December 31,				September 30,
(In thousands)		2008				2009
Prepaid expenses		$	5,481			$	7,938
Current deferred taxes			3,050				3,265
Other current assets			2,307				2,853
Prepaid expenses and other current assets		$	10,838			$	14,056

 

7. Property and Equipment, net

 

Property and equipment consisted of:

 

(In thousands)		Estimated Useful Lives				December 31, 2008				September 30, 2009
Computers, software and equipment		1-5 years				$	350,697			$	482,218
Furniture and fixtures		7 years					12,856				19,208
Buildings and leasehold improvements		2-30 years					61,839				110,849
Land		--					13,860				13,860
Property and equipment, at cost							439,252				626,135
Less accumulated depreciation and amortization							(188,300	)			(269,561	)
Work in process							111,090				62,880
Property and equipment, net						$	362,042			$	419,454

 

Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $21.8 million and $31.0 million for the three months ended September 30, 2008 and 2009, respectively, and $61.0 million and $85.4 million for the nine months ended September 30, 2008 and 2009, respectively.

 

At December 31, 2008, the work in process balance consisted of build outs of $47.0 million for office facilities and $53.5 million for data centers, and $10.6 million for capitalized software and other projects.  At September 30, 2009, the work in process balance consisted of build outs of $55.3 million for office facilities and $2.8 million for data centers, and $4.8 million for capitalized software and other projects.

 

Capitalized interest was $0.5 million and $0.2 million for the three months ended September 30, 2008 and 2009, respectively and $1.7 million and $0.7 million for the nine months ended September 30, 2008 and 2009, respectively.

8. Business Combinations and Goodwill

 

In October 2008, we acquired two companies with a total purchase price of $28.0 million, which were accounted for as business combinations.  The initial purchase price of the combined acquisitions was $11.5 million paid in cash and stock, with up to $16.5 million in additional payouts of cash and stock based on certain earnout provisions.  For the nine months ended September 30, 2009, earn-outs totaling $15.5 million were achieved and paid in both cash and stock, of which $8.0 million was achieved in the three months ended September 30, 2009.  If the remaining $1.0 million in additional earn-out is achieved, the payment will be accounted for as additional goodwill.

 

The following table provides a roll forward of our goodwill balance.

 

Balance at December 31, 2008		$	6,942
Earn-out payments for acquisitions			15,502
Purchase accounting adjustments			(115	)
Balance at September 30, 2009		$	22,329

 

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9. Accounts Payable and Accrued Expenses

 

Accounts payable and accrued expenses consisted of:

 

		December 31,				September 30,
(In thousands)		2008				2009
Trade payables		$	23,459			$	23,661
Accrued compensation and benefits			19,462				20,049
Foreign income taxes payable			324				6,068
Vendor accruals			19,984				19,257
Other liabilities			8,158				8,073
Accounts payable and accrued expenses		$	71,387			$	77,108

 

10. Debt

 

Debt outstanding consisted of:

 

		December 31,				September 30,
(In thousands)		2008				2009
Revolving credit facility		$	200,000			$	50,000
Notes payable			10,723				8,505
Total debt			210,723				58,505
Less current portion of debt			(5,944	)			(4,850	)
Total non-current debt		$	204,779			$	53,655

 

Revolving Credit Facility

 

Our revolving credit facility includes an aggregate commitment of $245.0 million.  The facility provides for letters of credit up to $25.0 million. The interest is based on a floating rate, generally the London Interbank Offered Rate (LIBOR) plus a margin spread, which changes ratably from 0.675% to 1.55% dependent on the total funded debt to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio. We are required to pay a facility fee of 0.2% per annum on the full amount committed under the facility and a quarterly administrative fee. The facility has a 5-year term and matures in August 2012, and is fully secured by our assets and governed by financial and non-financial covenants.  Financial covenants under our facility include a minimum fixed charge coverage ratio and a maximum total funded debt to EBITDA ratio. As of September 30, 2009, we were in compliance with all of the covenants under our facility.

In June 2009, we amended the revolving credit facility agreement to provide us with the ability to borrow under our credit facility in Pounds Sterling and Euros, rather than only allowing our borrowings in U.S. dollars. We have the ability to borrow up to $75 million in alternate currencies. In addition, the amendment provides for changes in regard to certain other items in the credit agreement, including but not limited to (i) the calculation to determine our “Minimum Fixed Charge Coverage Ratio”, (ii) our banking account maintenance, and (iii) requirements for access to collateral located at our various real property locations. These changes were made in order to provide clarifications that reflected compliance expectations that already existed among the parties. We incurred fees of $367 thousand in connection with the amendment which have been capitalized and are being amortized over the remaining term of the revolver. As of September 30, 2009 we did not have any borrowings on our credit facility in alternate currencies.

In July 2009 we repaid $50.0 million, reducing our borrowings on the facility to $50.0 million.

As of September 30, 2009, the amount outstanding under the facility was $50.0 million, with an outstanding letter of credit of $0.7 million, and an additional $194.3 million available for future borrowings.

 

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Interest Rate Swap

 

We have a cash flow hedge to limit our exposure that may result from the variability of floating interest rates. Effective December 10, 2007, we entered into an interest rate swap agreement with a notional amount of $50.0 million.  The interest rate swap  hedges the first $50.0 million of our outstanding floating-rate debt. This swap converts floating rate interest based on the LIBOR into fixed-rate interest as part of the arrangement with our primary lender and expires in December 2010.

 

We are required to pay the counterparty a stream of fixed interest payments at a rate of 4.135%, and in turn, receive variable interest payments based on 1-month LIBOR.  The margin spread as of September 30, 2009 was 1.05% resulting in an effective fixed rate of 5.185%.  The net receipts or payments from the swap are recorded as interest expense. The swap is designated and qualifies as a cash flow hedge under FASB ASC Topic 815, Derivatives and Hedging. As such, the swap is accounted for as an asset or a liability in the accompanying consolidated balance sheets at fair value. We are utilizing the dollar offset method to assess the effectiveness of the swap. Under this methodology, the swap was deemed to be highly effective for the nine month periods ended September 30, 2008 and September 30, 2009. There was no hedge ineffectiveness recognized in earnings for either period.  If the hedge becomes ineffective, or if certain terms of the facility change, the facility is extinguished, or if the swap is terminated prior to maturity, the fair value of the swap and subsequent changes in fair value may be recognized in the accompanying consolidated statements of income.  The fair value of the swap was estimated based on the yield curve as of December 31, 2008 and September 30, 2009, and represents its carrying value.

 

The following table presents the impact of the interest rate swap on the consolidated balance sheets:

 

		December 31,				September 30,
(In thousands)		2008				2009
Other non-current liabilities		$	2,901			$	2,201
Accumulated other comprehensive income    (loss), net of tax		$	(1,886	)		$	(1,431	)

 

		Three Months Ending September 30,								Nine Months Ending September 30,
(In thousands)		2008				2009				2008				2009
Effective gain (loss) recognized in accumulated    other comprehensive income, net of tax		$	(77	)		$	130			$	(220	)		$	455

 

    Our counterparty is also the primary lender on our revolving credit facility and we actively monitor the potential credit risk.  As of September 30, 2009, we were in a liability position to our primary lender and therefore had limited counterparty credit risk.

