RXT - Rackspace Technology: Turnaround Progress Showing Traction But Better To Wait

Summary

• RXT is a pure-play multi-cloud services provider that aims to serve small and medium-sized businesses.
• 4Q22 results exceeded expectations, but investors should be cautious about slower core revenue and multi-cloud growth.
• RXT needs to burn cash for its turnaround efforts, but positive operating cash flow expected beyond 1Q is a promising sign.

Overview

With over two-thirds of its revenue coming from cloud, Rackspace Technology ( RXT ) is a pure-play in the rapidly expanding multi-cloud services market. Unlike its competitors, RXT aims to serve small and medium-sized businesses ((SMB)), which is a key structural difference between them. Positive sentiment around the CEO and his new team was bolstered by RXT's fourth-quarter results, which surpassed expectations on revenue and adj operating earnings. The completion of RXT's reorganization and its subsequent operation under the Public Cloud and Private Cloud segments as of January 1, 2023, represents, in my opinion, a watershed moment. RXT's bookings are also on the upswing thanks to the company's newfound dedication to those efforts. Now that they've reached the first milestone, I expect RXT to face the challenges of establishing a services culture within a company whose primary business is the resale of used infrastructure. While I recognize that this is inevitable progress, I do not anticipate that it will stimulate positive stock market activity. I anticipate that the shares will face ongoing difficulties until the company achieves better profitability and overcomes the limited growth and gross margin constraints that I expect in the FY23 reorientation period.

My take on RXT remains the same, that it is better to wait for more concrete evidence of a successful turnaround before investing.

4Q22 results highlights

The revenue rose by 3% after excluding FX impact, reaching $787 million, which was higher than the expected range of $772 million to $782 million and surpassed the consensus estimate of $776 million. However, investors should be cautious about the slower growth of core revenue, which increased by 4% excluding FX impact compared to 7% in 3Q22. Additionally, multi-cloud growth decelerated to 4% from 6% in the previous two quarters, excluding FX impact, and applications growth also slowed to 7% from 10% and 9% in the last two quarters.

Positive sign in cash flow

When putting their turnaround plans into action, I believe RXT will need to spend money. As a result of the first quarter timing of certain supplier and employee bonus payments, management has forecasted a negative cash flow from operations. In addition, they expect a rise in capital spending to back the sizable private cloud deal sealed in Q3. The good news is that after an expected negative first quarter, management also expects operating cash flows to be positive for the rest of the year, meaning that the company can probably avoid a capital raise.

Balance sheet

Assuming free cash flow grows as projected, RXT's financial health appears to be secure. The company has a healthy cash position for the near future, with just over $600 million in the bank as of FYE23 (roughly $250 million in cash on hand plus an undrawn revolver of $375 million). With an enhanced FCF profile and an enhanced EBITDA profile, I believe RXT will be able to meet its upcoming interest payment. More importantly, no maturities are due for RXT anytime soon, and growth in adjusted EBITDA and free cash flow should ease liquidity concerns.

Things to take note of

Despite the fact that the turnaround appears to be proceeding smoothly, there are still two issues to keep in mind. For starters, negative margin trends have nullified the positive effect of higher revenues. While RXT's top line has been expanding rapidly, the company's gross margins have been shrinking, which could spell trouble for the future. It's also likely that the acceleration of margin decay has led to a year-over-year drop in earnings. As a second point, the Enterprise market is still highly competitive. By concentrating on the needs of SMBs, RXT has been able to remain largely unnoticed by its larger rivals. As it shifts its focus to serving Enterprise customers, however, I expect RXT to face increased competition.

Conclusion

RXT 4Q results exceeded expectations, and the completion of its reorganization represents a significant moment for the company. However, challenges lie ahead as RXT works to establish a services culture and overcome limited growth and gross margin constraints in FY23. I maintain my cautious stance on investing in RXT until more concrete evidence of a turnaround emerges. While the company may need to burn cash for its turnaround efforts, the positive operating cash flow expected beyond 1Q is a promising sign. RXT's balance sheet is strong, and assuming free cash flow increases as expected, the company's financial viability should not be a concern. That said, it's important to note that negative margin trends and increased competition in the Enterprise market remain potential obstacles for RXT.

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