards leveraging AI. We are also planning for general availability of a private cloud AI offering called AI Anywhere. While our operational turnaround is not dependent on short-term benefits from the secular wave in AI, we are maintaining our strategy and approach of thoughtfully developing AI capabilities so we can become the partner of choice for organizations as they embark on their AI journey. We'll continue to do so without getting too far in front of the market. In summary, I am pleased with the steady progress we have made despite a flat market. Our operational turnaround is focused on strengthening our pipeline and sales booking in both private and public cloud, stabilizing and growing revenue and profit while continuing to drive cost efficiencies. Although there is still work to be done, we are building momentum for consistent and sustainable growth in revenue, profits, and cash flows in the years to come. Before I wrap up, I'd like to thank our customers, partners, and all our actors. I'm proud of all we have achieved together already. I will now turn it over to Mark for an overview of our financial results and guidance.

Thank you, Amar. In the second quarter, total company GAAP revenue of $685 million exceeded the high end of our guidance driven by strength in public cloud. Total non-GAAP net revenue was $380 million, down 1% sequentially due to a decline in private cloud. Non-GAAP gross profit margin was 20.3% of GAAP revenue, flat sequentially, and 36.7% of non-GAAP net revenue, also flat versus prior quarter. For the quarter, non-GAAP operating profit was $23 million, exceeding the high end of our guidance. This was primarily driven by better-than-expected performance in our public cloud segment and continued focus on cost management. Non-GAAP operating margin was 3.3% of GAAP revenue, up 1% sequentially, and 6% of non-GAAP net revenue, up 1.8% sequentially. Non-GAAP loss per share was $0.08, which came in better than our guided range of a $0.09 to $0.11 loss per share. Cash flow from operations was $24 million, and free cash flow was negative $15 million in the second quarter. These amounts reflect the reclassification of a portion of our cash interest payments to financing cash flows as a result of the accounting treatment for the term loan we entered into as part of the Q1 debt refinancing. Moving forward, we will continue to reclassify a portion of the cash interest payments on this debt instrument plus the semi-annual cash interest payments on our 3.5% senior secured notes to financing. For the balance of fiscal year 2024, we expect cash flow from operations to remain positive and free cash flow to be slightly negative, driven by success-based capex. Turning to our segment results. For private cloud, GAAP revenue for the second quarter was $260 million within our guided range. This includes legacy OpenStack revenue of $25 million. Total private cloud revenue was down 3% sequentially due to customers rolling off older generation private cloud offerings. Private cloud gross margin was 37.4%, down 1.6% sequentially, primarily due to lower revenue. Segment operating margin was 26.8%, flat sequentially driven by improved cost efficiencies and better asset utilization. In public cloud, GAAP revenue was $425 million, exceeding the high end of our guidance, and was up 1% sequentially due to consumption-driven growth on infrastructure resale volumes. Gross margin for our public cloud segment was 35.1% of non-GAAP net revenue, up 3.6 percentage points sequentially, driven by improved operational efficiency and higher utilization. Non-GAAP segment operating profit was 9.8% of non-GAAP net revenue, up 1.8 percentage points versus prior quarter. We believe there is opportunity to further improve utilization over the rest of the year. Now an update on our debt repurchase activity for the quarter. Before I begin, a quick recap. As announced on our Q1 earnings call, we closed the public debt exchange in April with over 96% of our secured creditors supporting the exchange transaction. We reduced our outstanding principal by over $300 million and lowered annual cash interest costs by more than $11 million. We also extended the maturities on the revolver and other participating senior debt facilities so that we now have no corporate maturities prior to 2028. During Q2, we continued to repurchase our debt. We deployed $29 million of cash to repurchase $68 million in aggregate principal amount of debt. Early in the third quarter, we also repurchased an additional $24 million of the FLSO term loan at an average price of 46 cents on the dollar. In the first half of 2024, we deployed a total of $62 million to opportunistically repurchase $137 million in aggregate principal amount of our debt. We will continue to monitor and assess further opportunities to improve our capital structure. Now on to guidance. We expect third quarter GAAP revenue to be approximately $668 to $680 million, down 1% sequentially at the midpoint. Total non-GAAP operating profit is expected to be $29 to $31 million, up 31% sequentially at the midpoint, and non-GAAP loss is expected to be from 6 to 8 cents per share. From a segment perspective, we expect private cloud revenue of $255 to $262 million, and public cloud revenue of $414 to $419 million. Our non-GAAP tax rate is expected to be 26%, and non-GAAP other expense is expected to be approximately $51 to $55 million. The non-GAAP share count is expected to be around 231 to 233 million shares. I'll now turn the call over to Sagar.