 

 

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11. Other Non-Current Liabilities

 

Other non-current liabilities consisted of:

 

		December 31,				September 30,
(In thousands)		2008				2009
Texas Enterprise Fund Grant		$	5,000			$	5,000
Other			5,212				6,967
Other non-current liabilities		$	10,212			$	11,967

    In August 2007, we entered into an agreement with the State of Texas (Texas Enterprise Fund Grant) under which we may receive up to $22.0 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest.  In September 2007, we received the initial installment of $5.0 million from the State of Texas, which was recorded as a non-current liability.

 

    In July 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements. Under the amendment, the grant was divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a target of 1,225 new jobs created in the state of Texas by December 31, 2012. We already have drawn $5.0 million of this tranche. We can draw an additional $3.5 million when we reach the target. While we expect to meet the job target requirements, if we do not create these jobs by December 31, 2012 and maintain them through December 31, 2021, we will be required to repay portions of the grant (clawback), with the maximum clawback being the amounts we have drawn plus 3.4% interest on such amounts per year. The remaining three tranches are at our option and provide for additional draws up to $13.5 million, which are also subject to clawbacks.

12. Commitments and Contingencies

 

Legal Proceedings

 

    We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, on October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston, was filed in the 37th District Court in Bexar County Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We do not expect the results of this claim or any other current proceeding to have a material adverse effect on our business, results of operations or financial condition.

 

Contingent Liability

 

    We previously recorded a $­­­2.1 million charge to cost of revenue related to an unresolved contractual issue with a vendor. We recorded a loss contingency liability with respect to this matter in accordance with FASB ASC Topic 450, Contingencies (formerly SFAS 5).   Due to the uncertainty regarding the interpretation of certain contractual terms, it is possible the ultimate loss may exceed or be less than the amount currently accrued.

 

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13. Share-Based Compensation

 

In January 2009, our board of directors approved an additional 5.5 million shares for future grant under the Amended and Restated 2007 Stock Plan.  As of September 30, 2009, the total number of shares authorized under all of our plans was 42.8 million shares, of which approximately 6.3 million shares were available for future grants.

 

Outstanding stock awards were as follows:

 

		December 31,  2008				September 30, 2009
Restricted stock units			50,000				2,050,000
Stock options			19,255,644				17,944,547
Total outstanding awards			19,305,644				19,994,547

 

The following table summarizes our restricted stock unit activity for the nine months ended September 30, 2009:

 

		Number of Units
Outstanding at December 31, 2008			50,000
Units granted			2,000,000
Units vested			-
Units cancelled			-
Outstanding at September 30, 2009			2,050,000

 

    On February 25, 2009, our board approved grants of restricted stock units (RSUs) to our chief executive officer and another member of the executive team. A total of 2,000,000 RSUs were granted. The vesting of the RSUs are dependent on the company’s total shareholder return (TSR) on its common stock compared to other companies in the Russell 2000 Index. In addition, the company’s TSR must be positive for vesting to occur. Of the total RSUs granted, 1,050,000 have a measurement period at the end of three years, and the remainder at the end of five years.  The fair value of these awards was $7.0 million at the date of grant using a Monte Carlo pricing model, and are being amortized over their service periods.

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   The following table summarizes the activity under our stock plans:

 

		Number of Shares				Weighted Average Exercise Price				Weighted Average Remaining Contractual Life				Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2008			19,255,644			$	4.94				7.01			$	34,050
Granted			3,927,850			$	5.46
Exercised			(4,398,980	)		$	2.22
Cancelled			(839,967	)		$	7.40
Outstanding at September 30, 2009			17,944,547			$	5.61				7.64			$	205,481
Vested and exercisable at September 30, 2009			6,722,666			$	3.22				6.28			$	93,030
Vested and exercisable at September 30, 2009
and expected to vest thereafter *			16,517,907			$	5.45				7.53			$	191,732
* Includes reduction of shares outstanding due to estimated forfeitures

 

On February 25, 2009, our board approved the grant of 3.7 million stock options for certain employees with an exercise price of $5.09. The shares vest 25% at the end of each year over a four-year period and expire after ten years. The fair value of these stock options was $2.97 per option using the Black-Scholes option pricing model.

 

The total pre-tax intrinsic value of the stock options exercised during the three months ended September 30, 2008 and 2009, was $4.2 million and $12.5 million, respectively and $12.4 million and $31.9 million for the nine months ended September 30, 2008 and 2009, respectively.

 

The weighted average fair value of stock options issued for the three months ended September 30, 2008 and 2009 was $8.52 and $9.03 respectively, and $7.96 and $3.19 for the nine months ended September 30, 2008 and 2009, respectively, using the Black-Scholes option pricing model with the following assumptions:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2009				2008				2009
Expected stock volatility			60% - 61%				59%				60% - 65%				59% - 61%
Expected dividend yield			0.0%				0.0%				0.0%				0.0%
Risk-free interest rate			3.30% - 3.45%				3.03%				2.71% - 3.45%				2.24% - 3.03%
Expected life			6.25 - 6.50 years				6.25 years				6.25 - 6.50 years				6.25 years

    As of September 30, 2009, there was $44.6 million of total unrecognized compensation cost related to non-vested stock options granted under our various plans, which will be amortized using the straight line method over a weighted average period of 2.2 years.

 

Share-based compensation expense was recognized as follows:

		Three Months Ended September 30,								Nine Months Ended September 30,
(in thousands)		2008				2009				2008				2009
Cost of revenue		$	819			$	778			$	1,788			$	2,082
Sales and marketing			612				826				1,546				2,245
General and administrative			2,886				4,008				7,539				10,539
Pre-tax share-based compensation			4,317				5,612				10,873				14,866
Less: Income tax benefit			(1,356	)			(1,913	)			(3,916	)			(5,284	)
Total share-based compensation
expense, net of tax		$	2,961			$	3,699			$	6,957			$	9,582

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14. Income Taxes

 

We are subject to U.S. federal income tax and various state, local, and international income taxes in numerous jurisdictions. Our domestic and international tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions and the timing of recognizing revenue and expenses. Additionally, the amount of income taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we file.

 

We currently file income tax returns in the U.S., the U.K., the Netherlands and Hong Kong, which are periodically under audit by federal, state, and international tax authorities. These audits can involve complex matters that may require an extended period of time for resolution. The Internal Revenue Service completed an examination of our consolidated U.S. Federal income tax returns through fiscal year 2004 with no changes to the tax return. We remain subject to U.S. federal and state income tax examinations for the tax years 2005 through 2008, and to U.K. income tax examinations for the years 2002 through 2007. There are no income tax examinations currently in process. Although the outcome of open tax audits is uncertain, in management’s opinion, adequate provisions for income taxes have been made. If actual outcomes differ materially from these estimates, they could have a material impact on our financial condition and results of operations. Differences between actual results and assumptions, or changes in assumptions in future periods are recorded in the period they become known. To the extent additional information becomes available prior to resolution, such accruals are adjusted to reflect probable outcomes. Our effective tax rate is impacted by earnings being realized in countries where we have lower statutory rates.

 

During the three and nine months ended September 30, 2009 we received federal income tax refunds totaling $7.5 million and $10.1 million, respectively, related to the 2008 tax period.  We experienced a taxable loss in 2008 primarily as a result of the accelerated depreciation allowed under the 2008 Economic Stimulus Act passed in February 2008.

