RACKSPACE HOSTING, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) References to "we," "our," "our company," "us," "the company," "Rackspace Hosting," or "Rackspace" refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, are subject to the "safe harbor" created by those sections. The forward-looking statements in this report are based on our management's beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as "anticipates," "aspires," "believes," "can," "continue," "could," "estimates," "expects," "intends," "may," "plans," "projects," "seeks," "should," "will" or "would" or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this document in greater detail under the heading "Risk Factors." We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The risks described in "Risk Factors" included in this report, as well as any other cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of the events described in "Risk Factors" and elsewhere in this report could harm our business.

Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this document completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements.

Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

The following discussion should be read in conjunction with our consolidated financial statements and the related notes contained elsewhere in this document.

Overview of our Business We are the open cloud company, delivering open source technologies at web scale with a portfolio of cloud computing services. Our growth is the result of our technology leadership and our renowned service, known as Fanatical Support. We also distinguish ourselves through our innovative approach to cloud computing, our broad portfolio of services and our leadership in open standards that promote faster innovation and give customers freedom of movement among cloud providers. We are a founder of OpenStack®, the world's fastest-growing open cloud platform and developer community. We are also a pioneer in Hybrid Hosting, which combines the security, performance and scalability of our Dedicated and Public Cloud hosting services, integrated through our RackConnect® offering.

We offer a portfolio of cloud computing services, including Dedicated Cloud hosting, Public Cloud hosting, Hybrid hosting and Private Cloud software and related support. The equipment (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) required to deliver services is typically purchased and managed by us. We are committed to delivering Fanatical Support for the open cloud and our entire product portfolio, and we will continue to pursue our vision to be considered one of the world's great service companies.

We sell our services to small and medium-sized businesses, as well as large enterprises. For the first nine months of 2012, 26% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K.

Additionally, we operate a Hong Kong data center and sales office and recently announced the opening of a data center and sales office in Australia. Our growth strategy includes, among other strategies, targeting international customers as we plan to continue our expansion in continental Europe, the Asia-Pacific region and Latin America. For the first nine months of 2012, no individual customer accounted for greater than 2% of our net revenue.

- 18 --------------------------------------------------------------------------------- Table of Contents Product and Service Offerings We continue to invest in our Public Cloud service and believe it is a critical part of our future success. Public Cloud continues to emerge as a new technology with high adoption rates and investment, which is reflected in its high revenue growth rate. The primary benefit of Public Cloud is the value proposition that it provides for businesses because it enables them to match costs directly to revenue and to scale up and down on a real-time basis as necessary. We do not believe that Public Cloud will replace traditional Dedicated Cloud hosting offerings because we believe the two complement one another, allowing customers to choose the best platform for each of their applications. A focus in our growth strategy is to build our product portfolio to include higher service levels and additional capabilities. We are investing heavily in this strategy and are creating new technologies to help businesses leverage the benefits of Public Cloud hosting.

Our product strategy includes the development of a variety of new capabilities and features and building a support business around the OpenStack cloud computing platform. In August 2012, we announced the unlimited availability of Cloud Databases and Cloud Servers powered by OpenStack, along with a powerful new Control Panel. These solutions, backed by Fanatical Support, further expand our portfolio. The introduction of these open cloud products marks the first time any company has deployed a large-scale open source public cloud powered by OpenStack. Customers can now select from private, public or hybrid offerings and have the flexibility to deploy their solutions in one of our data centers or another data center of their choice. We also announced the release of Rackspace Private Cloud, powered by OpenStack, making it simple and easy for companies to install, test and run an OpenStack based private cloud environment. The offering enables Rackspace to extend Fanatical Support beyond the bounds of our data centers by remotely supporting and managing OpenStack environments that run in almost any data center and could become a meaningful part of our growth strategy in the long term. In addition to these announcements, we also introduced the following new products and services during the quarter: • Rackspace Cloud Monitoring, a flexible and scalable solution that empowers customers to track the health of their infrastructure, including websites, ports and protocols. The service provides real-time alerts allowing customers to react quickly and help prevent downtime. With Rackspace Cloud Monitoring, customers can monitor their infrastructure whether it's hosted on-premise, off-premise, with any cloud provider or any location across the globe.

• The industry's first certification program for OpenStack. Rackspace is launching the certification program for application developers and engineers of OpenStack beginning with a Rackspace Certified Technician for an OpenStack certification exam. This foundational certification is earned when an OpenStack professional has demonstrated the skills necessary to utilize and operate an OpenStack cloud.

