Rackspace - Q1 2024

Transcript

Operator (participant)

Good day, and thank you for standing by. Welcome to Rackspace Technology's Q1 Earnings Conference Call. At this time, all participants are on 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 one one on your telephone. You will then hear an automated message advising your hand is raised. To assure you're questioned, please press star one one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Sagar Hebbar, Head of Investor Relations. Please go ahead.

Sagar Hebbar (Head of Investor Relations)

Thank you, and welcome to Rackspace Technology's Q1 2024 Earnings Conference Call. I'm Sagar Hebbar, Head of Investor Relations. Joining me on today's call are Amar Maletira, 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 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. As previously announced, we successfully closed a series of debt refinancing transactions which we will discuss in more detail during today's call. As a result of the size and complexity of the transactions, we are presenting selected financial data in the earnings press release and during today's call. Full financial data for Q1 will be included in our upcoming 10-Q filing, which we expect to file with the SEC on or before the extended deadline of May 15th, 2024. I will now turn the call over to Amar for an update on the business.

Amar Maletira (CEO)

Thank you, Sagar, and welcome everyone to our Q1 2024 conference call. We continue to make steady progress on a turnaround. Results in the Q1 of 2024 exceeded the high end of our guidance for revenue, profit, and EPS. We have now either met or exceeded guidance the last seven quarters, a track record that speaks to our execution and commitment to transparency with the investment community. Underneath these financial results, I'm encouraged by progress on three strategic priorities. First, implementing an operational turnaround. Second, repositioning Rackspace as a forward-leaning and innovative hybrid multi-cloud and AI solutions company. And third, right-sizing our capital structure to ensure ample liquidity to support our key objective of driving long-term and sustainable profitable growth. Our recent debt refinancing and liquidity injection significantly improved our capital structure, giving us runway to execute our turnaround. Mark will provide more details in his comments.

Our operational turnaround continues to gain momentum. We are building a pipeline in both our businesses, growing bookings, and finding additional opportunities to increase efficiency across the board. While the overall market remains cautious in the near term, we are well-positioned and are leaning into the opportunities being created by secular market trends in public cloud, private cloud, and AI. Now, let me get into our business performance, starting with private cloud. We had very strong double-digit year-over-year growth in Q1 bookings in private cloud with continued strength in healthcare. Sequentially, bookings were down due to normal seasonality in Q1 and an exceptional bookings performance in the Q4 of 2023. Private cloud is seeing continued success in implementing a healthcare vertical strategy. Following on the heels of strong Q4 bookings in this vertical, we won several new deals in healthcare in the Q1.

Among them were marquee names, including two of the country's 10 largest healthcare payers, a large healthcare solutions provider, and a regional hospital and related services system provider. Many of these new engagements are for our unique and differentiated Epic as a services offerings. Rackspace holds all Epic certifications and is the perfect partner to host, operate, and manage electronic medical record workloads, one of the most critical workloads in the healthcare industry. Toward that end, in April, we had a successful implementation of Epic electronic medical record system with Seattle Children's Hospital, leveraging Rackspace's healthcare cloud solution. I'm proud of the partnership between Seattle Children's Hospital and our Rackspace team to provide a seamless migration of this workload to the Rackspace environment without impacting system availability or patient care. Private cloud continues to launch a steady stream of new and innovative products and solutions.

In the Q1, we launched UK Sovereign Solutions. This is a digital sovereign platform with the Ark-branded data centers in the UK, offering a flexible number of configurations to suit varying budgets, performance, and workload sizes. All compute and storage for the sovereign cloud is dedicated to UK government and healthcare. I'm encouraged by the success of the private cloud strategy to defend and expand our private cloud business. We are executing well with continued growth in pipeline, bookings, and new products and solutions. However, the private cloud business unit is also working through the negative impact on today's results from customer exit decisions made in prior years on legacy solutions. Fortunately, we expect that dynamic to normalize over the coming quarters and the next year, at which point revenue runoff should eventually be eclipsed by the continued new bookings and revenue conversion from that point forward.

As we start to leave the legacy effects behind, we expect to see private cloud performance tip decisively towards stability and then steady sequential growth in an underserved market where Rackspace brings unique capabilities, great brand, and two decades of experience in managing and operating a variety of hybrid cloud workloads delivered through our fanatical support. Now, moving to public cloud. In the Q1, total public cloud bookings showed solid double-digit growth year-over-year, and we're also up sequentially. Sequential growth in the Q1, which is seasonally the weakest quarter, is very encouraging. This was a result of solid execution by our go-to-market teams in two of our largest regions, Americas and the UK. The major go-to-market refresh we did in this business in the H2 of last year has started yielding results. I'm pleased with the go-to-market execution, especially in a tough services market.