 

15. Comprehensive Income

 

    Total comprehensive income was as follows:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
(In thousands)		2008				2009				2008				2009
Net income		$	5,235			$	7,604			$	14,859			$	21,183
Derivative instrument, net of deferred taxes of $64 and $(70) for the three months ended September 30, 2008 and 2009, and $142 and $(245) for the nine months ended September 30, 2008 and 2009.			(77	)			130				(220	)			455
Foreign currency cumulative translation adjustmment, net of taxes of $986 and $109 for the three months ended September 30, 2008 and 2009, $985 and $(1,588) for the nine months ended September 30, 2008 and 2009.			(4,160	)			(2,176	)			(4,168	)			5,299
Total other comprehensive income (loss)			(4,237	)			(2,046	)			(4,388	)			5,754
Total comprehensive income		$	998			$	5,558			$	10,471			$	26,937

 

(In thousands)		Derivative Instrument				Translation Adjustment				Accumulated other comprehensive income (loss)
Balance at December 31, 2008		$	(1,886	)		$	(14,141	)		$	(16,027	)
2009 changes in fair value			455				-				455
2009 translation adjustment			-				5,299				5,299
Balance at September 30, 2009		$	(1,431	)		$	(8,842	)		$	(10,273	)

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16. Segment Information

 

FASB ASC Topic 280, Segment Reporting (formerly SFAS 131), establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information by business unit and geographic region for purposes of evaluating financial performance and allocating resources.  We are organized as, and operate two business units: managed hosting and cloud computing services, which includes cloud hosting, as well as email and application hosting.  We have evaluated the criteria for aggregation by products and services, and by geography, and determined we have one reportable segment, which we describe as Hosting.  Revenue is attributed by geographic location based on the Rackspace Hosting operating location that enters into the contractual relationship with the customer, either the U.S. or outside U.S., primarily the U.K.  Our long-lived assets are primarily located in the U.S. and U.K., and to a lesser extent Hong Kong.

 

Total net revenue by geographic region was as follows:

 

		Three Months Ending September 30,								Nine Months Ending September 30,
(In thousands)		2008				2009				2008				2009
United States		$	99,173			$	119,896			$	276,120			$	343,769
Outside United States			39,181				42,503				112,676				115,702
Total net revenue		$	138,354			$	162,399			$	388,796			$	459,471

 

Long-lived assets by geographic region were as follows:

 

		December 31,				September 30,
(In thousands)		2008				2009
United States		$	322,949			$	373,261
Outside United States			68,930				89,236
Total long-lived assets		$	391,879			$	462,497

17. Related Party Transactions

 

We lease some facilities from a partnership controlled by our chairman of the board of directors. For these leases, we recognized $166 thousand and $180 thousand of rent expense on our consolidated statements of income for the three months ended September 30, 2008 and 2009, respectively, and $443 thousand and $546 thousand for the nine months ended September 30, 2008 and 2009, respectively.

 

18. Subsequent Events

 

In connection with the preparation of the consolidated financial statements and in accordance with FASB ASC Topic 855, Subsequent Events, (formerly SFAS 165) we evaluated events after the balance sheet date of September 30, 2009 through November 12, 2009, the day the consolidated financial statements were issued.

 

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ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 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

Rackspace Hosting, Inc. is the world leader in hosting and cloud computing. Our growth is the result of our commitment to serving our customers, known as Fanatical Support®, and our exclusive focus on hosting and cloud computing. We have been successful in attracting and retaining thousands of customers and in growing our business. We are a pioneer in an emerging category, hybrid hosting, which combines the benefits of both traditional dedicated hosting and cloud computing. We are committed to maintaining our service-centric focus and will follow our vision to be considered one of the world’s greatest service companies.

Rackspace offers a full suite of hosting services, including managed hosting, cloud hosting, as well as email and application hosting.  The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by us.

We sell our services to small and medium-sized businesses as well as large enterprises. For the nine months of 2009, 25.2% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Late in 2008, we also began operations of a Hong Kong data center and a sales office, which generated minimal revenue in 2008 and the first nine months of 2009.  Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. For the first nine months of 2009, no individual customer accounted for greater than 2% of our net revenue.

 

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.

 

 

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		Three Months Ended
		(Unaudited)
(Dollar amounts in thousands, except annualized net		September 30,				December 31,				March 31,				June 30,				September 30,
revenue per average technical square foot)		2008				2008				2009				2009				2009
Growth
Managed hosting customers at period end			18,012				18,480				19,048				19,363				19,328
Cloud customers at period end*			18,173				34,820				43,030				51,440				61,616
Number of customers at period end			36,185				53,300				62,078				70,803				80,944
Managed hosting, net revenue		$	131,908			$	134,275			$	134,204			$	138,943			$	147,065
Cloud, net revenue		$	6,446			$	8,862			$	10,873			$	13,052			$	15,334
Net revenue		$	138,354			$	143,137			$	145,077			$	151,995			$	162,399
Revenue growth (year over year)			44.0	%			34.2	%			21.3	%			16.2	%			17.4	%
Net upgrades (monthly average)			1.8	%			1.4	%			0.9	%			1.2	%			1.2	%
Churn (monthly average)			-1.2	%			-1.3	%			-1.1	%			-1.0	%			-1.1	%
Growth in installed base (monthly average)			0.6	%			0.1	%			-0.2	%			0.2	%			0.1	%
Number of employees (Rackers) at period end			2,536				2,611				2,661				2,648				2,730
Number of servers deployed at period end			45,231				47,518				50,038				52,269				54,655
Profitability
Income from operations		$	9,490			$	12,125			$	13,021			$	13,403			$	13,128
Depreciation and amortization		$	23,174			$	26,310			$	27,804			$	29,711			$	32,696
Share-based compensation expense
Cost of revenue		$	819			$	678			$	629			$	675			$	778
Sales and marketing		$	612			$	595			$	698			$	721			$	826
General and administrative		$	2,886			$	2,871			$	2,910			$	3,621			$	4,008
Total share-based compensation expense		$	4,317			$	4,144			$	4,237			$	5,017			$	5,612
Adjusted EBITDA (1)		$	36,981			$	42,579			$	45,062			$	48,131			$	51,436
Adjusted EBITDA margin			26.7	%			29.7	%			31.1	%			31.7	%			31.7	%
Operating income margin			6.9	%			8.5	%			9.0	%			8.8	%			8.1	%
Income from operations		$	9,490			$	12,125			$	13,021			$	13,403			$	13,128
Effective tax rate			29.6	%			27.7	%			36.6	%			36.2	%			33.9	%
Net operating profit after tax (NOPAT) (1)		$	6,681			$	8,766			$	8,255			$	8,551			$	8,678
NOPAT margin			4.8	%			6.1	%			5.7	%			5.6	%			5.3	%
Capital efficiency and returns
Interest bearing debt		$	297,933			$	300,413			$	201,507			$	210,284			$	167,976
Stockholders' equity		$	269,008			$	269,684			$	282,880			$	308,823			$	330,392
Less: Excess cash		$	(235,421	)		$	(200,620	)		$	(117,611	)		$	(129,638	)		$	(83,462	)
Capital base		$	331,520			$	369,477			$	366,776			$	389,469			$	414,906
Average capital base		$	316,245			$	350,499			$	368,127			$	378,123			$	402,188
Capital turnover (annualized)			1.75				1.63				1.58				1.61				1.62
Return on capital (annualized) (1)			8.5	%			10.0	%			9.0	%			9.0	%			8.6	%
Capital expenditures
Purchases of property and equipment, net		$	45,328			$	32,547			$	25,589			$	31,027			$	26,024
Vendor financed equipment purchases		$	23,009			$	14,848			$	11,683			$	23,637			$	20,664
Total capital expenditures		$	68,337			$	47,395			$	37,272			$	54,664			$	46,688
Customer gear		$	27,627			$	23,073			$	19,255			$	32,448			$	28,705
Data center build outs		$	21,679			$	14,240			$	11,386			$	13,914			$	4,028
Office build outs		$	11,227			$	8,340			$	2,239			$	1,651			$	5,432
Capitalized software and other projects		$	7,804			$	1,742			$	4,392			$	6,651			$	8,523
Total capital expenditures		$	68,337			$	47,395			$	37,272			$	54,664			$	46,688
Infrastructure capacity and utilization
Technical square feet of data center space at period end **			136,962				134,923				157,523				177,371				167,821
Annualized net revenue per average technical square foot **		$	4,093			$	4,212			$	3,969			$	3,631			$	3,764
Utilization rate at period end			63.4	%			70.4	%			64.6	%			59.8	%			62.3	%
* Beginning December 31, 2008 amounts include customers resulting from the Slicehost acquisition, and beginning March 31, 2009 amounts
include SaaS customers for Jungle Disk.
** The technical square feet as of September 30, 2009 includes an additional 2,200 square feet for the Virginia data center less 11,750 square feet for operations
at a U.K. data center that was decommissioned and migrated to the Slough data center during the third quarter 2009.
(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.

