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Fitch Maintains Rackspace's Sr. Secured Rating at 'BB+/RR1'; Outlook Stable
November 1, 2017 / 4:13 PM / 19 days ago

Fitch Maintains Rackspace's Sr. Secured Rating at 'BB+/RR1'; Outlook Stable

(The following statement was released by the rating agency) CHICAGO, November 01 (Fitch) Fitch Ratings maintains the 'BB+/RR1' issue rating assigned to Rackspace Hosting Inc.'s (Rackspace) senior secured term loan B following the company's announced $800 million upsize of its existing term loan. The proceeds from the additional issuance will be used to fund the acquisition of Datapipe Holdings, LLC (Datapipe), which was announced on Sept. 11, 2017. The acquisition is expected to close during the fourth quarter of 2017 (4Q17). Other than the incremental issuance, no changes are being made to the credit facility. The Rating Outlook is Stable. With the acquisition of Datapipe, Fitch anticipates Rackspace's gross leverage to temporarily exceed the negative sensitivity of 4x. Fitch expects the company to use its free cash flow to reduce debt in 2018 and lower its total leverage to below 4x exiting 2018. Total leverage sustaining above 4x could result in negative rating actions. With the acquisition of Datapipe, Rackspace expects to strengthen its access to emerging markets, including Brazil, China, and Russia, and the west coast of the U.S. where it currently has a limited presence. The acquisition would also strengthen the company's access to the public sector. KEY RATING DRIVERS Secular Tailwinds: Fitch expects solid growth across Rackspace's markets, driven by increased outsourcing, growth in workloads across platforms, and customer adoption of hybrid cloud environments. Fitch also expects outsourcing of information technology (IT), which is in relatively early stages, will continue over the longer term, driven by pressured IT budgets and increasing complexity around hybrid cloud environments. Workload growth across cloud platforms and integration of legacy systems should support solid hybrid cloud adoption. Strengthening Free Cash Flow (FCF) Profile: Fitch anticipates that Rackspace's FCF profile will strengthen further as it shifts investments to managed cloud services from building out its public cloud, which meaningfully reduces capital intensity. Building out Rackspace's public cloud has driven significant historical capital expenditures, and Fitch expects this capital will be reinvested in managed cloud services or made available for debt reduction. As a result, capital spending as a percentage of revenue should decline closer to 15% versus 20% to 25% historically. Fitch projects more than $250 million of annual FCF through the forecast period. Elevated Leverage: Fitch estimates total leverage (total debt to operating EBITDA) to be more than 4x in 2018, given $3.3 billion of debt at the end of second quarter 2017, incremental debt for the Datapipe acquisition, and a Fitch forecast of approximately $1 billion of operating EBITDA for 2018. Fitch estimates total leverage to decline to below 4x in 2019. Pivot From Public Cloud: Fitch expects Rackspace to strategically shift growth emphasis away from public cloud operations toward managed cloud service. Fitch believes public cloud business will be pressured over the longer term as incremental workloads increasingly migrate to larger Amazon Web Services (AWS) and Microsoft (Azure). As a result, Fitch expects high single-digit revenue declines through the intermediate term for the public cloud business. Significant capital spending by public cloud operators including AWS and Azure have led to subsequent aggressive price cuts. This has left Rackspace's public cloud less competitive for new workloads, despite higher service levels. Fitch does not anticipate significant customer churn for existing workloads, although Rackspace will focus on leveraging existing customer relationships and providing managed cloud services for incremental workloads on AWS or Azure. Managed Cloud Service Growth: Fitch expects greater emphasis on managed cloud service will drive robust revenue growth from increasing complexity associated with hybrid cloud environments. Fitch believes customers will increasingly embrace third-party service providers to architect, secure and operate dedicated hosting and public and private cloud environments. Fitch believes Rackspace is uniquely positioned within managed cloud services, given leadership positions in dedicated hosting (#1) and public cloud (top 4), cloud domain expertise, scale which enables investments in accreditations with AWS and Azure, and its support strategy. Fitch views revenue contributions from managed cloud services as small, given Rackspace only started offering these services at the beginning of 2015, and expects growth to offset declines in the public cloud business over the intermediate term. Potential Internalization Threat: Over the long term, Fitch believes AWS and Azure will likely build out service offerings to compete with partners, including Rackspace, potentially constraining growth or pressuring margins in managed cloud services. However, over the near term, AWS and Azure should remain focused on building out highly profitable public cloud infrastructure rather than investing in non-core higher service levels. Additionally, AWS and Azure would be challenged to replicate Rackspace's services, particularly in the middle market, given its dedicated hosting and private cloud domain expertise in servicing this fragmented segment. As a result, Fitch believes AWS and Azure expanding cloud services are more likely to accelerate partner stratification or consolidation. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action: --Fitch's expectation that total leverage will sustain below 3x from voluntary debt reduction with annual FCF above $250 million; --Strong adoption of Rackspace's managed cloud services offsetting public cloud churn and stable dedicated hosting and private cloud performance, resulting in mid-single-digit positive organic revenue growth, validating the company's strategy. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action: --Fitch's expectation that total leverage will sustain above 4x through the intermediate term, likely due to incremental debt issuance to support restricted payments or make acquisitions; --Weaker than expected or more volatile revenue growth through the intermediate term, indicating less robust industry growth or adoption of Rackspace's managed cloud services, potentially in conjunction with greater than anticipated public cloud customer churn. LIQUIDITY Fitch believes Rackspace's liquidity is sufficient and supported by: --Over $100 million of available cash at the end of 2Q 2017, a portion of which is located outside the U.S.; --$225 million undrawn senior secured RCF. Fitch's projections of more than $250 million of annual FCF also support liquidity. Total debt is $4.1 billion (after Datapipe acquisition) and consists of: --$2.9 billion of senior secured Term Loan B due Nov. 26, 2023; --$1.2 billion of 8.625% senior unsecured notes due Nov. 15, 2024. FULL LIST OF CURRENT RATINGS Fitch currently rates Rackspace as follows: --Long-Term Issuer Default Rating 'BB-'; --Senior secured revolving credit facility 'BB+/RR1'; --Senior secured Term Loan B 'BB+/RR1'; --Senior unsecured notes 'BB-/RR4'. The Rating Outlook is Stable. Contact: Primary Analyst Alen Lin Senior Director +1-312-368-5471 Fitch Ratings, Inc. 70 West Madison Street Chicago, IL 60602 Secondary Analyst Jason Pompeii Senior Director +1-312-368-3210 Date of Relevant Rating Committee: Sept. 12, 2017 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Additional information is available on www.fitchratings.com ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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