Rackspace Technology, Inc. (RXT) Q3 2022 Earnings Call Transcript

Operator

Thank you. [Operator Instructions] Our first question comes from Kevin McVeigh with Credit Suisse. Please go ahead.

Kevin McVeigh

Great. Thanks so much and congratulations on the results from Amar. Obviously, there is a lot going on in terms of the transition. I wonder, can you give us a sense, as you think about 2023 and you reposition the business across the two new segments, are you starting at the same base of revenue? Or should there be some shrinkage? And if you look at the goodwill impairment, it looks like it’s about 15% of the goodwill on your balance sheet. Is that a proxy for the adjustment on the revenue? Or is there any way to think about just the base of revenue and then maybe some sequencing on margins, just so we can get a couple of goalposts. I know it’s still a little bit early, but just try to frame that a little bit.

Amar Maletira

Yes. Kevin, good to hear your voice. Thank you for the question. You’re absolutely right, Kevin. It is difficult, as you can imagine, right, to provide guidance for the full year given the number of macro and micro changes that we’re experiencing, right? But let me give you some color. First, there is, as I mentioned in my prepared remarks, there is a macro uncertainty, which may lead to sort of longer sales cycles as well as a slowdown in decision-making in 2023.

Second, to improve our execution, we are making some tough choices here and also implementing operational changes over the next couple of quarters that will position the company for sustained profitable growth. Now this will be reflected in our numbers. So these choices, Kevin include deemphasizing infrastructure resale and shifting the mix of our pipeline and bookings to higher-value services and solutions. So this takes time. But as you can imagine, it is the right thing to do for the business. It will involve refocusing our go-to-market organization and in some cases, also rebuild in certain areas. And more importantly, we also have very, very targeted investments in solutions development, such as industry verticals. So as we get to the end of 2023, Kevin, we will start to see the benefits of our reorganization and also our execution focus. And we are seeing some really encouraging pipeline development in bookings, but it is still early and the business that we can close, as you know, can take about 6 or 9 months to materialize into revenue. So with that said, although the outlook for the last – next four quarters is really tough, even the near-term is tough. But based on what we are seeing, for example, macro-uncertainty, as I mentioned earlier, which might result in potentially longer sales cycle, operating model changes that may lead to some disruption, the deemphasis on infrastructure resale that I mentioned earlier as well as some continued FX headwinds. We expect Q1, which is seasonally down quarter because you have some usage-based volumes in our managed public cloud seasonally goes down. We expect revenue to be sequentially down between 1.5% to 2% as a result of all those factors that I mentioned. Does that help, Kevin?

Kevin McVeigh

It helps a lot. And then just maybe just this is a two-part, but I’ll ask it. I mean, really nice to see Shashank. It sounds like not only elevated to the Board but buy $2.5 million of stock, which is a really nice signal. Is there any way to think about the bookings, Amar, just for Q4 just within the context and, again, very helpful on the sequencing of the revenue for Q1?

Amar Maletira

Sure. So on bookings for Q3, let me give some color here, Kevin. I’m actually very pleased to see a favorable mix shift in the bookings to more of a higher value and higher-margin business away from infrastructure resale. So as you know, infrastructure resale bookings come at low margins, so this shift in focus to higher-margin services and solution bookings was by design. And so I’m pleased that we are making that shift. In fact, the public cloud services bookings were up year-on-year and included about 17 new public cloud services customers and also a large expansion deal with a major media and communications company in Europe. So, very pleased with that. Of course, the base of the public cloud services business is smaller compared to our infrastructure resale. So our focus is on growing the services booking space more quickly and on the private cloud side, as I mentioned in my prepared remarks, and I’ll give some color there, we had a strong – very strong bookings quarter, which was largely driven by this large private cloud deal, and I will talk a little bit more about it, but we continue to gain traction and build pipeline in private cloud as we improve our focus there.

Now on the – since you asked about the bookings question and I referenced the large private cloud deal, let me give you some color there so that you understand the dynamics here. This private cloud deal is one of the largest deal in the history of the company and is over a couple of hundreds of millions of dollars of TCV over 5 years, in fact, with the customer and the technology sector. We offered a very compelling value proposition to the customer. These were stable storage-intensive analytics-heavy workloads, which were better suited to operate in a private cloud environment. In fact, Rackspace was able to offer a solution that significantly lowered their cost while delivering improved performance in both storage and compute. So this is particularly a large opportunity, Kevin, but it is a representative of the types of deals we will begin to see in our managed hosting and private cloud business as a result of multiple things. We have a very strong brand in this market, great market presence. We have the scale, and we will also see an increased focus with our two-business unit structure.

Kevin McVeigh

Very helpful. Thank you, Amar.

Operator

Thank you. Our next question comes from Amit Daryanani from Evercore. Please go ahead.