 

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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 and deferred income taxes)

 

    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.

For the periods ending March 31, 2009 through September 30, 2009 we define excess cash as the amount of cash and cash equivalents that exceeds our operating cash requirements, which for these periods is calculated as three percent of our annualized net revenue for the three months prior to the period end.  For prior periods, we defined excess cash as our investments in money market funds.  As a result of a decrease in capital requirements due to the completion of the last phase of our DFW data center build out and phase 2 of our Slough, U.K. data center, as well as the signing of leases to occupy data centers that have minimal data center build out costs, our operating cash needs have declined.  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 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 consider to be the most directly comparable GAAP measure. 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 8.5% to 8.6% for the three months ended September 30, 2008 compared to the three months ended September 30, 2009, primarily due to a reduction of operating costs as a percentage of revenue due to a focus on scaling our cost structure during 2008 and continuing into 2009, partially offset by a lower tax rate favorably impacting the ROC calculation for the three months ended September 30, 2008.  Included in the average capital base for 2008 and 2009 are capital expenditures related to the build out of our new corporate headquarters facility and data centers.

 

Return on assets increased from 3.8% for the three months ended September 30, 2008 to 4.7% for the three months ended September 30, 2009. This increase was primarily due to higher revenue and net income, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.  In addition we have held additional amounts of cash and cash equivalents since our IPO in August 2008.

 

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See our reconciliation of the calculation of return on assets to ROC in the following table:

 

		Three Months Ended
		(Unaudited)
(In thousands, except financial metrics)		September 30, 2008				December 31, 2008				March 31, 2009				June 30, 2009				September 30, 2009
Income from operations		$	9,490			$	12,125			$	13,021			$	13,403			$	13,128
Effective tax rate			29.6	%			27.7	%			36.6	%			36.2	%			33.9	%
Net operating profit after tax (NOPAT)		$	6,681			$	8,766			$	8,255			$	8,551			$	8,678
Net income		$	5,235			$	6,844			$	6,588			$	6,991			$	7,604
Total assets at period end		$	685,211			$	685,261			$	601,434			$	656,793			$	625,330
Less: Excess cash		$	(235,421	)		$	(200,620	)		$	(117,611	)		$	(129,638	)		$	(83,462	)
Less: Accounts payable and accrued expenses		$	(81,740	)		$	(71,387	)		$	(71,211	)		$	(87,316	)		$	(77,108	)
Less: Deferred revenues (current and non-current)		$	(20,055	)		$	(20,167	)		$	(20,374	)		$	(20,011	)		$	(18,222	)
Less: Other non-current liabilities and deferred taxes		$	(16,475	)		$	(23,610	)		$	(25,462	)		$	(30,359	)		$	(31,632	)
Capital base		$	331,520			$	369,477			$	366,776			$	389,469			$	414,906
Average total assets		$	546,761			$	685,236			$	643,348			$	629,114			$	641,062
Average capital base		$	316,245			$	350,499			$	368,127			$	378,123			$	402,188
Return on assets (annualized)			3.8	%			4.0	%			4.1	%			4.4	%			4.7	%
Return on capital (annualized)			8.5	%			10.0	%			9.0	%			9.0	%			8.6	%

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 as a percentage of net revenue has increased from 26.7% for the three months ended September 30, 2008 to 31.7% for the three months ended September 30, 2009 due to revenue increasing at a faster rate than our operating costs, partially offset by marginal increases in most cost categories.

 

Income from operations has been favorably impacted by cost reduction efforts, but was partially offset by higher depreciation and amortization expense resulting from capital investments, and increasing share-based compensation expense from grants of stock options and other stock awards to employees. Our operating income margin increased from 6.9% for the three months ended September 30, 2008 to 8.1% for the three months ended September 30, 2009.

 

 

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See our Adjusted EBITDA reconciliation below.

		Three Months Ended
		(Unaudited)
(Dollars in thousands)		September 30, 2008				December 31, 2008				March 31, 2009				June 30, 2009				September 30, 2009
Net revenue		$	138,354			$	143,137			$	145,077			$	151,995			$	162,399
Income from operations		$	9,490			$	12,125			$	13,021			$	13,403			$	13,128
Net income		$	5,235			$	6,844			$	6,588			$	6,991			$	7,604
Plus: Income taxes		$	2,199			$	2,620			$	3,807			$	3,973			$	3,900
Plus: Total other (income) expense		$	2,056			$	2,661			$	2,626			$	2,439			$	1,624
Plus: Depreciation and amortization		$	23,174			$	26,310			$	27,804			$	29,711			$	32,696
Plus: Share-based compensation expense		$	4,317			$	4,144			$	4,237			$	5,017			$	5,612
Adjusted EBITDA		$	36,981			$	42,579			$	45,062			$	48,131			$	51,436
Operating income margin			6.9	%			8.5	%			9.0	%			8.8	%			8.1	%
Adjusted EBITDA margin			26.7	%			29.7	%			31.1	%			31.7	%			31.7	%

 

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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.

