I believe that truth has only one face: that of a violent contradiction."― Georges Bataille
Today, we take an in-depth look at a tech concern whose stocks has fallen on hard times despite decent revenue growth and reasonable valuations at first glance. A full analysis follows in the paragraphs below.
Rackspace Technology, Inc. (NASDAQ:RXT) is a San Antonio-based end-to-end multicloud technology services concern that develops and operates customer cloud environments across all major technology platforms. The company boasts having served over 100,000 customers across 120 countries as of YE21, including more than half of the Fortune 100.
Rackspace was founded in 1998 as an IT infrastructure company for small to mid-sized businesses, initially going public in 2008. With the aid of private equity shop Apollo Global Management (APO), it went private via leveraged buyout in 2016 and transformed into a pure-play cloud solutions company. It then reentered the public markets in August 2020, raising net proceeds of $666.6 million at $21 a share. The stock trades right at just over nine bucks a share, translating to a market cap of $1.95 billion. Apollo still owns 61% of Rackspace.
Management operates its business through three segments: Multicloud Services; Apps & Cross Platform; and OpenStack Public Cloud.
Multicloud Services includes managed private clouds powered by technologies like VMware (VMW), multicloud deployments, management of applications and data on public clouds such as Amazon's (AMZN) AWS, Microsoft (MSFT) Azure, and Google (GOOG) (GOOGL) Cloud, as well as "mature" offerings such as managed hosting and colocations services. This segment is responsible for a large majority of Rackspace's revenue, generating $2.45 billion in FY21, up 14% from FY20 and representing 81% of total.
This segment is undergoing a transformation from its higher gross margin mature offerings that are hosted on its own infrastructure to lower gross margin managed public cloud services. However, since the latter is hosted on third-party infrastructure, they require lower operating expenses (and cap ex), meaning that the operating margins should be relatively similar for both offerings. The transition is ongoing but nearing completion, with 75% of the Multicloud Services' FY21 top line coming from high-growth markets, such as managed cloud services and Rackspace Services for VMware Cloud, and revenue from these markets was up 30% over FY20.
Apps & Cross Platform includes managed applications, managed security and data services, as well as professional services related to designing and implementing application, security, and data service. It accounted for FY21 revenue of $377.6 million, up 12% from FY20, representing 13% of total.
OpenStack Public Cloud is a high-margin legacy business that has been de-emphasized since 2017 and is not included in the company's core results. It generated FY21 revenue of $182.8 million, down 20% from the previous year, now representing only a 6% contribution to Rackspace's top line.
To improve on its operating profitability and better align with its business mix shift strategy, the company announced a restructuring in July 2021 that included a 10% workforce reduction and a $50.5 million charge to realize $95 to $100 million in annual savings as many of its service centers were moved offshore.
Rackspace markets itself on its automation technology, multicloud expertise, ~3,000-partner strong ecosystem, and differentiated customer experience to increase share in what is forecasted to be a $520 billion managed services and cloud infrastructure marketplace by 2023. According to Gartner's survey of public cloud users, 80% have adopted a multicloud approach. Furthermore, AWS sees the cloud market as only being 5-15% penetrated. All of these dynamics should provide a strong tailwind for Rackspace.
In addition to the in-house IT efforts of customers and would-be customers, the company competes against IT systems integrators, single cloud service providers and digital system integrators, regional managed cloud service providers, and colocation concerns - over which, in each instance, management believes it enjoys some form of advantage. For example, IT systems integrators such as Accenture (ACN), Cognizant (CTSH), Deloitte, and IBM (IBM) provide consulting and outsourcing to enterprise level customers, but their legacy IT revenue streams disincentivize them (according to Rackspace) from enthusiastically transitioning customers to the cloud. Furthermore, single cloud service providers' offerings are too narrow in scope to service larger clients with multicloud objectives.