Amit Daryanani

Hello. Thanks for taking my question. I have two as well. I guess, first one, I was hoping if you folks could just talk about when you look at your debt stack in debt structure right now, maybe just talk about how much of is floating versus fix and then more importantly, given the compression in margins that we’ve been seeing, could you just talk about what are some of the covenants and the leverage metrics that we should be aware about would rely to those?

Amar Maletira

Okay. Hey, Amit. Good to hear your voice. By the way, you’re not coming across very clear, but I got the gist of your question, you wanted to – basically is how our debt structure looks fixed versus variable and the covenant on it, right? So let me start with the covenant first. We have minimal debt covenants after the debt refinancing we did in early 2021. So when I arrived here in November 2020, we took advantage of the very favorable debt market and refinanced our debt in 2021. All of these debts are not due for another 6 or 7 years. We have two – there is a senior secured note, which is at 3.35%, fixed. We have a term loan B, which has a variable component to it. And then we have a non – sort of non-secured note, which is at 5.375%, so a wide variety of the debt structure. I think I’m not sleeping – I’m not losing any sleep so to speak, servicing this from an interest expense perspective. And as you know, based on the rates right now, it’s a very attractive pricing right now on the debt side. So minimal debt covenants, a wide variety of interest expenses on this, but overall, I think it is very manageable interest expense, given that most of this debt is – two of those notes are actually fixed interest rates. Does that help?

Amit Daryanani

Yes. No, that is really helpful. Thank you for that. If I can just follow-up, when I look at the December quarter guide, right, maybe just something on the more near-term side, you started talking about flattish revenues on a year-over-year basis, I think, right, on total numbers. Maybe just talk about how much of the FX headwind are you seeing in the December quarter numbers on a year-over-year basis? And then how macro impacting you in the December quarter, I am wondering if seeing deal push-outs, deals having delayed. Just any clarity on kind of the macro and FX and how that’s impacting December quarter would be helpful?

Amar Maletira

I think you’ve covered just key points there, Amit. So, let me start with the macro, right. So, we took a revenue haircut primarily in services and also a bit in the usage-based volumes that come to our managed public cloud business, mainly due to macro outlook, okay. And the macro outlook, as you know, when you take a look at what’s going on from a demand environment, etcetera, all companies in the cloud ecosystem are being cautious about the demand environment. And rightfully so, given the tough macro outlook, in fact, the hyperscalers are cautioned that the growth rates are slowing, although they are still growing double digits. And we do believe that customers will maintain their current IT spend on mission-critical projects, but slow down spending on lower priority less critical projects. And this, of course, varies by customer and verticals. But broadly speaking, Amit, customers will be focused on cost optimization as well as on projects that have a faster payback period. And I have done this for a long time and I have gone through these cycles multiple times, and it’s not unusual to expect some of the changes in the size and scope of the deals, longer sales cycles and also a slowdown in decision-making. So, we have factored those in when we guided. So, typically, you would see as the revenue either be flattish or go up sequentially, we have guided to a sequential decline in revenue because of that. FX continues to remain a headwind. It was, I think 2 percentage points of headwind in Q3. We are also taking a look at our October numbers that are coming in now. I don’t have any color right now. But we have factored in that FX headwind. It’s very difficult to predict, but we did factor in some of these FX headwinds. And we did that in Q3 too. So, we are not changing the way we guide when it comes to FX.

Amit Daryanani

Prefect. Thank you.

Operator

Thank you. [Operator Instructions] Our next question comes from Tien-Tsin Huang with JPMorgan. Please go ahead.

Tien-Tsin Huang

Hey. Thanks so much and good to have a track record here from the – with these results. I wanted to ask if you don’t mind on – also on bookings and because we have been hearing a lot through this results season, how clients as well as vendors are being more careful around the gross profit dollars or margins around new contracts, new award activity? How – are you seeing that manifest itself in some way in your business? Are you may be seeing a shift and need to spend a little bit more in terms of capital intensity to win work? I am just curious if you are already seeing that, and that’s a factor with your selectivity on winning business on the bookings side.