Consolidated Statements of Income (Unaudited):

 

(In thousands)		September 30, 2008				December 31, 2008				March 31, 2009				June 30, 2009				September 30, 2009
Net revenue		$	138,354			$	143,137			$	145,077			$	151,995			$	162,399
Costs and expenses:
Cost of revenue			45,499				45,019				46,210				48,235				53,093
Sales and marketing			21,462				21,447				20,502				19,080				19,860
General and administrative			38,729				38,236				37,540				41,566				43,622
Depreciation and amortization			23,174				26,310				27,804				29,711				32,696
Total costs and expenses			128,864				131,012				132,056				138,592				149,271
Income from operations			9,490				12,125				13,021				13,403				13,128
Other income (expense):
Interest expense			(1,912	)			(3,153	)			(2,535	)			(2,172	)			(2,147	)
Interest and other income (expense)			(144	)			492				(91	)			(267	)			523
Total other income (expense)			(2,056	)			(2,661	)			(2,626	)			(2,439	)			(1,624	)
Income before income taxes			7,434				9,464				10,395				10,964				11,504
Income taxes			2,199				2,620				3,807				3,973				3,900
Net income		$	5,235			$	6,844			$	6,588			$	6,991			$	7,604

 

Consolidated Statements of Income, as a Percentage of Net Revenue (Unaudited):

 

(Percent of net revenue)		September 30, 2008				December 31, 2008				March 31, 2009				June 30, 2009				September 30, 2009
Net revenue			100.0	%			100.0	%			100.0	%			100.0	%			100.0	%
Costs and expenses
Cost of revenue			32.9	%			31.5	%			31.9	%			31.7	%			32.7	%
Sales and marketing			15.5	%			15.0	%			14.1	%			12.6	%			12.2	%
General and administrative			28.0	%			26.7	%			25.9	%			27.3	%			26.9	%
Depreciation and amortization			16.7	%			18.4	%			19.2	%			19.5	%			20.1	%
Total costs and expenses			93.1	%			91.5	%			91.0	%			91.2	%			91.9	%
Income from operations			6.9	%			8.5	%			9.0	%			8.8	%			8.1	%
Other income (expense)
Interest expense			-1.4	%			-2.2	%			-1.7	%			-1.4	%			-1.3	%
Interest and other income (expense)			-0.1	%			0.3	%			-0.1	%			-0.2	%			0.3	%
Total other income (expense)			-1.5	%			-1.9	%			-1.8	%			-1.6	%			-1.0	%
Income before income taxes			5.4	%			6.6	%			7.2	%			7.2	%			7.1	%
Income taxes			1.6	%			1.8	%			2.6	%			2.6	%			2.4	%
Net income			3.8	%			4.8	%			4.5	%			4.6	%			4.7	%

 

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

 

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Third Quarter 2009 Overview

 

To aid in understanding our operating results for the periods covered by this report, we have provided an executive overview and a summary of the significant events that affected the most recent reporting period.  These sections should be read in conjunction with the other portions of management’s discussion and analysis of our financial condition and results of operations, our “Risk Factors” section, and our consolidated financial statements and notes included in this report.

 

The highlights and significant events of the three months ended September 30, 2009 and the impact on our operating results compared to the three months ended, June 30, 2009 were as follows:

 

Net Revenue - Net revenue increased $10.4 million or 6.8% from $152.0 million in the three months ended June 30, 2009 to $162.4 million in the three months ended September 30, 2009.  The growth rate continued to be impacted by the broader economic environment.  Also, the market for hosting services continues to be highly competitive and we face increasing competition from our existing competitors as well as new market entrants resulting in downward pricing pressure for some of our offerings. Partially offsetting the negative impact was a weakening U.S. dollar relative to the pound sterling, which resulted in an increase to revenue of approximately $2.4 million or 1.5% for the three months ended September 30, 2009 compared to the three months ended June 30, 2009 with a minimal impact to our margins as the majority of these customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. In addition, for the three months ended June 30, 2009, revenue was impacted by approximately $2.4 million in service credits related to service interruptions in a portion of our Grapevine, Texas data center.  Customer revenue lost in the third quarter due to downgrades and defection churn has been offset with customer upgrades and the addition of new customers. For the three months ended June 30, 2009 we experienced a monthly average churn rate of 1.0%, which slightly increased to 1.1% for the three months ended September 30, 2009, while net upgrades remained flat at 1.2% for the three months ended June 30, 2009 and September 30, 2009.  Overall, our installed base had growth at an average rate of 0.2% per month for the three months ended June 30, 2009 compared to growth at an average rate of 0.1% for the three months ended September 30, 2009.

 

Income from Operations - Income from operations decreased $0.3 million or 2.2% from $13.4 million for the three months ended June 30, 2009 to $13.1 million for the three months ended September 30, 2009.  Operating income margin was 8.8% for the three months ended June 30, 2009 compared to 8.1% for the three months ended September 30, 2009.  

 

Adjusted EBITDA -Adjusted EBITDA increased $3.3 million or 6.9% from $48.1 million for the three months ended June 30, 2009 to $51.4 million in the three months ended September 30, 2009.  Adjusted EBITDA as a percentage of revenue was 31.7% for the three months ended June 30, 2009 and September 30, 2009. See the discussion of Adjusted EBITDA, a non-GAAP financial measure for additional information.

 

Net Income and Net Income per Share - Net income was $7.0 million, or $0.06 per share on a diluted basis for the three months ended June 30, 2009 compared to net income of $7.6 million, or $0.06 per share on a diluted basis for the three months ended September 30, 2009. The increase in net income was mainly due to revenue growth.  Lower  general and administrative expenses, and sales and marketing expenses as a percentage of revenue, as well as a decrease in other expense for the three months ended September 30, 2009 compared to the three months ended June 30, 2009, were offset by an increase in cost of revenue, and depreciation and amortization expense as a percentage of revenue.

 

    In February 2009 and July 2009, Rackspace entered into agreements with DuPont Fabros Technology to lease approximately 11,000 and 36,700 square feet of technical square feet in a data center facility in the Northern Virginia area and the Chicago area, respectively. Although we have made only minimal payments for the Virginia lease and have not begun making payments for the Chicago lease, the lease accounting rules require the lease costs to be amortized on a straight-line basis beginning in the period that we have physical possession of the property. We have already commenced operations in a portion of the Virginia facility and expect to commence operations in the Chicago facility in early 2010.  Non-cash rent expense for these two facilities, which we believe reflects the portion of the facilities that have not commenced operations, was $0.2 million for the three months ended June 30, 2009 and $1.9 million for the three months ended September 30, 2009 and is reflected in our cost of revenue.

 

    We continue to make investments in our cloud computing division.  During the three months ended June 30, 2009, we released the specifications for our Cloud Servers and Cloud Files APIs under the Creative Commons 3.0 Attribution open source license.  During the three months ended September 30, 2009, we launched Cloud Tools, which is an online service for sharing tools, applications and services built by our strategic partners and independent developers for The Rackspace Cloud, and Rackspace Archiving, which enables our hosted email customers to automatically keep a long-term backup of incoming and outgoing email.

 

    In July 2009, we decommissioned operations at a U.K. data center with 11,750 technical square feet due to the completion of the second phase of our data center build out at our Slough, U.K. data center in June 2009.

 

Quarterly Results of Operations (September 30, 2008 through September 30, 2009)

 

Revenue has increased sequentially in each of the quarters primarily due to increased volume of services provided, both due to an increasing number of customers over time and due to incremental services rendered to existing customers. In the three months ended December 31, 2008 and the three months ended March 31, 2009, the growth rate was negatively impacted by the deteriorating economic conditions and the strengthening U.S. dollar versus the pound sterling.  For the three months ended June 30, 2009 and the three months ended September 30, 2009, we continued to be negatively impacted by the economic conditions and decreased IT spend by our customers, but we experienced a favorable impact by a weakening U.S. dollar versus the pound sterling. For the twelve month period ended September 30, 2009, our average monthly growth in installed base was 0.1% per month.

 

Because of the growth of our revenue, total operating expenses increased sequentially in each of the quarters presented. During the second half of 2008, we focused on scaling our expenditures, which is evidenced in the reduction in sales and marketing, and general and administrative expenses as a percentage of revenue.  Sales and marketing continued to scale through 2009 as we identified more efficient use of our sales resources.  These reductions were partially offset with increasing depreciation and amortization expense resulting from equipment expenditures and facility additions to support our customer growth.  Rackspace completed strategic build outs during this time period including the Slough, U.K. data center, in June 2008, the completion of the third phase of our Grapevine, Texas data center in January 2009, and the second phase of our Slough U.K. data center in June 2009, as well as capital expenditures related to the build out of a corporate facility.

