Rackspace Technology: Attractive TAM But Challenges Persist In The Near Term

Thesis

Rackspace Technology, Inc. (NASDAQ:RXT) operates in a promising market, serving a large and growing multi-cloud total addressable market (TAM). However, the company's Public Cloud business is still experiencing a decline. The company is encountering ongoing challenges in its services revenue, which has decreased in the previous quarter. The company's inconsistent performance, uncertainty regarding its long-term profitability and growth prospects, the impact of the volatile macroeconomic environment on near-term bookings, and an unclear strategy regarding divestments keep me cautious on the shares at the moment.

Business Overview

RXT collaborates with corporate clients to develop their cloud strategies and assists in migrating, managing, and optimizing workloads on various public or private cloud platforms chosen by the customer. Today, the legacy OpenStack business constitutes only a small portion of the company's total revenues, and it's expected to decrease to around 4% by 2023. In addition to its expertise in public cloud services, RXT provides additional value to its customers through its proprietary technology and automation solutions. For instance, RXT's primary access platform, known as Rackspace FabricTM, offers customers a unified user interface for managing multiple cloud environments. This platform includes features like consolidated billing, a central security framework, and a unified system for handling support requests and interactions.

2Q23 Review and Outlook

RXT reported better-than-expected financial results in the second quarter, surpassing both revenue and margins expectations due to strong performances in Private Cloud and improved adjusted EBIT margins. Furthermore, the company provided guidance for the third quarter that aligns with market expectations, including revenue projections of $722 million to $732 million. The breakdown of Q3 guidance includes Public Cloud revenue between $428 million and $433 million, and Private Cloud revenue between $294 million and $299 million. Additionally, the company anticipates adjusted operating income of $43 million to $47 million and adjusted EPS ranging from -$0.06 to -$0.04.

Furthermore, RXT reported a positive free cash flow of $14 million in Q2, rebounding from a $14 million decline in Q1, and anticipates this positive trend to continue into Q3. Management also highlighted early client interest in Generative AI, indicating that they have generated approximately 250 leads, have about 50 potential opportunities in the pipeline, and are currently negotiating three deals. Finally, management reiterated the key components of its turnaround strategy, which includes growing the Public Cloud segment, stabilizing the decline in the Private Cloud segment, establishing a more efficient cost structure, and driving profitable growth and free cash flow.

While I see the second-quarter results as evidence of the new management's ability to manage expectations and execute effectively, I acknowledge that the current macroeconomic environment presents challenges for accelerating growth. I believe the transition towards selling higher-value services instead of infrastructure will take time, but it represents the right direction for positioning the company for future growth.

Operating in a Fast-Growing TAM

I see RXT as well-aligned to a fast-growing industry (i.e., digital cloud services) with an impressively large TAM. The total addressable market in this sector is quite substantial. According to IDC's forecast, global spending on public cloud services is expected to reach $1.35 trillion by 2027, with a five-year compound annual growth rate (CAGR) of 19.9%. Among the various segments within this market, Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) stand out as two of the fastest-growing areas, both of which are highly relevant to RXT. PaaS, in particular, is expected to witness the most rapid growth over a five-year period, expected to grow at a CAGR of 27.2%. This surge is mainly driven by investments in data management software, application platforms, and analytics and business intelligence software. On the other hand, IaaS spending, encompassing expenses related to computing, storage, and networking equipment, is projected to be the second-fastest growing category, with a CAGR of 23.5%.

Several Reasons to Remain Cautious For Now

Although RXT's results have met the higher end of expectations, the company's Public Cloud business is still experiencing a decline. The company is encountering ongoing challenges in its services revenue, which has decreased by -5% YoY in the previous quarter, as customers are prioritizing cost optimization and reducing discretionary spending. Additionally, the Public Cloud segment has seen its profit margins contract by approximately 5 percentage points year-on-year due to reduced spending volumes in both reseller and services areas. I anticipate the macroeconomic conditions to continue to put pressure on Public Cloud margins in the short term, as customers continue to emphasize cost-cutting measures. The Private Cloud sector is also facing difficulties, including customers transitioning away from older technology and lingering effects from a ransomware attack in December. Furthermore, Public Cloud margins have contracted by about 10 percentage points due to fixed costs associated with the business as revenues decline.

Valuation

RXT is a company that specializes in multi-cloud services, and a significant portion of its revenue, more than 75%, comes from cloud-based implementation and managed services. Within the cloud business, approximately 25% of the revenue comes from managed public cloud services. Rackspace is well-aligned to large multicloud TAM with attractive industry tailwinds; however, inconsistent execution, a decline in the public cloud business, uncertain long-term margin/growth profile, volatile macro environment present challenges to the company in the near term which is why I believe a discount to leading IT services peers as well as infrastructure technology companies, is warranted. When comparing RXT to its peers in the IT services industry, which include Accenture PLC (ACN), EPAM Systems Inc (EPAM), Infosys Ltd (INFY), and Wipro Ltd (WIT), it's important to note that RXT's revenue growth rates, as well as its EV/EBITDA and P/E multiples for previous years, appear to be lower. This suggests that RXT may warrant a discounted valuation due to its high levels of leverage, uncertain path to accelerating revenue (despite recent bookings performance), and potential margin challenges in the medium term. Hence, I remain cautious in the near term and assign a hold rating on the stock.

Risks to Thesis

Possible upside risks encompass favorable macroeconomic conditions, advantageous pricing dynamics, exceptional expansion in both public and private cloud markets, and the establishment of more partnerships with major cloud service providers.

Downside risks include a significant risk associated with the key individual, as CEO Amar Maletira plays a central role in the ongoing reorganization efforts. Additionally, Apollo retains the majority of outstanding shares, creating a potential risk related to the supply of shares. Moreover, RXT currently has significantly higher debt levels compared to its industry peers with a leverage ratio of ~5.7x. RXT's goal is to gradually reduce this ratio. However, currently, the debt levels remain high which presents a key risk in the current deteriorating macro environment.

Conclusion

Rackspace is a specialized player in the rapidly expanding multi-cloud services sector, with over two-thirds of its revenue coming from cloud services. However, there are several factors that confirm my hold rating on the stock. Despite RXT's results meeting the higher end of expectations, the company's Public Cloud business is still declining. I anticipate that the current macroeconomic conditions will continue to exert pressure on Public Cloud margins in the short term as customers focus on cost-cutting measures. Hence, I see limited chances of upside in the near term and assign a hold rating to the stock.