Amar Maletira

So, I think – thanks, Tien-Tsin for the question. So, there are two parts of our business, right. We are a multi-cloud provider, Tien-Tsin. We have public cloud and then also we have private cloud. And I can tell you, let me – public cloud demand continues to remain strong. I do believe that as we go through this process, the demand in multi-cloud will remain, but it may start moving to the right. And we have seen that happen in down cycles, not with multi-cloud business but in other businesses. And to be honest, to the extent that market is taking a pause, it comes at a good time for us to go complete the reorganization exercise, etcetera, and get ready when the customers return to normal spending levels and we will be prepared to capture the demand with newer offerings in an operationally realigned organization. So, for us, on the public cloud side, customers are looking for cost optimization. You have heard that multiple – most of the hyperscalers are talking about it. We have also seen that. And so we do have cost optimization services that we deliver today. We are going to expand those offerings. We are going to lead with those offerings so that we start building relationship with the public cloud customers who need help on optimizing their spend on public cloud. But the services business, the demand still remains. But the sales cycles will be longer, as you know, to go and as you are making the pivot from say infrastructure resale to services. It takes time for us to build the services pipeline, but it’s all doable. And the focus will help us to start building those pipelines fast. So, on the public cloud side, I feel – I think we have a good opportunity to pursue. On the private cloud side, many had thought that the private cloud was – I will just give you an example. I have been in the job for 45 days, and I have been on the road for 40 days out of those 45 days, talking to customers, partners and employees. And the biggest surprise for me, Tien-Tsin, is there is an ample demand signals out there. The issue is we have not been listening carefully. We need to better listen to those demand signals and you would be surprised how much of opportunity there is in the private cloud space, which has been underestimated by the company as well as the market. And so I feel that if we are focused on a couple of industry verticals, for example, regulated industries like healthcare, on the commercial side, industries like technology, I think we are going to do quite well in private cloud. So, stay tuned, we are going to launch a lot of offerings in this area in the next 6 months to 12 months or even before that. But we are separately seeing traction in private cloud and public cloud remains strong despite the slowdown in growth from the hyperscale aspect.

Tien-Tsin Huang

Got it. Thanks for that. I appreciate the hard work as well. Thanks.

Operator

[Operator Instructions] Our next question comes from Nate [indiscernible] with Deutsche Bank. Please go ahead.

Unidentified Analyst

Hi guys. This is Nate on for Bryan. I just wanted to ask about sort of gross margin expectations in fourth quarter and sort of the right way to think about modeling margins into next year. So, I think at the end of the last earnings call, you had snuck in some comments and you expected gross margins around 26% in the fourth quarter and mid-20s for fiscal ‘23. Just wanted to check in to see if there is any update to that thinking or if those numbers still hold?

Amar Maletira

Yes. So, Nate, thanks for asking the question. Now given the mix of the business, Nate, that we are projecting in Q4 after taking the haircut, etcetera, we still expect the gross margins to be between 25.5% and 26% for fiscal Q4, okay. So, that is actually not changing. Now, when it comes to gross margins for fiscal 2023, you see, Nate, my mandate from the Board is to turn this business around and align it to the strong growth markets that we address today. So, I months not going to manage to an arbitrary near-term targets since I am driving a transformation. So, in 2023, we are going to make some tough decisions and set us up well for 2024. And as I mentioned to Tien-Tsin, the demand signals remained strong. And to the extent that the market is taking a pause, it comes at a good time for us to complete this whole reorganization that we aren’t taking today. And so just as a reminder, right, our gross margin pressures are almost entirely a function of the mix of the business. And so as we turn the business around, as we stabilize the private cloud business, start growing the services component of our public cloud, we will see improvements in our mix that will drive gross margin accretion. But similar to revenue, it is difficult to know exactly how the mix will play out in the next few quarters. Now I can also tell you, from an OpEx standpoint, we plan to keep it roughly flat year-on-year, and we will continue to monitor it. So, we have a good – very tight control on our expenses, we have cost efficiency programs that we are running that will continue to run, and we will keep a tight lid on the expenses as we go through this tough macro environment and also the micro changes that we are making in the company.

Unidentified Analyst

Got it. That’s very helpful. And then just my follow-up was on BT. So, is there any updates or color you can give beyond sort of the high-level comments that were given in the prepared remarks. So, I think last quarter, you had mentioned it was sort of ramping slower than you had hoped for, but it seems like maybe that’s turned around. So, any way to quantify that impact or any sort of broader qualitative color you could give on BT would be great.

Amar Maletira

So, let me give some qualitative color here on BT. So, when you look at the BT deal, and probably we have explained this in the past, we have two distinct phases in the BT deal. First is the customer onboarding phase. We are currently operating in the first phase onboarding over 200 marquee customers. We have made some good progress on transitioning customers since our last update last quarter. The second phase is I call that as a transformation phase, where we can transform the customers’ environment by moving them to the Rackspace private cloud solutions. And this will create significant value for them as well as for us. And when we talk about our partnership with BT, we have a great partnership with BT. Both the companies BT and Rackspace are working well together. We are aligning our product and solution roadmaps. We will collaborate on bringing the best value to the market through this newly developed joint solutions that we are launching.

Unidentified Analyst

Appreciate the color. Thank you.

Amar Maletira

Thanks.

Operator

Thank you. I am showing no further questions at this time. I would now like to turn it back to Robert Watson for closing remarks.

End of Q&A

Robert Watson

Thanks Andrea and thank you everyone for joining us. If we didn’t get to your question or you have a follow-up, please send us an e-mail at ir@rackspace.com. Have a great evening everyone. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the program. You may now disconnect.