Thank you, Mark. 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, and we will now begin the question and answer session. If you have dialed in and would like to ask a question, simply press the star, followed by the number one on your telephone keypad to raise your hand and join the queue. If you would like to withdraw your question, simply press the star one again. If you are called upon to ask your question and are listening via loudspeaker on your device, Please pick up your handset and ensure that your phone is not on mute when asking your question. Again, please press the star 1 to join the queue. And your first question comes from the line of Frank Luton with Raymond James. Please go ahead.

Great. Thank you. If you can give us an idea of the outlook of kind of when we can expect getting back to positive top-line growth and and when some of the initiatives you've done will start to kick in there. And then can you give us an idea of what percentage of your bookings currently are AI-related? Thanks.

Yeah, thank you. I will get started, and I'll take both the questions, and Mark, please jump in, okay? So as we – Frank, thank you very much for the question. As we indicated last quarter, we will start seeing revenue stabilization in the second half, You already started seeing that in Q3. In fact, in Q2, when you look at our revenue beat, the revenue beat came from two sources. One was in infrastructure. Resale volumes were up. And the second was from services. Now, the services beat and, you know, higher than our own internal expectation was good news. because we have started seeing some leading indicator with good bookings and services in the previous quarters, and we saw that in this quarter too. Where I'm going with this is if you exclude that increase in infrastructure volume consumption, which is very hard to predict, Frank, because, you know, this is not something that, you know, we have complete visibility to. So if you exclude that, our revenue is roughly flat from going from Q2 to Q3. That's what our guidance is. So we have started seeing the revenue stabilization front. I feel good about the pipeline building. You know, you saw both in private cloud as well as public cloud, the pipeline has grown significantly. In fact, in private cloud, it was up over 35% year-on-year. And when you go dig into that pipeline, the top of the funnel is growing very rapidly. In fact, in our healthcare business, our funnel was close to about $1.2 billion at the top of the funnel. as compared to roughly $750-plus million just about three months ago. So good development of pipeline. We have to go convert that into bookings. Typically in private cloud, the sales cycles are a bit longer, as you know. We also, when you look into our funnel, we see some large deals developing in the funnel. And that's quite encouraging for us. And there's always deal lumpiness in the private cloud business, as you are aware. So all leading indicators are good. We're also seeing revenue runoff, right? That's one of the challenges that we are faced with because the older generation products are running off. We also see some of our commercial customers, which is, you know, the customers with less than $300 million in revenue, their revenue, not our revenue, but their revenue. We are also seeing that long tail also running off. as we start building our pipeline and book of business more towards mid-market and enterprise customers. So I feel very good about those leading indicators. We will continue to work on the revenue runoff on the private cloud side. We have initiatives in place. We started seeing some improvements in revenue runoff, and we expect it to improve in the next few quarters. And we believe in the next couple of quarters or so, our bookings will outpace revenue. Having said that, you know, the bookings to convert to revenue in private cloud takes about anywhere from six to nine months. So we should expect the business to start stabilizing. That's what, you know, the most important priority we had in the short term was stem the decline in private cloud. We're working towards that and then start growing. Now, when it comes to public cloud, I think it's a different story. We already started seeing improvements there of bookings. Second quarter in row, you know, Q1 as well as Q2, we are reporting a fiscal Q2. We grew sequentially in bookings in both in Q1 as well as Q2. Now, as I tell people internally, you know, one quarter is just a point. Two quarters are two points to make a line. We have to go and do it, you know, more than two quarters to really start seeing a trend. But we do, whenever we look at the funnel, we look at the conversion. I think we are doing quite well. So I expect services revenue also to start stabilizing in the next couple of quarters, as we indicated earlier. On the infrastructure side, you know, as we have indicated to you earlier, that, you know, we will walk away from some low-margin infrastructure or non-profitable infrastructure resale deals. And that might impact our revenue, but should not impact our profit as much. So just to summarize, you know, we do expect stabilization. in revenue, overall revenue, barring us walking away from some of the low margin infrastructure deals in both the businesses in the next couple of quarters. The second question, you go ahead.