 

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Three Months Ended September 30, 2008 and September 30, 2009

 

Net Revenue

 

Our net revenue was $138.4 million for the three months ended September 30, 2008 and $162.4 million for the three months ended September 30, 2009, an increase of $24.0 million, or 17.3%. Our increase in net revenue was primarily due to increased volume of services provided, resulting from an increasing number of customer accounts and incremental services rendered to existing customers. Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the pound sterling for the three months ended September 30, 2009 compared to the three months ended September 30, 2008.  Net revenue for the three months ended September 30, 2009 would have been approximately $6.5 million higher had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.  Net revenue includes non-recurring revenue of $4.6 million for the three months ended September 30, 2008 compared to $4.5 million for the three months ended September 30, 2009, a decrease of 2.0% as a result of decreased customer overage charges.

 

Cost of Revenue

 

Our cost of revenue was $45.5 million for the three months ended September 30, 2008, and $53.1 million for the three months ended September 30, 2009, an increase of $7.6 million, or 16.7%. Of this increase, $2.4 million was attributable to an increase in salaries, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of data center and support personnel to support our growth. The cost increase was further attributable to an increase in license costs of $2.5 million and an increase in data center costs of $1.6 million related to power and rent.

 

Sales and Marketing Expenses

 

Our sales and marketing expenses were $21.5 million for the three months ended September 30, 2008 and $19.9 million for the three months ended September 30, 2009, a decrease of $1.6 million, or 7.4%. Of this decrease, $2.7 million was attributable to advertising and Internet-related marketing expenditures, with a focus on areas that generate more efficient growth opportunities.  The overall decrease was partially offset by a $1.1 million increase in salaries, commissions, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales.

 

General and Administrative Expenses

 

Our general and administrative expenses were $38.7 million for the three months ended September 30, 2008 and $43.6 million for the three months ended September 30, 2009, an increase of $4.9 million, or 12.7%. Of this increase, $3.7 million was attributable to an increase in salaries and benefits, of which share-based compensation expense increased by $1.0 million as a result of stock option and restricted stock unit grants to employees in 2008 and in the first nine months of 2009. Bad debt expense increased by $1.2 million due to customers generally extending payment terms or not being able to pay as a result of the current economic conditions.

 

Depreciation and Amortization Expense

 

Our depreciation and amortization expense was $23.2 million for the three months ended September 30, 2008 and $32.7 million for the three months ended September 30, 2009, an increase of $9.5 million, or 40.9%. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build outs (primarily the expansion of our data center in Grapevine, Texas and the opening, as well as expansion, of the data center in Slough, U.K.) and internally developed and purchased software.

 

Other Income (Expense)

 

Our interest expense was $1.9 million for the three months ended September 30, 2008 and $2.1 million for the three months ended September 30, 2009, an increase of $0.2 million or 10.5%.  Interest expense was partially offset by capitalized interest of $0.5 million for the three months ended September 30, 2008 and $0.2 million for the three months ended September 30, 2009.  Although we had an increased level of indebtedness in 2009, interest expense did not increase significantly due to lower borrowing rates.

 

Interest and other income (expense) was $(0.1) million for the three months ended September 30, 2008 and $0.5 million for the three months ended September 30, 2009.  In the three months ended September 30, 2008, we recognized $0.4 million in interest income and foreign currency losses of $(0.5) million.  In the three months ended September 30, 2009, we recognized $0.1 million of interest income and $0.4 million of foreign currency gains.

 

Income Taxes

 

Our effective tax rate increased from 29.6% for the three months ended September 30, 2008 to 33.9% for the three months ended September 30, 2009.  The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, state income taxes, research and development credits, and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States. 

 

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Nine months ended September 30, 2008 and September 30, 2009

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.

Consolidated Statements of Income (Unaudited):

 

		Nine Months Ended
(In thousands)		September 30, 2008				September 30, 2009
Net revenue		$	388,796			$	459,471
Costs and expenses:
Cost of revenue			127,564				147,538
Sales and marketing			58,876				59,442
General and administrative			110,470				122,728
Depreciation and amortization			63,862				90,211
Total costs and expenses			360,772				419,919
Income from operations			28,024				39,552
Other income (expense):
Interest expense			(5,076	)			(6,854	)
Interest and other income (expense)			276				165
Total other income (expense)			(4,800	)			(6,689	)
Income before income taxes			23,224				32,863
Income taxes			8,365				11,680
Net income		$	14,859			$	21,183

 

Consolidated Statements of Income, as a Percentage of Net Revenue (Unaudited):

 

		Nine Months Ended
(Percent of net revenue)		September 30, 2008				September 30, 2009
Net revenue			100.0	%			100.0	%
Costs and expenses
Cost of revenue			32.8	%			32.1	%
Sales and marketing			15.1	%			12.9	%
General and administrative			28.4	%			26.7	%
Depreciation and amortization			16.4	%			19.6	%
Total costs and expenses			92.8	%			91.4	%
Income from operations			7.2	%			8.6	%
Other income (expense)
Interest expense			-1.3	%			-1.5	%
Interest and other income (expense)			0.1	%			0.0	%
Total other income (expense)			-1.2	%			-1.5	%
Income before income taxes			6.0	%			7.2	%
Income taxes			2.2	%			2.5	%
Net income			3.8	%			4.6	%

 

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

 

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Net Revenue

 

Our net revenue was $388.8 million for the nine months ended September 30, 2008 and $459.5 million for the nine months ended September 30, 2009, an increase of $70.7 million, or 18.2%. Our increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of customers and incremental services rendered to existing customers. Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the pound sterling for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008.  Net revenue for the nine months ended September 30, 2009, would have been approximately $30 million higher had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.  Net revenue includes non-recurring revenue of $13.9 million for the nine months ended September 30, 2008 compared to $12.7 million for the nine months ended September 30, 2009, a decrease of 8.7% as a result of decreased customer overage charges.

 

Cost of Revenue

 

Our cost of revenue was $127.6 million for the nine months ended September 30, 2008 and $147.5 million for the nine months ended September 30, 2009, an increase of $20.0 million, or 15.6%. Of this increase, $7.0 million was attributable to an increase in salaries, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of data center and support personnel to support our growth. The cost increase was further attributable to an increase in license costs of $9.1 million and an increase in data center costs of $3.8 million related to power and bandwidth.

 

Sales and Marketing Expenses

 

Our sales and marketing expenses were $58.9 million for the nine months ended September 30, 2008 and $59.4 million for the nine months ended September 30, 2009, an increase of $0.5 million, or 0.8%. Of this increase, $5.3 million was attributable to an increase in salaries, commissions, benefits, and share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. Partially offsetting the increase was a $4.7 million decrease to advertising and Internet-related marketing expenditures as a result of a concentrated effort to decrease marketing spend, with a focus on areas that generate more efficient growth opportunities.