Subsequent to quarter-end, we launched two additional products: Cloud Block Storage and Cloud Networks. Cloud Block Storage provides a superior approach to attached storage in the Cloud by addressing customer demand for consistent and affordable performance for file systems, databases and other input/output intensive applications. Cloud Networks allows customers to create isolated, multi-tiered networks on our Cloud Servers powered by OpenStack, all with the click of a button.

These initiatives are still in the early stages, and while we believe that these new capabilities and features could drive future incremental demand, there are certain risks associated with such a significant product transition and platform shift.

We believe these risks could adversely impact our ability to execute on our growth strategy and therefore capitalize on the current market opportunity, both in the short and long term. They include: (i) the acceptance by current and prospective customers of our new Public Cloud and Rackspace Private Cloud platform and product set, (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources; larger customer bases; longer operating histories; greater brand recognition; more established relationships in the industry; and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities, (iii) new pricing strategies that may include lowering price points for Cloud products to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our Cloud products to certain significant Cloud customers, (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases, (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve, including the current volatile economic environment found in Europe, and (vi) other risks as set forth in the section titled "Risk Factors." - 19 --------------------------------------------------------------------------------- Table of Contents Recent Developments In February 2012 we acquired SharePoint911, an industry leader in SharePoint consulting, training, and "JumpStart" services within SharePoint, and in August 2012 we acquired Mailgun, an email services company. While the acquisitions did not have a material impact on the results of the quarter, the acquisitions further enhance our portfolio of products and services. We expect to make additional, similar acquisitions in the future that can increase our service capabilities and product offerings.

In August 2012, we announced the opening of a data center in Australia, which enables us to offer local Dedicated Cloud solutions to Australian customers who prefer to keep their data onshore. The data center will also provide the infrastructure to launch an OpenStack-based open cloud platform in the future.

Key Metrics We carefully track several financial and operational metrics to monitor and manage our growth, financial performance, and capacity. Our key metrics are structured around growth, profitability, capital efficiency, infrastructure capacity, and utilization. The following data should be read in conjunction with the consolidated financial statements, the notes to the financial statements and other financial information included in this Quarterly Report on Form 10-Q.