Yeah, just to follow up on that, how are you defining stabilization? Stabilization relative to what? Relative to this year, Q2, how should we think about where it's going to kind of start to grow from?

Yes, yes. I think that's a good question. When we talk about stabilization, we do it on a sequential basis, right? When you take a look at a private cloud revenue, the last few quarters, we were declining anywhere from 4% to 6%, right? Now you're seeing that decline significantly reduce in this quarter and next quarter. So it's gone from minus 3 to minus 1. So for us, stabilization, Frank, is on a sequential basis, and then we start growing from there on, on a sequential basis, which should land in a year-on-year growth. Is that helpful?

Yes, thank you.

Now, coming to AI. Now, listen, I think, as I mentioned in my prepared remark, we are long-term very optimistic about AI and Gen AI. We believe that it's going to impact all functions, all industries, And it's really a promising secular wave. Having said that, in the near term, in the short term, we are very realistic in our approach. So when you talk about bookings, it's not a big portion of our bookings. You know, I think, and I will give you a little bit more color there on how we look at this opportunity. So it's not a big portion of our bookings, but we have 40-plus engagements through a fair initiative and we are seeing a very good traction in AI. And some of this is also a follow-on on our data business. As I mentioned, our data services business, which has data engineering, data migration, and data modernization, all three, that data services bookings two quarters in a row grew substantially, both year-on-year as well as sequentially. And that's getting customers ready for the data lakes and re-architecting the, you know, the data architecture, et cetera. And that's the kind of work we are doing. So, partially driven by AI and partially driven by the move to cloud itself. Now, let me, since I have this opportunity, let me just give you a little bit of more color on how we look at AI. So, we believe that there are two types of spend happening out there, Frank, in AI. One is the spend in AI infrastructure, and that's the big spend happening today. And that's mainly for model training. And the model training is driven by hyperscalers, Meta as an example, OpenAI, and many of the startups. And to some extent, sovereign countries as well as maybe some of the enterprises where they're doing a very high-value research work. And this spend is going into GPUs, into building systems, into data center build-outs, and so on and so forth. a lot of enterprises are not really participating in that infrastructure spend, so to speak, because the model training is usually happening on the hyperscalers. So we believe that where we will participate as an infrastructure service provider on the private cloud or hybrid side is mainly on the inferencing of the workload. Once model training is done, as it moves into inferencing, that is the day two plus workload is the production workload that's very sticky and It's long-term, and that's where we are building our private AI and hybrid AI architecture around it and launching a good, you know, solution around private AI, mainly around inferencing and some on modern training. The second area where the spend is going, which is relatively smaller compared to the infra spend, is on application and data, right? Enterprises are participating in this. but a very tactical approach to AI currently. So it's mainly an experimentation mode. And there we participate through a FAIR initiative. So all the bookings that you're seeing come in right now is through FAIR. It's helping customers develop, you know, help them identify the use cases, help them train the models, LLMs, and also industrialize them either on private or public. So that's where we are seeing traction as a tip-of-the-sphere kind of solution that we provide through FAIR, and that will also help us to build a portfolio and solution as these workloads move more into inferencing and fine-tuning. That's where our hybrid AI with both private and public will come into play.

Okay, great. That's very helpful. Thank you.

And your next question comes from the line of Kevin McVeigh with UBS. Please go ahead.

Great. Thank you, and congratulations on the results. Marty, your point, you've kind of beaten or kind of coming at the high end of the range for eight quarters. It looks like the revenue beat was about 2%. You'd been pacing it, you know, I think about 1% or so, maybe a little less than that. So acceleration, was that incremental kind of, revenue beat the infrastructure kind of step up that you saw, or would there have been anything else to call out there?