Most of the company's core business revenue is generated from monthly recurring fees. After landing a client with infrastructure services, the company then attempts to move up the technology stack and expand with offerings including cloud-native apps and data. There are certainly enough customers to upsell with its 100,000+ strong base that allows negligible concentration concerns, with no client accounting for 3% of its top line in FY21. The flip-side to this dynamic is that the announcement of the biggest new business win in the company's history, a deal to migrate BT's hybrid customers to its technology, was met with a relative yawn.
Investors have been yawning at shares or RXT for some time as they are down 65% from their all-time high of $26.43 set in April 2021 as the market has chosen to focus on the company's gross margin, operating margin, and net income lines in the higher interest rate environment. It's not that Rackspace isn't profitable on a non-GAAP basis, having improved net income by 36% to $206.5 million in FY21, or $0.97 a share; it's more a function of believing that the company's transformation to third-party multicloud services will result in growth at these lines, a concept Street analysts started to focus on after its 2Q21 and 4Q21 earnings reports.
There was nothing wrong with Rackspace's final stanza of 2021 (per se), in which it earned $0.25 a share (non-GAAP) and Adj. EBITDA of $183.2 million on revenue of $777.3 million versus $0.26 a share (non-GAAP) and Adj. EBITDA of $198.8 million on revenue of $716.2 million in 4Q20. These results beat Street expectations by $0.01 and $6.1 million at the bottom and top lines, respectively.
The problem stemmed from the company's outlook on margins. After generating gross margins of 31.1% and Adj. operating margins of 16.1% in FY21 - down from 36.4% and 17.5% (respectively) in FY20 - management guided gross margins to "around 30%" and a "range of 14% to 15%" for FY22, blaming some of the decline on the preparation required to onboard BT clients to its cloud. Either way, it continued to invalidate its narrative of flattish operating margins as gross margins compress due to the business mix shift. Furthermore, Rackspace's 1Q22 non-GAAP earnings outlook of $0.20 to $0.22 a share was well below Street consensus of $0.26.
On May 10th, the company reported first quarter numbers. The company had non-GAAP earnings of 22 cents a share as revenues rose nearly 7% on a year-over-year basis to $776 million. Leadership guided to $780 million to $790 million worth of sales for Q2, a bit under the roughly $800 million analysts were expecting at the time. The company did have $65 million worth of operational cash flow in the quarter.
In addition to its gross and operating margins taking a hit, the company has also stated that its free cash flow - which improved dramatically from essentially zero in FY20 to $262.4 million in FY21 - would, as a percentage of revenue, fall below the 8.7% generated in FY21. Considering its debt of $3.4 billion against cash of around $300 million - for a leverage ratio of 4.3 - this development has not sat well with investors.
Analysts have been mixed on Rackspace since its last earnings report. Five analyst firms including Citigroup and RBC Capital have maintained Buy or Outperform ratings, albeit three of these contained downward price target revisions. Price targets proffered ranged from $11 to $16 a share. Both BMO Capital ($10.50 price target) and Deutsche Bank ($9 price target) reissued Hold ratings. 18% of the outstanding float is currently held short. There has been no insider activity in the stock so far in 2022.
The current analysis consensus sees a slight in earnings in FY2022 to around 75 cents a share as revenues rise in the 6-7 percent range to $3.2 billion.
Rackspace is in a sexy industry, but with unsexy margins and high debt, the market is only assigning a P/E of 12.3 to 2022 earnings, a price-to-FY22E sales ratio of .6, and an EV/TTM Adj. EBITDA multiple of under seven. It can be argued that this a 2023 story, when the company substantially reaps the benefits from the BT partnership and almost all of its transitioning is behind them. Furthermore, as private equity is wont to do, Apollo will likely be looking for favorable price points to exit some of its position over the next year. As such, Rackspace seems like it is dead money for now while we wait for a turnaround in margins or perceptions about them.
It's a most distressing affliction to have a sentimental heart and a skeptical mind."― Naguib Mahfouz
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