We are in the early innings, and there's more to do to continue building on this momentum. Our public cloud strategic imperative is to lead with services. We offer an unparalleled ability to meet our customers' needs with a full-stack multi-cloud solution spanning platform, applications, data, and security. This focus has yielded a number of new wins, such as a platform services and security engagement with a large international insurance company. We also won a platform services agreement with a large media company. In data services, we have been engaged by another large insurance company to migrate and modernize an on-prem data warehouse to cloud. Public cloud also continues to develop many new innovative services and solutions. We are also being increasingly selective with infrastructure resale, including not recompeting some low-profit renewals. This may impact near-term revenue but will improve our overall margins.

While I want to make a few remarks specifically about AI, I also want to note that AI permeates the organization and is integrated into everything we do. So it is a part of both public and private cloud businesses as well as our internal functions. Our opportunity base for AI, or our FAIR offerings, continues to grow since its launch in June 2023 and is in excess of 30 opportunities. These opportunities are at varying stages of implementation across our ideate and incubate phases. In general, our customers are starting to turn to the hard work of making AI a reality. That usually starts with data. You can't train and fine-tune an AI model and run inferencing without unified, normalized data. That data business represents significant near-term opportunity for Rackspace but speaks to the long road ahead to full-scale AI implementation. We're also developing new capabilities.

Earlier this year, Private Cloud launched Private AI Anywhere. On our future roadmap later this year, we'll be introducing AI Business, an AI-optimized platform for fine-tuning and inferencing AI workloads. We have broad and deep engagement with the AI ecosystem to quickly move on opportunities and help our customers in their AI journey. In summary, this quarter, we once again did a little better than expected. Our guidance shows an appropriately cautious but improving trajectory. Our goal for 2024 remains: lock in a sustainable business model that generates consistent revenue and profit growth over the long term, building momentum that will put us on a profitable growth trajectory entering 2025. Before I wrap up, I'd like to thank our customers, partners, and all our Rackers. I'm proud of all we have achieved together already. We are heading in the right direction.

I will now turn it over to Mark for an overview of our financial results and guidance.

Mark Marino (CFO)

Thanks, Amar. In the Q1, total company GAAP revenue of $691 million exceeded the high end of our guidance driven by strength in public cloud. Total non-GAAP net revenue was $384 million, down 7% sequentially due to declines in both private cloud and public cloud. Note that Q1 typically shows seasonal weakness relative to Q4. Non-GAAP gross profit margin was 20.4% of GAAP revenue and 36.7% of non-GAAP net revenue. For the quarter, non-GAAP operating profit was $16 million, exceeding the high end of our guidance. This was largely due to slightly better revenues and cost efficiencies. Non-GAAP operating margin was 2.3% of GAAP revenue and 4.2% of non-GAAP net revenue. Non-GAAP loss per share is $0.11, which exceeded our guided range of $0.12-$0.14 loss per share. Cash flow from operations was -$90 million, and free cash flow was -$118 million in the Q1.

Historically, the Q1 is typically our lowest free cash flow quarter because of a large vendor prepayment and our annual bonus payout. This quarter, we also had one-time outflows, including certain fees related to the debt refinancing along with fees relating to exiting our corporate headquarters. For the balance of fiscal year 2024, we expect cash flow from operations to be positive and free cash flow to be slightly negative as we continue to invest in success-based CapEx. Additionally, in the Q1, we recorded $593 million of non-cash goodwill and intangible impairment charges. Turning to our segment results. For private cloud, GAAP revenue for the Q1 was $268 million, which was at the low end of our guidance. This includes legacy OpenStack revenue of $27 million. Total private cloud revenue was down 6% sequentially due to customers rolling off older generation private cloud offerings.

Private cloud gross margin was 39%, up 1 percentage point sequentially, primarily due to cost efficiencies and better asset utilization. Segment operating margin was 26.7%, roughly flat quarter-over-quarter. In public cloud, GAAP revenue was $422 million, exceeding the high end of our guidance, down 3% quarter-over-quarter driven by both infrastructure and services revenue declines. Infrastructure revenues are seasonally lower in the Q1, and we continue to walk away from renewals that do not meet our profit objectives. Public cloud services revenue was also down 3% sequentially given the continued cyclical headwinds in IT services. Gross margin for our public cloud segment was 31.5% of non-GAAP net revenue, down 9 percentage points sequentially driven by revenue declines, headwinds from seasonal fringe benefits in the U.S., and lower labor utilization in services. We will continue to improve utilization for the rest of the year.