- 20 --------------------------------------------------------------------------------- Table of Contents Three Months Ended (Unaudited) (Dollar amounts in thousands, except average September 30, December 31, March 31, June 30, September 30, monthly revenue per server) 2011 2011 2012 2012 2012 Growth Dedicated Cloud, net revenue $ 213,899 $ 224,808 $ 236,604 $ 246,417 $ 256,559 Public Cloud, net revenue $ 50,673 $ 58,453 $ 64,751 $ 72,573 $ 79,426 Net revenue $ 264,572 $ 283,261 $ 301,355 $ 318,990 $ 335,985 Revenue growth (year over year) 32.5 % 31.9 % 31.0 % 29.0 % 27.0 % Net upgrades (monthly average) 1.8 % 2.0 % 1.5 % 1.7 % 1.6 % Churn (monthly average) -0.9 % -0.8 % -0.8 % -0.8 % -0.8 % Growth in installed base (monthly average) (2) 0.9 % 1.2 % 0.7 % 1.0 % 0.8 % Number of customers at period end (3) 161,422 172,510 180,866 190,958 197,635 Number of employees (Rackers) at period end 3,799 4,040 4,335 4,528 4,596 Number of servers deployed at period end 78,717 79,805 82,438 84,978 89,051 Average monthly revenue per server $ 1,155 $ 1,191 $ 1,238 $ 1,270 $ 1,287 Profitability Income from operations $ 31,070 $ 39,765 $ 37,084 $ 40,704 $ 45,330 Depreciation and amortization $ 49,518 $ 54,844 $ 55,151 $ 61,808 $ 63,972 Share-based compensation expense Cost of revenue $ 1,005 $ 1,047 $ 1,236 $ 1,113 $ 1,282 Sales and marketing $ 864 $ 839 $ 1,114 $ 1,393 $ 1,943 General and administrative $ 5,526 $ 5,699 $ 6,159 $ 6,869 $ 9,193 Total share-based compensation expense $ 7,395 $ 7,585 $ 8,509 $ 9,375 $ 12,418 Adjusted EBITDA (1) $ 87,983 $ 102,194 $ 100,744 $ 111,887 $ 121,720 Adjusted EBITDA margin 33.3 % 36.1 % 33.4 % 35.1 % 36.2 % Operating income margin 11.7 % 14.0 % 12.3 % 12.8 % 13.5 % Income from operations $ 31,070 $ 39,765 $ 37,084 $ 40,704 $ 45,330 Effective tax rate 31.7 % 34.5 % 35.5 % 35.7 % 38.3 % Net operating profit after tax (NOPAT) (1) $ 21,221 $ 26,046 $ 23,919 $ 26,173 $ 27,969 NOPAT margin 8.0 % 9.2 % 7.9 % 8.2 % 8.3 % Capital efficiency and returns Interest bearing debt $ 144,152 $ 139,126 $ 143,978 $ 149,226 $ 150,112 Stockholders' equity $ 551,049 $ 599,423 $ 668,436 $ 714,819 $ 781,934 Less: Excess cash $ (92,931 ) $ (125,865 ) $ (150,368 ) $ (177,169 ) $ (217,333 ) Capital base $ 602,270 $ 612,684 $ 662,046 $ 686,876 $ 714,713 Average capital base $ 575,298 $ 607,477 $ 637,365 $ 674,461 $ 700,795 Capital turnover (annualized) 1.84 1.87 1.89 1.89 1.92 Return on capital (annualized) (1) 14.8 % 17.2 % 15.0 % 15.5 % 16.0 % Capital expenditures Purchases of property and equipment $ 67,916 $ 56,629 $ 67,604 $ 65,786 $ 54,644 Non-cash purchases of property and equipment $ 25,642 $ 22,726 $ 14,712 $ 16,182 $ 30,739 Total capital expenditures $ 93,558 $ 79,355 $ 82,316 $ 81,968 $ 85,383 Customer gear $ 53,643 $ 47,376 $ 52,999 $ 53,746 $ 51,026 Data center build outs $ 16,715 $ 6,568 $ 9,473 $ 3,285 $ 5,767 Office build outs $ 8,806 $ 9,915 $ 4,666 $ 4,015 $ 3,413 Capitalized software and other projects $ 14,394 $ 15,496 $ 15,178 $ 20,922 $ 25,177 Total capital expenditures $ 93,558 $ 79,355 $ 82,316 $ 81,968 $ 85,383 Infrastructure capacity and utilization Megawatts under contract at period end 41.9 48.1 47.8 58.0 58.0 Megawatts available for use at period end 29.7 30.7 32.2 32.7 33.7 Megawatts utilized at period end 20.2 20.9 21.4 22.7 23.5 Annualized net revenue per average Megawatt of power utilized $ 53,994 $ 55,136 $ 56,994 $ 57,867 $ 58,179 - 21 --------------------------------------------------------------------------------- Table of Contents (1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.

(2) Due to rounding, totals may not equal the sum of the line items in the table above.

(3) Customers are counted on an account basis, and therefore a customer with more than one account with us would be included as more than one customer.

Furthermore, amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third-party storage solution are excluded.

Non-GAAP Financial Measures Return on Capital (ROC) (Non-GAAP financial measure) We define Return on Capital as follows: ROC = Net operating profit after tax (NOPAT) / Average capital base NOPAT = Income from operations x (1 - Effective tax rate) Average capital base = Average of (Interest bearing debt + stockholders' equity - excess cash) = Average of (Total assets - excess cash - accounts payables and accrued expenses - deferred revenue - other non-current liabilities, deferred income taxes, and deferred rent) Year-to-date average balances are based on an average calculated using the quarter-end balances at the beginning of the period and all other quarter-ending balances included in the period.

We define excess cash as the amount of cash and cash equivalents that exceeds our operating cash requirements, which is calculated as three percent of our annualized net revenue for the three months prior to the period end. We will periodically review the calculation and adjust it to reflect our projected cash requirements for the upcoming year.

We believe that ROC is an important metric for investors in evaluating our company's performance. ROC relates to after-tax operating profits with the capital that is placed into service. It is therefore a performance metric that incorporates both the Statement of Comprehensive Income and the Balance Sheet. ROC measures how successfully capital is deployed within a company.