 

General and Administrative Expenses

 

Our general and administrative expenses were $110.5 million for the nine months ended September 30, 2008 and $122.7 million for the nine months ended September 30, 2009, an increase of $12.2 million, or 11.0%. Of this increase, $6.9 million was attributable to an increase in salaries and benefits, of which share-based compensation expense increased by $3.0 million as a result of stock option and restricted stock unit grants to employees in 2008 and in the first nine months of 2009. Bad debt expense increased $4.6 million due to customers generally extending payment terms or not being able pay as a result of the current economic conditions. We also experienced increases in internal software support and maintenance of $1.3 million. Partially offsetting these increases were decreases to travel expenditures of $1.1 million.

 

Depreciation and Amortization Expense

 

Our depreciation and amortization expense was $63.9 million for the nine months ended September 30, 2008 and $90.2 million for the nine months ended September 30, 2009, an increase of $26.3 million, or 41.2%. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets including increases in data center equipment and leasehold improvements due to data center build outs (primarily the expansion of our data center in Grapevine, Texas and the opening, as well as expansion, of the data center in Slough, U.K.) and internally developed and purchased software, as well as intangible assets acquired through acquisitions.

 

Other Income (Expense)

 

Our interest expense was $5.1 million for the nine months ended September 30, 2008 and $6.9 million for the nine months ended September 30, 2009, an increase of $1.8 million, or 35.3%.  This relative increase was primarily due to the increased level of indebtedness, which was mostly offset by decreased borrowing rates.  Interest expense was partially offset by capitalized interest of $1.7 million for the nine months ended September 30, 2008 and $0.7 million for the nine months ended September 30, 2009.

 

Interest and other income (expense) was $0.3 million for the nine months ended September 30, 2008 and $0.2 million for the nine months ended September 30, 2009.  In the nine months ended September 30, 2008, we recognized $0.9 million in interest income partially offset by foreign currency losses of $(0.6) million. In the nine months ended September 30, 2009, we recognized $0.2 million of interest income.

 

Income Taxes

 

Our effective tax rate was decreased from 36.0% for the nine months ended September 30, 2008 to 35.5% for the nine months ended September 30, 2009, primarily as a result of a larger portion of our earnings being realized in countries where we have lower statutory rates than compared to the nine months ended September 30, 2008.  The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, state income taxes, research and development credits, and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States.

 

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Liquidity and Capital Resources

At September 30, 2009, our cash and cash equivalents balance was $103.0 million. We use our cash and cash equivalents, cash flow from operations, capital leases, and existing amounts available under our revolving credit facility as our primary sources of liquidity.  We believe that internally generated cash flows, along with cash and cash equivalents currently available to us, are sufficient to support business operations and capital expenditures, in addition to a level of discretionary investments.

In June 2009, we amended our revolving credit facility agreement to provide us the ability to borrow from our credit facility in pounds sterling and euros, rather than restricting borrowings to U.S. dollars. We are limited to borrowings of $75 million in alternate currencies. The option to borrow in other foreign currencies will provide protection against fluctuations in currencies in the countries in which we do business.

We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), and our overall cost of capital. Outstanding debt under our line of credit decreased from $200.0 million as of December 31, 2008 to $50.0 million at September 30, 2009.  The decrease in amounts outstanding under our line of credit was due to the repayment of $150.0 million in the nine months ended September 30, 2009.  As of September 30, 2009, we had an additional $194.3 million available for future borrowings.

 

We have vendor finance arrangements in the form of leases and notes payable with our major vendors that permit us to finance our purchases of data center equipment.  As of December 31, 2008 and September 30, 2009, we had $100.4 million and $118.0 million outstanding with respect to these arrangements.  We believe our borrowings from these arrangements will continue to be available and, as long as they are competitive, we will continue to finance purchases through these arrangements.

 

Capital Expenditure Requirements

 

For the full year of 2009, we expect to have total capital expenditures of approximately $185 million, including $110 million dollars for customer gear, $35 million for data centers, $15 million for office space, and $25 million for capitalized software and other.

 

Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds.  Our money market mutual funds invest exclusively in high-quality, short-term securities that are issued or guaranteed by the U.S. government or by U.S. government agencies.  We actively monitor the third-party depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation or “FDIC” insurance limits or are not insured by the FDIC.  While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

 

We currently believe that current cash and cash equivalents, cash generated by operations, as well as available borrowings through vendor financing arrangements and our credit facility will be sufficient to meet our operating and capital needs in the foreseeable future.  Our long-term future capital requirements will depend on many factors, most importantly our growth of revenue, and our investments in new technologies and services. Our ability to generate cash depends on our financial performance, general economic conditions, technology trends and developments, and other factors. We could be required, or could elect, to seek additional funding in the form of debt or equity.

 

The following table sets forth a summary of our cash flows for the periods indicated:

 

		Nine Months Ended
		(Unaudited)
(In thousands)		September 30, 2008				September 30, 2009
Cash provided by operating activities		$	102,213			$	131,204
Cash used in investing activities		$	(132,849	)		$	(89,462	)
Cash provided by (used in) financing activities		$	266,879			$	(179,045	)
Acquisition of property and equipment by capital    leases and equipment notes payable		$	70,642			$	55,984

 

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Operating Activities

 

    Net cash provided by operating activities is primarily a function of our profitability, the amount of non-cash charges included in our profitability, and our working capital management. Net cash provided by operating activities was $102.2 million in the first nine months of 2008 compared to $131.2 million in the first nine months of 2009, an increase of $29.0 million or 28.4%. Net income increased from $14.9 million in the first nine months of 2008 to $21.2 million in the first nine months of 2009.  A summary of the significant changes in non-cash adjustments affecting net income and changes in assets and liabilities impacting operating cash flows is as follows:

 

• Depreciation and amortization expense was $63.9 million in the first nine months of 2008 compared to $90.2 million in the first nine months of 2009.  The increase in depreciation and amortization was due to the purchases of servers, networking gear and computer software (internally developed technology), and leasehold improvements, as well as amortization of intangibles related to acquisitions.

• Our provision for bad debts and customer credits increased from $2.3 million in the first nine months of 2008 to $8.8 million in the first nine months of 2009 due to certain customers’ inability to pay as a result of the current economic conditions.

• Share-based compensation expense was $10.9 million in the first nine months of 2008 compared to $14.9 million in the first nine months of 2009.  The increase in expense was due to stock options and restricted stock units granted in 2008 and the first nine months of 2009.

 

• The change in accounts receivable was a cash outflow of $5.4 million in the first nine months of 2008 compared to a cash outflow of $17.0 million in the first nine months of 2009.  Our accounts receivable balance has increased during the first nine months of 2009 as a result of increased sales and slower customer payment patterns that are being influenced by the current economic conditions.

• The change in income taxes receivable was a cash outflow of $10.8 million in the first nine months of 2008 compared to a cash inflow of $8.2 million in the first nine months of 2009.  As we anticipated a net loss for tax in 2008, the September 30, 2008 balance sheet included an income tax receivable for a carryback claim for our loss.  We received federal income tax refunds totaling $10.1 million in 2009, related to the 2008 tax period.

• The change in accounts payable and accrued expenses created a $17.7 million cash inflow in the first nine months of 2008 compared to a $2.6 million cash inflow in the first nine months of 2009.  The changes resulted from the timing of payments for trade payables.

    Investing Activities

 

    Net cash used in investing activities was primarily capital expenditures to meet the demands of our growing customer base. Historically our main investing activities have consisted of purchases of IT equipment for our data center infrastructure, furniture, equipment and leasehold improvements to support our operations.

 

    Our net cash used in investing activities was $132.8 million for the first nine months of 2008 compared to $89.5 million for the first nine months of 2009, a decrease of $43.3 million, or 32.6%.

