vk.com/id446425943

Goldman Sachs

Credit Outlook

Technology: Franklin Jarman

Sector View

We maintain a Neutral coverage view of the HY Technology Sector, although we are more cautious as we approach the new year. The HY Technology sector (6.5% YTW, 343 OAS) has moved nearly 80 bps wider since we last took stock of the sector in June, as investors digest the risk that some of the tailwinds supporting 2018 fundamentals could fade in 2019. HY Tech now trades 69 bps inside the broader HY market (7.2% YTW, 418 OAS).

As we look into 2019, we see a heightened risk of spread volatility in HY

Technology. The yoy growth in IT spending appears poised to decelerate from mid-single digit growth in 2018. We think that the tailwinds from U.S. Tax Reform which pulled forward corporate IT spend into 2018 could have a diminished effect in 2019 up against already difficult growth comps. We also see slowing U.S. and global GDP growth as a risk to demand. Goldman Sachs’ economists are calling for U.S. real GDP growth of 2.5% yoy in 2019 vs. 2.9% in 2018, and global growth of 3.8% in 2018 and 3.5% in 2019. Trade tensions between the U.S. and China have only had a modest impact on tech thus far, but higher tariff levels in 2019 could be a greater headwind in 2019. From our checks and discussions with companies, current trade tariffs are primarily impacting production costs, though demand has been stable despite higher pass through pricing. That said, incremental tariffs could stress this equation and move deeper into the technology supply chain.

More specific to the PC industry, we think that the Windows 10 refresh cycle has inflated PC demand in 2018, but should be less important to growth in 2019. The elongation of phone replacement cycles is also driving smartphone saturation, causing Apple to lower its iPhone production outlook, impacting the broader IT ecosystem. Beyond moderating demand, we also see emerging supply side risks in 2019. The memory cycle is (once again) showing its cyclicality, driven by oversupply in both DRAM/NAND. We expect lower NAND pricing to drive HDDs market share losses in 2019. Other 2019 Technology risks include: (1) a rising interest rate environment; (2) more aggressive underwriting in LBOs, particularly in software where the average Technology deal is being underwritten at higher valuations and capitalized with more leverage (average tech LBO is 10x levered); and (3) continued migration of IT infrastructure and applications to the public cloud, causing disintermediation for select companies (although benefiting others).

With this as context, we see continue to see opportunities in deep in-the-money callable bonds where yields are still elevated. A number of private software bonds offer these dynamics in addition to high cash conversion operating profiles built on high recurring revenues and retention rates. We also think the volatility experienced in the last few weeks has created opportunities in CCC rated software deals that are going through business transitions (i.e. Rackspace).

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Goldman Sachs

Credit Outlook

Exhibit 129: The HY Tech sector has softened, but is still trading	Exhibit 130: ...both HY Software & Hardware have widened from
tight of the broader HY Index...	local lows, as investors expect a less accommodative backdrop in
At 6.5% YTW, HY Tech is 69 bps tight to the overall HY Index (vs. 120 bps	2019
tight to the HY Index at YE2017)	We see a heightened probability of wider spreads in HY Tech in 2019 as
	tailwinds that supported 2018 fundamentals fade and new risks emerge

	11	50	11.0
	10	0	10.0
	9		9.0
		-50
	8		8.0
	7	-100	7.0
	6	-150	6.0
	5		5.0
		-200
	4		4.0
			3.0
	3	-250

400

350

300

250

200

150

100

50

0

	Yield differential (bp; RHS)		HY Software YTW (%)		HY Hardware YTW (%)

Yield differential (bp; RHS) HY Tech YTW (%)

HY Index YTW (%)

Source: Goldman Sachs Global Investment Research, Bloomberg

Source: Goldman Sachs Global Investment Research, Bloomberg

Exhibit 131: YoY IT spend growth should moderate in 2019 from MSD to LSD levels

	Revenue	2018E Growth Rate	2019E Growth Rate
	IT Spending	+ Mid-single digit %	+ 3-4% (Global Real GDP-like)
	IT Services	+ Mid-single digit %	+ 4-5% Growth
	Software	+ High-single digit %	+ Mid-Single digit %
	Semiconductors	+ Low to Mid-teens %	- Low-single digit %
	Network Equipment	+ Flat to Low-single digit %	+ Flat to Low-single digit %
	Telecom Equipment	- Low-single digit %	- Low-single digit % to Flat
			Growth
	External Storage	+ Flat Growth	+ Flat to Low-single digit %
	Network Equipment	2018E Growth Rate	2019E Growth Rate
	PC Shipment	+ Flat Growth	- Low-single digit % to Flat
			Growth
	Smartphone Shipment	- Low-single digit %	+ Flat Growth
	Server Shipment	+ Low teens %	+ Low to Mid-single digit %
	Hard Disk Drive Shipment	- Mid-single digit %	- High-single digit %

