RXT - Rackspace Restructures To Counteract Revenue Decline And Operating Losses

2023-07-14 16:26:13 ET

Summary

• Rackspace Technology, Inc. provides organizations with an array of Public and Private Cloud services.
• The firm will likely produce top line revenue contraction in 2023, but management says Q2's operating results will be the "trough" before a better second half of 2023.
• Leadership will need to prove its restructuring and ability to grow revenue and eliminate operating losses.
• I'm Neutral [Hold] on Rackspace Technology stock until we see a return to growth and operating breakeven.

A Quick Take On Rackspace Technology

Rackspace Technology, Inc. ( RXT ) provides a range of multi-cloud environment services for all major technology platforms.

I previously wrote about Rackspace with a Hold outlook.

Until management can restart top line growth and eliminate operating losses, I’m Neutral [Hold] on RXT.

Rackspace Overview

San Antonio, Texas-based Rackspace was founded to provide infrastructure solutions to enterprises.

After its take-private acquisition by private equity firm Apollo Capital Management in 2016, the firm has transitioned to a cloud-agnostic services focus on recurring revenue.

Management is headed by Chief Executive Officer Amar Maletira, who has been with the firm since 2020 and was previously Chief Financial Officer at Viavi Solutions and CFO at Hewlett-Packard Enterprise Services for Americas.

The firm provides multicloud services for the following infrastructure and software platforms:

• Amazon AWS

• Google Cloud

• Microsoft Azure

• VMware

• Oracle

• Salesforce

• SAP

• Others.

The company pursues new customers via a dedicated sales and marketing force optimized by specialty and business unit functions.

Rackspace reports operating activity via three segments:

• Public Cloud

• Private Cloud.

In addition, the firm has developed an ecosystem of more than 3,000 partners.

Rackspace’s Market & Competition

According to a 2023 market research report by Grand View Research, the global market for cloud computing was valued at $484 billion in 2022 and is expected to reach $1.39 trillion by 2030.

This represents a forecast CAGR of 14.1% from 2023 to 2030.

The main drivers for this expected growth are the historic and multi-decade transition by enterprises from on-premise systems to cloud infrastructures.

Also, the chart below shows the historic and forecast U.S. cloud computing market size, by use, from 2016 to 2027:

Major competitive or other industry participants include:

• Amazon

• Google

• Microsoft

• IBM

• Oracle

• Nutanix

• NetApp

• Equinix.

Rackspace’s Recent Financial Trends

• Total revenue by quarter has plateaued; Operating income by quarter has dropped into negative territory in the most recent quarter.

• Gross profit margin by quarter has trended lower recently; Selling, G&A expenses as a percentage of total revenue by quarter have risen in the most recent quarter.

• Earnings per share (Diluted) have been heavily negative as the chart shows below.

(All data in the above charts is GAAP.)

In the past 12 months, RXT’s stock price has fallen 58.7%, as the chart indicates below.

For the balance sheet , the firm ended the quarter with $217.8 million in cash, equivalents and trading asset securities and $3.4 billion in total debt, of which $55.9 million was categorized as the current portion due within 12 months.

Over the trailing twelve months, free cash flow was $107 million, during which capital expenditures were $73.3 million. The company paid $67.7 million in stock-based compensation ("SBC") in the last four quarters.

Valuation And Other Metrics For Rackspace

Below is a table of relevant capitalization and valuation figures for the company.

(Source - Seeking Alpha.)

The Rule of 40 is a software industry rule of thumb that says that as long as the combined revenue growth rate and EBITDA percentage rate equal or exceed 40%, the firm is on an acceptable growth/EBITDA trajectory.

RXT’s most recent Rule of 40 calculation was 15.5% as of Q1 2023’s results, so the firm has significant improvement needed, per the table below.

(Source - Seeking Alpha.)

Commentary On Rackspace

In its last earnings call ( Source - Seeking Alpha ), covering Q1 2023’s results, management highlighted the first full quarter since the company's reorganization into two new primary business units, Public Cloud and Private Cloud.

However, leadership said "there has been little improvement to the macro environment since the last time we spoke with you."

Customers "remain cautious resulting in lengthening sales cycles and deferred decisions," although these conditions are not limited to RXT, but industry-wide as businesses remain careful in a slowing economic environment.

Management didn’t disclose any company, customer or revenue retention rate metrics or characterize them.

Total revenue for Q1 2023 fell 2.2% year-over-year, while gross profit margin dropped 6.9%.

Selling, G&A expenses as a percentage of revenue rose 0.5% and operating income turned materially negative.

The company's financial position is moderate, with substantial long-term debt and modest liquidity although it is generating reasonable free cash flow.

From management’s most recent earnings call, I prepared a chart showing the frequency of key terms mentioned (or not) in the call, as shown below.

I’m most interested in the frequency of potentially negative terms, so management or analyst questions cited ‘Uncertain’ three times, "Challeng[es][ing]" three times, "Macro" 20 times, "Drop" once and "Volatil[e][ity]" once.

The frequency of these negative terms is significant, as management appears to be dealing with difficult business conditions and risks.

Regarding valuation, the market has increased its EV/Sales multiple slightly since Q3 2022 when I last wrote about Rackspace, from 1.3 to 1.4 currently.

Looking ahead, management only provided guidance for Q2, as it expects 2023 to be a "choppy year."

It guided Q2 revenue to be $720 million, so three times Q2’s estimate plus Q1’s actual leads to my estimated 2023 revenue drop of 6.8% versus 2022’s results.

Compared to 2022’s top line revenue growth of 3.75%, this is obviously a worse result going forward in terms of revenue trajectory.

A potential upside catalyst to the stock could include improved operating results from cost-saving initiatives "and some improvement in mix."

The primary business risk to the company’s outlook is the continued slowdown in customer demand and slowing sales cycles.

While management believes Q2 will represent the "trough" in terms of operating losses, with sequential improvement in the back half of 2023, I’m in the camp that will wait and see how management proves itself.

Until management can restart topline growth and eliminate operating losses, I’m Neutral [Hold] on RXT.

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