Non-GAAP segment operating profit was 8% of non-GAAP net revenue, down 13 percentage points sequentially driven by the decline in gross margins as well as a modest uptick in our go-to-market investments to drive future growth in services. Operating expenses should flatten out from here. As Amar mentioned, we closed the public debt exchange in April with positive results. We ended with over 96% of our secured creditors supporting the exchange transaction. In 2024, we have reduced our outstanding principal by over $300 million and annual interest costs by more than $11 million. Since the end of fiscal year 2022, we have reduced our principal debt by over $800 million and annual interest costs by more than $38 million between the debt exchange and the company's open market purchases. Let me offer some key takeaways for modeling purposes.

Cash interest payments will run at about $48 million a quarter starting in Q2 2024. Aggregate principal balance of debt will be roughly $2.6 billion. Our revolver remains in place and fully available, providing an incremental $375 million of additional liquidity. As we mentioned last quarter, we also extended the maturities on the revolver and other participating senior debt facilities to May of 2028. The company has no corporate maturities prior to 2028. You'll note that the reduction of the total carrying value of debt net of premiums and discounts is significantly less than the $300 million reduction in the principal amount of our debt. The difference in the carrying value of our debt reported on our balance sheet and the principal amount of debt is a result of applying the required debt restructuring accounting guidance to the exchange.

This accounting required the company to recognize significant premiums on the newly issued debt, which are subsequently amortized over the life of the new debt, reducing quarterly GAAP interest expense. We are very encouraged by these results as it provides both a liquidity and runway to implement our strategy. Now on to guidance. We expect Q2 GAAP revenue to be approximately $668-$678 million. Total non-GAAP operating profit is expected to be $20-$22 million and non-GAAP loss per share of $0.09-$0.11. From a segment perspective, we expect private cloud revenue of $260-$265 million and public cloud revenue of $408-$413 million. The sequential decline in public cloud revenue is mainly attributable to declines in low-margin infrastructure resale. This decision not to pursue low-profit renewals, as emphasized by Amar in his prepared remarks, underscores our strategic focus on higher-margin service opportunities.

Our non-GAAP tax rate is expected to be 26% and non-GAAP other income and expense of approximately $52-$54 million in expenses. The non-GAAP share count is expected to be around 227-229 million shares. I'll now turn the call over to Sagar.

Sagar Hebbar (Head of Investor Relations)

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.

Operator (participant)

Thank you. As a reminder, to ask a question, you'll need to press star one one on your telephone. To withdraw your question, please press star one one again. Please wait for your name to be announced. We ask that you please limit yourself to one question with one follow-up. Please stand by while we compile the Q&A roster. One moment for our first question, please. Our first question will come from the line of Kevin McVeigh with UBS. Your line is now open.

Kevin McVeigh (Analyst)

Great. Thanks so much, and congratulations on the results. Hey, I wonder, can you give us a sense of where the upside was relative to your expectations, particularly on the public side? And is there any way to dimensionalize how much of the lower-margin infrastructure revenue that you walked away from? Just because, obviously, terrific result on the revenue. Just trying to dimensionalize how much was also not kind of renewed just from a margin perspective.

Mark Marino (CFO)

Yeah, thanks for the question. Yeah, good question there. From a color perspective, I would just say that the revenue beat was largely driven by the public cloud side of the house due to higher infrastructure resale volumes sort of carrying into that trend from Q4. From a private cloud revenue, although slightly lower, it was still within our guided range. But I think to sort of get at your second part of the question there, most of the impact from business we're walking away from, low-margin reseller business, you'll start seeing into Q2 a little bit more than we saw it into Q1, just given sort of the timing on some of those renewals. But that'll be more pronounced as we get into the Q2.

Kevin McVeigh (Analyst)

Great. And then can you just help?

Amar Maletira (CEO)

Kevin, if I can just add, those are low-margin, very low-margin business that we're walking away from. So I think it should improve the overall margin of that business as we walk away from very low-margin resale business. So it's net positive from a margin perspective.

Kevin McVeigh (Analyst)

That makes a lot of sense. Thank you.

Operator (participant)

Thank you. One moment for our next question, please. Our next question comes from the line of Frank Louthan with Raymond James. Your line is now open.

Speaker 6

Hey, guys. This is actually Rob on for Frank. So what verticals would you say that you had the most traction with during the quarter? And where do you expect to see the most traction going forward over the next couple of quarters? Thank you.

Amar Maletira (CEO)

Just, Rob, I just want to make sure I get the questions. You're talking about where we saw traction from a vertical perspective in the quarter?

Speaker 6

Yes.

Amar Maletira (CEO)

Yes. Okay. Thank you for the question, Rob. So clearly, we are seeing very good traction in our healthcare vertical. We continue to win a lot of business in Epic as a service. In my prepared remarks, I did mention that. The funnel remains strong. We still have TCV in the funnel in excess of about $700 million, even after closing a lot of business in Q1. So clearly, that vertical is playing out very well for us. In public cloud, we saw business across multiple verticals, but it was very broad-based. Our public cloud business also did quite well. In fact, we're starting to see a lot of green shoots in our services-led motion. Our overall bookings and services grew high double digits year-over-year, and in fact, mid-single digits in a seasonally declining quarter.