Source: Standard and Poor’s, Goldman Sachs Global Investment Research

Exhibit 132: The downturn in the memory market should extend into 2019, driven by oversupply in both DRAM/NAND

		Supply	Demand
		Bottom Line: 1.1% oversupply for 2019E	• Demand growth to decelerate to +17% yoy in
		• 2019E supply growth to decelerate to ~19%	2019E
	DRAM
		• Lower 2019 capex to bring down bit growth vs prior	• See weaker end market demand than previously
		view
		• Near-term oversupply typically exacerbated by	expected
		customers who delay purchases to hold out for
		incremental price benefits
		Bottom Line: 2% oversupply for 2019E, 5% for
		2018E	• Estimate demand growth of +40% yoy in 2019E
	NAND	• 2019E supply growth to decelerate to ~36%
		• 2019E driven by improved NAND yield causing	• Faster demand growth driven by increasing SSD
		faster bit growth	penetration and rising content per device
		• Excess inventory held at both ends of the market	• As companies take the right steps to correct
		is another factor leading to oversupply	excess inventory, see a lag in steps taken vs effects

Source: Goldman Sachs Global Investment Research

Exhibit 133: DRAM ASP growth has decelerated for the last several	Exhibit 134: NAND ASP growth is also under pressure, driven by
quarters	oversupply
It can take 3-5 quarters for DRAM ASP declines to positively inflect.	Lower NAND prices could accelerate shares gains for SSDs relative to
DRAM pricing could turn negative in 4Q18 and remain negative in 2019	HDDs in 2019

30%	30%
20%	20%
10%	10%
0%	0%
-10%	-10%
-20%	-20%
-30%	-30%
-40%	-40%

DRAM median QoQ ASP change		NAND median QoQ ASP change
Source: Goldman Sachs Global Investment Research, Company data		Source: Goldman Sachs Global Investment Research, Company data

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Goldman Sachs

Credit Outlook

Exhibit 135: Leading Public Cloud vendors added $13bn in LTM	Exhibit 136: ...We expect Public Cloud to continue to take market
sales	share from legacy tech

Public Cloud added $15bn of revenue in 2018, and Gartner expects Public Cloud to add another $16bn in 2019, with Leading Cloud Vendors taking the lion-share

							Cloud Public Cloud										$90				$78bn	120%
																$48	$80
							Revenue from…															100%
															$43		$70				16%
																				$62bn
														$39							7%
$40bn													$34			$17	$60					80%
															$16		$50		$47bn		8%
												$31
				$12										$14							22%	60%
											$27						$40	$35bn
													$12
			$10	149%	$14					$25
									$22			$11
$20bn		$9				$16	$18	$20			$9						$30			16%		40%
	$8		98%		100%	81%			$8	$9							$20				47%
							68%	$8						63%	68%	62%						20%
		60%											54%				$10			42%
	24%				$6	$7	$7	38%	36%	32%	28%	41%						35%	37%
		$4	$4	$6													$0					0%
	$3																	2016	2017	2018	2019
	$5	$6	$6	$7	$8	$9	$10	$12	$14	$16	$18	$20	$22	$25	$27	$31
$0bn
	1Q	2Q	3Q	4Q	1Q	2Q	3Q	4Q	1Q	2Q	3Q	4Q	1Q	2Q	3Q	4QE
																	Other	Google - GCP	Ali Baba - Cloud Computing		Microsoft - Azure	Amazon - AWS
		2015				2016				2017				2018

Source: Company data, Goldman Sachs Global Investment Research

Source: Gartner, Goldman Sachs Global Investment Research

Exhibit 137: ...We believe that the Public Cloud disruption potential of the enterprise IT market is still in the early innings

We estimate that Public Cloud vendors are only about 8% of the $610bn total enterprise IT market in 2017

$800bn												13%		15%
										11%			$28
$700bn								9%			$23		$89	$116
	% penetrated								$19		$72	$95
						8%	$16			$78
								$62	$58
$600bn		4%		6%	$13	$47	$46
	$7		$9	$35	$35
		$24	$25
	$18								$201		$213		$225
$500bn
							$190
					$179
	$163		$168
$400bn
$300bn	$124		$124		$129		$133	$589	$140	$610	$147	$627	$155	$644
		$531		$536		$563
$200bn							$192		$195		$194		$192
	$171		$170		$181
$100bn
$0bn	$73		$73		$74		$73		$73		$72		$72
	2015		2016		2017		2018		2019		2020		2021

' 2017 Gartner, Inc. and/or its Affiliates. All Rights Reserved.