Note that ROC is not a measure of financial performance under GAAP and should not be considered a substitute for return on assets, which we calculate directly from amounts on the Statement of Comprehensive Income and the Balance Sheet. ROC has limitations as an analytical tool, and when assessing our operating performance, you should not consider ROC in isolation or as a substitute for other financial data prepared in accordance with GAAP. Other companies may calculate ROC differently than we do, limiting its usefulness as a comparative measure.

ROC increased from 14.8% for the three months ended September 30, 2011 to 16.0% for the three months ended September 30, 2012, primarily due to a reduction of operating costs as a percentage of revenue, partially offset by growth in our capital base. Included in the average capital base are capital expenditures of $30.8 million and $41.8 million related to the build-out of our corporate headquarters and data centers, respectively, since the beginning of the third quarter of 2011.

Return on assets increased from 8.6% for the three months ended September 30, 2011 to 9.1% for the three months ended September 30, 2012. This increase was primarily due to operating expenses decreasing as a percentage of revenue, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.

- 22 --------------------------------------------------------------------------------- Table of Contents See our reconciliation of the calculation of return on assets to ROC in the following table: Three Months Ended September 30, December 31, March 31, June 30, September 30, (In thousands) 2011 2011 2012 2012 2012 Income from operations $ 31,070 $ 39,765 $ 37,084 $ 40,704 $ 45,330 Effective tax rate 31.7 % 34.5 % 35.5 % 35.7 % 38.3 % Net operating profit after tax (NOPAT) $ 21,221 $ 26,046 $ 23,919 $ 26,173 $ 27,969 Net income $ 19,982 $ 25,047 $ 23,180 $ 25,134 $ 27,197 Total assets at period end $ 970,677 $ 1,026,482 $ 1,089,393 $ 1,138,728 $ 1,241,765 Less: Excess cash (92,931 ) (125,865 ) (150,368 ) (177,169 ) (217,333 ) Less: Accounts payable and accrued expenses (148,464 ) (156,004 ) (153,668 ) (148,091 ) (177,328 ) Less: Deferred revenue (current and non-current) (17,772 ) (18,281 ) (20,195 ) (19,227 ) (18,483 ) Less: Other non-current liabilities, deferred income taxes, and deferred rent (109,240 ) (113,648 ) (103,116 ) (107,365 ) (113,908 ) Capital base $ 602,270 $ 612,684 $ 662,046 $ 686,876 $ 714,713 Average total assets $ 929,127 $ 998,580 $ 1,057,938 $ 1,114,061 $ 1,190,247 Average capital base $ 575,298 $ 607,477 $ 637,365 $ 674,461 $ 700,795 Return on assets (annualized) 8.6 % 10.0 % 8.8 % 9.0 % 9.1 % Return on capital (annualized) 14.8 % 17.2 % 15.0 % 15.5 % 16.0 % - 23 --------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA (Non-GAAP financial measure) We use Adjusted EBITDA as a supplemental measure to review and assess our performance. We define Adjusted EBITDA as Net income, plus income taxes, total other (income) expense, depreciation and amortization, and non-cash charges for share-based compensation. Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.

Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP. Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

Adjusted EBITDA increased $33.7 million, or 38.3%, from $88.0 million in the three months ended September 30, 2011 to $121.7 million in the three months ended September 30, 2012. Adjusted EBITDA as a percentage of revenue increased from 33.3% for the three months ended September 30, 2011 to 36.2% for the three months ended September 30, 2012. The primary drivers of the increase in Adjusted EBITDA margin were decreases in Cost of Revenue and Sales and Marketing expenses as a percentage of revenue, partially offset by an increase in General and Administrative expenses as a percentage of revenue. Also impacting our results were changes in non-cash deferred rent and non-equity incentive compensation.

Non-cash rent decreased from $2.5 million in the three months ended September 30, 2011 to $2.3 million in the three months ended September 30, 2012. Overall, non-equity incentive compensation for the three months ended September 30, 2012 decreased $2.4 million from the three months ended September 30, 2011 due to a decrease in the payout percentage, partially offset by increased headcount. Adjusted EBITDA margin increased from 35.1% for the three months ended June 30, 2012 to 36.2% for the three months ended September 30, 2012 primarily due to a decrease in Sales and Marketing expenses as a percentage of revenue.