So overall bookings that I mean in public cloud, that including services. So if you recall, we did mention that we made a lot of structural changes in our go-to-market motion in the H2 of fiscal 2023, including refreshing our sales talent so that we bring in services so that we bring in services-specific skills in a go-to-market organization. We hired a lot of client partners. We also hired new leadership. And that all is now playing out quite well. We have better execution against our go-to-market plan. We are now landing and expanding in both our installed base as well as net new, specifically in Americas and Europe, which is one of our two largest regions. We also have increased our engagement with all three hyperscalers. And that's very important.

In fact, when it comes to AI and GenAI, we are very much embedded with the hyperscalers, all the three, specifically AWS as well as Azure. We continue to enable our go-to-market organization with very specific sales plays in both public cloud and private cloud. And we also started doing very good account planning. And it's sort of coordinated 360-degree account management for both mid-market and our enterprise customers. So this is all working well. Again, the market remains tough. As you know, macro environment has not changed as much. But I think within that construct, I think we, from a go-to-market perspective, are doing quite well on the public cloud side. And on the private cloud side, our healthcare vertical strategy is really working well. And we feel really good about the healthcare vertical strategy. In fact, we're also executing well against that strategy.

We implemented one of our we brought on board a healthcare customer, Seattle Children's Hospital, as I mentioned in my prepared remarks. It was a very, very good and smooth transition over to our Rackspace Cloud solution on the healthcare side.

Speaker 6

Great. Thank you, guys.

Operator (participant)

Thank you. As a reminder, to ask a question, you'll need to press star one one and wait for your name to be announced. Our next question will come from the line of Ramsey El-Assal with Barclays. Your line is now open.

Ramsey El-Assal (Analyst)

Hi. Thanks for taking my question this evening. You mentioned green shoots for services and good bookings. What's resonating in the market for you now? And I guess kind of also speak to your confidence level about seeing some level of inflection later on as we get deeper into the year.

Amar Maletira (CEO)

Yeah. Thanks, Ramsey. That's a good question. So we, on the services side, Ramsey, as I mentioned, we refreshed our go-to-market organization in the H2 of last year. We have started basically looking at a lot of enterprise and mid-market customers. As an example, Ramsey, we have about 20 MSAs in motion right now, Master Services Agreement with large enterprises and mid-market customers. Almost 50% of those we have already signed. That gives us a license to go hunt. I'll come specifically into the type of services, but I want to give you a bigger picture here. We are also signing a large strategic relationship with larger customers in all the three regions, in Americas, in Europe, as well as in the Middle East, by the way. We also have some very good frame agreements in certain verticals in our DACH region, specifically in the auto vertical.

So those are the green shoots I'm talking about. When it comes to services, what we saw, Ramsey, again, I think it also reflects what's happening in the marketplace. We are seeing our data services business really perform well. This quarter, our data services business grew very strong growth in our data services bookings, so to speak. We also saw professional services, consulting services across all three service lines in public cloud platform, in security, in applications, as well as in data grew sequentially. So we are starting to see and I think it's more of a better go-to-market execution. Now, these are all bookings numbered, by the way, as opposed to the market. The macroenvironment still remains challenging, uncertain, so to speak. And a lot of projects are more focused on cost optimization, but we are starting to see a lot of projects emerge on the AI side.

On private cloud, our vertical strategy is working very well on the private cloud side. Looking forward into the H2, Mark, you want to talk about what we are seeing from an overall perspective?

Mark Marino (CFO)

Yeah, sure. Yeah. Thanks, Amar. Yeah, just from a high level in terms of the H2 of the year, we do see revenue stabilizing sequentially in Q3 and a slight uptick in sequential revenue going into Q4 across both business units. And from an operating profit perspective, we see overall H2 operating profit being significantly higher than the H1 as we continue to see the pull-through on the revenue, higher revenue, as well as driving efficiencies throughout the organization.

Amar Maletira (CEO)

On efficiencies, we continue to drive a lot of efficiencies throughout the organization, Ramsey. From the actions, actually, we took early on in the H2 of 2023, as well as the actions we continue to take in 2024. These are efficiencies across both labor as well as non-labor. So that's why we believe the H2 operating profit should be significantly higher than the H1.

Ramsey El-Assal (Analyst)

Got it. Thank you.

Operator (participant)

Thank you. Now, this concludes today's Q&A session. I will now turn the call back over to Sagar Hebbar with closing remarks.

Sagar Hebbar (Head of Investor Relations)

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 [email protected]. Have a great evening, everyone.

Operator (participant)

This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day.