Yeah, I think infrastructure consumption volume definitely is part of it, Kevin, and it is also services. Our services, we also did very well in services, and it came in higher than what we expected in the quarter. And our services bookings, just taking it a little bit forward, right, which is a main leading indicator. Services bookings grew, you know, a high single digit both sequentially as well as year on year across all three cloud-related services that we offer. Platform, which is infrastructure services, application, both migration and modernization, and data services that I talked about. In fact, our professional services, Kevin, bookings grew double digits across the board.

And I guess some more And that'll be my second question. Why are you seeing that now? Is that kind of just demonization of the pivot in the sales force or the go-to-market? Because obviously that's a really important part to the story, the incremental margins on professional services. So just, you know, why is it now, and again, it sounds like the attachment rate's much higher than where it's been historically as well. So maybe understand that a little bit.

Yeah, I think, Kevin, that's a good question. So I explained to you where it's happening. Let me explain why it is happening. It is mainly because of the foundation that we laid in the public cloud business in the second half of last year. If you recall, we churned out about 70% of our sales force. We hired and refreshed our sales organization in the second half, hired sellers with services skills, We also hired client principals. That is number one. Number two, we have been relentlessly driving sales enablement and training across all the nine sales space that we have. And today, within our organization, it's a highly rated program. Number three, we also are supporting top of the funnel with specific demand generation activities. We have sales and solutions campaigns that are working very well, and they are actually helping with the top of the funnel. And there's a major shift in how we are selling. Today we are selling through relationship. We do a power selling at the CXO level. So for example, let me give you another data point that might be of interest to you. More larger deal sizes are now showing up in the funnel as well as in bookings. 53% of bookings came from top 20 customers in this quarter. And we were able to go sign 10 out of the 20 master service agreements with large enterprises. Now, that's a big achievement. And now we have also hired client principals that are attached to these 10 large enterprises so that we can start selling our value proposition and our services and solution to these customers. You know, in fact, our largest go-to-market segment in the Americas exceeded our target significantly two quarters in a row, which is also a very good proof point that, you know, we are executing quite well on the field. We were also included in Microsoft Managed Partner List. this quarter, which was a big achievement. And we are working with Microsoft on Azure as well as with AWS very closely. And Kevin, one of the things as we pivoted to being a services-led organization on public cloud, we also are recognized by industry analysts like IDC, Everest, ISG. They're ranked as either leaders or major players. So that's what's actually driving our services business as we see growth in funnel, good bookings, conversions, so on and so forth. Similar story, even on private cloud. So I think what we laid as a foundation is started working well.

Thanks, Kevin.

And your next question comes from the line of Ramsey LSO with Barclays. Please go ahead.

Hi, this is Ryan on for AMSI. Thanks for taking my question today. I was hoping to get an update on the competitive landscape. This quarter you even mentioned some success with mid-market and enterprise clients. I guess I was curious to see if you're coming up against any different competition than you did prior and really what solutions are resonating the most with these clients at market. Thank you.

No, I think so the competition remains the same, Brian. That's a very good question. The competitive landscape has not changed as much. You know, one of the things to Kevin's question earlier, you know, we are playing in markets where the markets, you know, for example, IDC said in cloud services for the next 12 months, you know, it's the design migration modernization work on cloud. the budgets are going to go up by mid-singular digits. So we are playing in markets that are growing even in this kind of macro environment, especially on the cloud side. And we see competition there. But our relationship with the hyperscalers and our differentiation, when we go to market, we go not as a big SI. We go in as a labor minus model. For example, if you think about data services, right, there are a lot of companies in data services. So where do we differentiate? It is our deep experience and talent in data engineering, as an example. We go in with differentiated solutions with an IP wrapped around it. That's a labor minus model. And we have been executing very well from a go-to-market perspective. So our value proposition is resonating with the customers. We are showing up very well. and we are delivering to our commitments. Our NPS are pretty high, even in these, even in, and as we continue to grow our bookings and deliver.

Great. Thank you.

There are no further questions at this time. I would like to turn it back to Sagar Hibbar for closing remarks.

Thank you, Brilla. Thanks, everyone, for joining us. If you did not get your question, Or if you have a follow-up, please email us at ir at rightspace.com. Have a wonderful evening, everyone.

Thank you. And this concludes today's conference call. Thank you all for participating. You may now disconnect.