Employee non-equity incentive compensation through our current non-equity incentive plan, in effect since January 1, 2009, is dependent upon the financial results of the company in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense. If company achievement of the pre-set target results in a 10% increase in the non-equity incentive compensation percentage payout, this would increase total non-equity incentive compensation by approximately $0.7 million on an after-tax basis and increase net income by $0.7 million. Company achievement resulting in a 10% decrease in the non-equity incentive compensation percentage payout would decrease total non-equity incentive compensation by approximately $0.7 million on an after-tax basis and decrease net income by $0.7 million. Additionally, the Compensation Committee has the discretion to increase or decrease a payout under the plan at any time in the event that it determines that circumstances warrant adjustment or to pay bonuses outside of the plan. The Compensation Committee exercised its discretion to decrease the bonus payout for the three months ended September 30, 2012. The metric we use for evaluating the financial results of the company is called NOPAT Before Bonus, which is calculated as NOPAT (as defined above) without the inclusion of any impact of non-equity incentive compensation and assumes a statutory tax rate. This cannot be calculated from our financial statements as we do not separately disclose total non-equity incentive compensation for the period.

Income from operations has been favorably impacted by decreases in our Cost of Revenue and Sales and Marketing expenses as a percentage of revenue. Our operating income margin increased from 11.7% for the three months ended September 30, 2011 to 13.5% for the three months ended September 30, 2012.

- 24 --------------------------------------------------------------------------------- Table of Contents See our Adjusted EBITDA reconciliation below.

Three Months Ended September 30, December 31, March 31, June 30, September 30, (Dollars in thousands) 2011 2011 2012 2012 2012 Net revenue $ 264,572 $ 283,261 $ 301,355 $ 318,990 $ 335,985 Income from operations $ 31,070 $ 39,765 $ 37,084 $ 40,704 $ 45,330 Net income $ 19,982 $ 25,047 $ 23,180 $ 25,134 $ 27,197 Plus: Income taxes 9,281 13,188 12,769 13,932 16,918 Plus: Total other (income) expense 1,807 1,530 1,135 1,638 1,215 Plus: Depreciation and amortization 49,518 54,844 55,151 61,808 63,972 Plus: Share-based compensation expense 7,395 7,585 8,509 9,375 12,418 Adjusted EBITDA $ 87,983 $ 102,194 $ 100,744 $ 111,887 $ 121,720 Operating income margin 11.7 % 14.0 % 12.3 % 12.8 % 13.5 % Adjusted EBITDA margin 33.3 % 36.1 % 33.4 % 35.1 % 36.2 % - 25 --------------------------------------------------------------------------------- Table of Contents Adjusted Free Cash Flow (Non-GAAP financial measure) We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditures (including non-cash purchases of property and equipment), cash payments for interest, net, and cash payments for income taxes, net.

We believe that Adjusted Free Cash Flow is an important metric for investors in evaluating how a company is currently using cash generated and may indicate its ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, payment of dividends, etc.

Note that Adjusted Free Cash Flow is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.

See our Adjusted Free Cash Flow reconciliation to Adjusted EBITDA below, as well as our reconciliation of Net income to Adjusted EBITDA provided above.

Three Months Ended Nine Months Ended September 30, September 30, (In thousands) 2012 2012 Adjusted EBITDA $ 121,720 $ 334,351 Non-cash deferred rent 2,279 6,329 Total capital expenditures (85,383 ) (249,667 ) Cash payments for interest, net (1,091 ) (3,526 ) Cash payments for income taxes, net (3,425 ) (7,200 ) Adjusted free cash flow $ 34,100 $ 80,287 Net Leverage (Non-GAAP financial measure) We define Net Leverage as Net Debt divided by Adjusted EBITDA (trailing twelve months). We believe that Net Leverage is an important metric for investors in evaluating a company's liquidity. Note that Net Leverage is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies. We believe that Net Leverage provides an additional indicator when assessing our liquidity, capital structure and leverage and provides insight into a company's ability to assume more debt if and when required. A negative Net Leverage indicates that our cash and cash equivalents is greater than our total debt as of the balance sheet date.

See our Net Leverage calculation below.

As of (Dollars in thousands) September 30, 2012 Obligations under capital leases $ 145,111 Debt 5,001 Total debt $ 150,112 Less: Cash and cash equivalents (257,651 ) Net debt $ (107,539 ) Adjusted EBITDA (trailing twelve months) $ 436,545 Net leverage (0.25 ) x - 26 --------------------------------------------------------------------------------- Table of Contents Results of Operations The following tables set forth our results of operations for the specified periods and as a percentage of our revenue for those same periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

[ Back To Technology News's Homepage ]