IaaS and PaaS

Disruption Potential

(ex-IaaS and ex-PaaS)

PaaS Total

IaaS Total

Infrastructure Software

(Ex-PaaS)

Data Center Services

Total

IT Hardware Total

Support Services Total

Source: Gartner, Goldman Sachs Global Investment Research

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Goldman Sachs

Best ideas

Trade Idea #1:

Credit Outlook

We recommend both RAX 8.625% Unsecured Notes due 2024 ($84; 12.5% YTW) and RAX TLB L+300 ($93.5, 7.3% YTW), which we think offer compelling value given the current market context; we remain Outperform on the credit. For context, RAX net 1st lien leverage is 3.7x versus the 6.5x Apollo take-out multiple for an LTV of 55%. This is 50-100bp wide to high single B rated first lien loans. The 8.625% Unsecured Notes currently trade about 590 bps wide of the broader HY Technology Index, and ~520 bps wide of the HY Index.

RAX loans and bonds are at their recent lows as investors debate how client migration towards third-party public cloud solutions will ultimately impact Rackspace. While expectations for Rackspace’s revenue growth have been reset lower over the last couple years on the back of migration to the Public Cloud, Rackspace has managed revenue pressures by growing its Managed Public Cloud Services and Managed Applications revenue. We continue to think that the revenue dollar declines in both Managed Hosting and in Public Cloud are manageable given the offsetting revenue growth in Rackspace’s other segments (Private Cloud, Public Cloud Managed Services, and Managed Applications). We forecast a strong ramp for Rackspace’s Managed Public Cloud Services business amid an increasingly hybrid IT environment.

We acknowledge the company’s transition towards a Managed Service company will continue to pressure Rackspace’s margins. We expect Adj. EBITDA to decline 3% or $25mn in 2019 on flat revenue growth. That said, as Rackspace’s revenue mix shifts moves increasingly towards Managed Services, its capital intensity should also decline. If Rackspace can keep its Managed Hosting & Private Cloud revenue stable, we think Rackspace can actually grow its FCF. A stable top-line supports flat to low-single digit declines in Adj. EBITDA. This should sustain FCF in the range of $100-200mn per year, which adequately supports the capital structure given that there are no immediate maturities until 2023. We estimate Rackspace will generate about $130mn in FCF in 2019.

We expect the RAX complex to trade on changes to expectations around the relative growth trajectory of Managed Hosting versus Private Cloud and Managed Public Cloud Services. Managed Hosting & Private Cloud organic revenue growth was down low-single digits yoy in the last reported quarter, as Managed Hosting revenue declined at a high-single digit pace, more than offsetting the dollar revenue growth from Private Cloud. That said, we think the revenue pressure within the Managed Hosting & Private Cloud segment could improve from here. Private Cloud revenue is now nearing parity with that of Managed Hosting, and given the revenue growth rate differential between those two underlying products, we see a path for improved revenue stability in this segment. Rackspace believes it can grow revenue in the Managed Hosting & Private Cloud segment going forward, with ongoing investments in products and go-to-market strategies.

Risks to our rating on RAX (OP) include: (1) worse-than-expected decline in Managed Hosting and Public Cloud revenue driven by the migration to third-party Public Cloud

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Goldman Sachs
		solutions; (2) slower-than-expected revenue growth in Private Cloud and in Managed
		Public Cloud Services.

Exhibit 138:

	Rackspace Summary Financials
			FY16		FY17		FY18E		FY19E
	Sales	$	2,075	$	2,135	$	2,454	$	2,451
	Sales growth				3%		15%		0%
	Adjusted EBITDA	$	721	$	727	$	793	$	768
	Sales growth				1%		9%		-3%
	EBITDA Margin		35%		34%		32%		31%
	Free cash flow	$	267	$	100	$	48	$	132
	Cash	$	298	$	231	$	178	$	289
	Total Debt	$	3,299	$	4,280	$	4,237	$	4,216
	Net Debt	$	3,000	$	4,049	$	4,059	$	3,927
	Total leverage		4.6x		5.9x		5.3x		5.5x
	Net leverage		4.2x		5.6x		5.1x		5.1x

Source: Goldman Sachs Global Investment Research, Company reports

Exhibit 139:

	Capital Structure	LTM Amt	LTM	FY18E	FY18E
		Outst	Lvrge	Outst	Lvrge
	ABL due 11/3/2021 ($225mn)	0.0	3.9x	0.0	4.0x
	TL B due 11/3/2023 (L+300)	2,861.0	3.9x	2,855.8	4.0x
	Capital leases/finance leases	287.1	3.9x	287.1	4.0x
	8.625% Senior unsec notes due 2024	1,200.0	5.3x	1,200.0	5.3x
	Other	(105.8)	5.3x	(105.8)	5.3x
	Gross Debt	4,242.3	5.3x	4,237.1	5.3x
	Cash on Hand	188.5	-	178.0	-
	Net Debt	4,053.8	5.0x	4,059.1	5.1x

Source: Goldman Sachs Global Investment Research, Company reports

Risks to our view: Downside risks include: a worse-than-expected decline in hosting

revenues; managed cloud service business fails to ramp.

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