CHICAGO--(BUSINESS WIRE)--Fitch Ratings has assigned first-time ratings to Rackspace Hosting Inc. (Rackspace) as follows:
--Long-Term Issuer Default Rating (IDR) at 'BB-';
--Senior secured revolving credit facility (RCF) at 'BB+/RR1';
--Senior secured term loans at 'BB+/RR1';
--Senior unsecured notes at 'BB-/RR4'.
The Rating Outlook is Positive. Fitch's actions affect $3.5 billion of debt, including a $225 million secured RCF. A full list of ratings follows at the end of this release.
On Aug. 26, 2016, Rackspace announced it is being acquired by private equity firm, Apollo Global Management LLC (Apollo), in an all-cash going private transaction valued at $4.4 billion. Apollo plans to fund the acquisition with $3.2 billion of debt and $1.3 billion of new equity, provided by a syndicate led by Apollo in partnership with Searchlight Capital Partners. Rackspace's Board of Directors has approved the acquisition. Apollo and Rackspace expect the deal will close by the end of calendar 2016, pending customary approvals.
In connection with the acquisition, Rackspace will enter into $2.25 billion of credit facilities consisting a $2 billion senior secured Term Loan B and $225 million senior secured RCF, which will be undrawn at closing. Fitch expects the credit facilities will be secured by substantially all of Rackspace's assets and that covenants related to the credit facilities will be customary. Rackspace also will issue $1.2 billion of senior unsecured notes with existing cash at closing to be used to repay the existing $500 million of 6.5% senior notes due 2024.
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 expects that 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 expects 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%-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) will be elevated at the acquisition's close. Given the proposed $3.2 billion of funded debt and a Fitch forecast of approximately $775 million of operating EBITDA (excluding identified cost synergies) for 2016, total leverage will be more than 4x at deal closing. However, the Positive Outlook reflects our expectations that Rackspace will use FCF for debt reduction which, along with profitability growth, will result in deleveraging to below 3.5x over 12-18 months.
--Pivot from Public Cloud: Fitch expects Rackspace's public cloud business will be pressured over the longer term as incremental workloads increasingly migrate to meaningfully larger Amazon Web Services (AWS) and Microsoft (Azure). As a result, Fitch expects low single-digit revenue declines through the intermediate term for the public cloud business. Significant capital spending mainly by AWS but also Azure and subsequent aggressive price cuts have 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 services for incremental workloads on AWS or Azure.
--Managed Cloud Service Growth: We expect robust revenue growth in managed cloud services from increasing complexity associated with hybrid cloud environments. Fitch believes customers will increasingly embrace third-party service providers to architect, secure and operate optimized 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), domain expertise from a broad set of long-term tenants and scale which enables investments in accreditations with AWS and Azure, and its support strategy. Fitch believes revenue contributions from managed cloud services remain 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 longer term, Fitch believes AWS and Azure likely will build out service offerings to compete with partners, including Rackspace, potentially constraining growth or pressuring margins in managed cloud services. Over the nearer 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, given its dedicated hosting and private cloud domain expertise. As a result, Fitch believes AWS and Azure expanding cloud services are more likely to accelerate partner stratification or consolidation.
Fitch's key assumptions within the rating case for Rackspace include:
--Mid-single-digit revenue growth, driven by core markets, including dedicated hosting, continuing to grow by mid-single digits.
--Mid- to high-digit negative revenue growth in Rackspace's public cloud business offset by robust positive growth in managed cloud services business.
--Operating EBITDA margin should remain in the mid-30s, driven by lower investment intensity and productivity gains partially offset by a shifting sales mix to managed cloud services from public cloud.
--Capital intensity will decline to 15%-17% of revenue from the mid-20%s through the intermediate term.
--Rackspace will use available FCF for debt reduction, resulting in total leverage below 3.5x over the next 12-18 months.
The ratings could be affirmed with a Stable Outlook if Fitch expects:
--Total leverage will remain closer to 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.
Positive rating actions could occur if Fitch expects:
--Total leverage sustained 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.
Fitch expects liquidity will be sufficient and supported by:
--$94 million of available cash, a portion of which will be located outside the U.S.;
--$225 million undrawn senior secured RCF.
Fitch's expectations for more than $250 million of annual FCF also support liquidity.
Fitch expects total debt, pro forma for the transaction, will be $3.2 billion and consist of:
--$2 billion of senior secured Term Loan B; and
--$1.2 billion of senior unsecured notes.
FULL LIST OF RATING ACTIONS
Fitch has assigned the following ratings:
--Long-Term Issuer Default at 'BB-';
--Senior secured revolving credit facility 'BB+/RR1';
--Senior secured Term Loan B 'BB+/RR1';
--Senior unsecured notes 'BB-/RR4'.
Date of Relevant Rating Committee: Oct. 6, 2016.
Summary of Financial Statement Adjustments - Fitch made no adjustments that depart materially from those contained in the published financial statements of Rackspace Hosting Inc.
Additional information is available on www.fitchratings.com.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
Recovery Ratings and Notching Criteria for Non-Financial Corporate
Issuers (pub. 05 Apr 2016)
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