 

    We also purchase equipment through capital lease arrangements and other types of vendor financing that do not require an initial outlay of cash.  Purchases through these arrangements decreased from $70.6 million for the first nine months of 2008 to $56.0 million for the first nine months of 2009.

 

    The combined total for cash and non-cash capital expenditures for property and equipment decreased from $203.5 million for the first nine months of 2008 to $138.6 million for the first nine months of 2009. Of the 2009 amount, $80.4 million was used to purchase dedicated customer equipment, $29.3 million for data center build outs, $9.3 million related to build out of office space and $19.6 million was invested in capitalized software, including internally developed software that is focused on improving our service offerings, and other purchases. The decrease in combined capital expenditures resulted primarily from a decline of $36.3 million in data center build outs and $23.6 million from office build outs, which mostly resulted from the renovations for our headquarters facility in 2008.

 

    Financing Activities

 

    Net cash provided by (used in) financing activities was $266.9 million for the first nine months of 2008 compared to $(179.0) million for the first nine months of 2009, a change of $445.9 million. This was due primarily to $142.7 million in net advances on our revolving credit facility for the first nine months of 2008 compared to repayments of $150.0 million on our revolving credit facility in the first nine months of 2009. Principal payments on capital leases and notes payable were $28.4 million for the first nine months of 2008 compared to $38.4 million for the first nine months of 2009.  In addition, proceeds from exercises of stock options and the related excess tax benefits increased by $4.6 million in the first nine months of 2009.

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Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of September 30, 2009 (unaudited):

(In thousands)		Total				2009					2010-2011				2012-2013			2014 and Beyond
Capital leases (1)		$	117,225			$	12,082			$	86,618			$	18,525			$	-
Operating leases			243,607				4,075				35,697				41,227				162,608
Purchase commitments			5,839				1,086				4,222				531				-
Revolving credit facility (2)			50,000				-				-				50,000				-
Software and equipment notes (2)			8,505				651				6,974				880				-
Total contractual obligations		$	425,176			$	17,894			$	133,511			$	111,163			$	162,608
(1)     Represents principal and interest.
(2)     Represents principal only.

    Leases

 

Capital and finance method leases are primarily related to expenditures for IT equipment. Our operating leases are primarily for data center facilities and, to a lesser extent, office space.

 

In July 2009, Rackspace entered into an agreement to lease approximately 36,700 raised square feet and approximately 10,000 square feet of office and storage space in a data center facility in the Chicago area. The operating lease has a term of 15 years from the commencement date. Rackspace has a one-time option to terminate the lease after ten years subject to a penalty, as well as upon expiration of the lease, to renew the lease for two successive five year periods.

 

Purchase commitments

 

Our purchase commitments are primarily related to bandwidth for our data centers.

 

Revolving Credit Facility

 

We have a credit facility with a committed amount of $245.0 million. As of September 30, 2009, we had $50.0 million of revolving loans outstanding and a $0.7 million letter of credit outstanding under the credit facility, and $194.3 million available for future borrowings.

In December 2007, we entered into an interest rate swap agreement converting a portion of our interest rate exposure from a floating rate basis to a fixed rate of 4.135% per annum. The interest rate swap agreement has a notional amount of $50.0 million and matures in December 2010.

 

Software and Equipment Notes

 

We finance certain software and equipment from third-party vendors. The terms of these arrangements are generally one to five years.

 

Off-Balance Sheet Arrangements

 

During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities or any other entity defined as such within ASC Topic 810, Consolidation (formerly FASB Interpretation No. 46 (Revised 2003), Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51). These entities are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

 

We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us, our employees, agents or representatives. To date, there have been no claims against us or our customers pertaining to such indemnification provisions and no amounts have been recorded.

 

These indemnification obligations are considered off-balance sheet arrangements in accordance with ASC Topic 460, Guarantees (formerly FASB Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others). To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements.

 

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Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in accordance with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, significant judgment is required in making estimates, and selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. These judgments and estimates affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We consider these policies requiring significant management judgment and estimates used in the preparation of our financial statements to be critical accounting policies.

 

We review our estimates and judgments on an ongoing basis, including those related to revenue recognition, service credits, allowance for doubtful accounts, property and equipment, goodwill and intangibles, contingencies, the fair valuation of stock related to share-based compensation, software development, and income taxes.

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to determine the carrying values of assets and liabilities. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.  We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our financial statements.

• Revenue recognition;

• Valuation of accounts receivable and service credits;

• Property, equipment, and other long lived assets;

• Goodwill and intangible assets;

• Contingencies;

• Share-based compensation;

• Software development; and

• Income taxes.

 

A description of our critical accounting policies that involve significant management judgment appears in our Annual Report filed on Form 10-K filed with the SEC on March 2, 2009, as amended under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies.”

 

Recent Accounting Pronouncements

 

For a full description of new accounting pronouncements, including the respective dates of adoption and impact on results of operation and financial condition, see Note 2 of the Consolidated Financial Statements.

 

 

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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Power Prices.    We are a large consumer of power.  During the first nine months of 2009, we expensed approximately $13.2 million that was paid to utility companies to power our data centers, representing 2.9% of our net revenue. Because we anticipate further revenue growth for the foreseeable future, we expect to consume more power in the future. Power costs vary by geography, the source of power generation, seasonal fluctuations, and are subject to certain proposed legislation that may increase our exposure to increased power costs. Our largest exposure to energy prices based on consumption currently exists at our Grapevine, Texas data center in the Dallas-Fort Worth area, a deregulated energy market. In August 2008, we entered into a fixed price contract with a provider of electricity for power for our Grapevine data center. The contract allows the company to periodically convert the price to a floating market price during the arrangement.  The contract is for 19 months, and allows the provider an option to extend the contract for an additional 19 months.  Also, in June 2009, we entered into a fixed price contract for 12 months for our Slough U.K. data center.

 

Interest Rates.    Our main credit facility is a revolving line of credit with a base rate determined by the London Interbank Offered Rate, or LIBOR. This market rate of interest is fluctuating and exposes our interest expense to risk. Our credit agreement obligates us to hedge part of that interest rate risk with appropriate instruments, such as interest rate swaps or interest rate options. On December 10, 2007, we entered into an at-the-market fixed-payer interest rate swap with a notional amount of $50.0 million at an annual rate of 4.135%. This swap essentially fixes the rate we pay on the first $50.0 million outstanding on our revolving credit facility. As we borrow more, we may enter into additional swaps to continuously control our interest rate risk. Generally, we do not hedge our complete exposure. As a result, we may be exposed to interest rate risk on the un-hedged portion of our borrowings.  For example, a 100 basis point increase in LIBOR would increase the interest expense on $10 million of borrowings that are not hedged by $0.1 million annually.  As of September 30, 2009 we did not have exposure to interest rate risk as we only had $50.0 million outstanding on our revolving credit facility.

 

Leases.    The majority of our purchases of customer gear are vendor financed through capital leases with fixed payment terms generally over three to five years, coinciding with the depreciation period of the equipment.  As of September 30, 2009, we have a liability for these leases of $109.5 million on our consolidated balance sheet, of which $46.4 million is classified as current.  Although we believe our borrowings from these arrangements will continue to be available, we have exposure that vendor financing may no longer be available or the borrowing rates, which are fixed rates, may increase.

 

Foreign Currencies.    The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. A relatively insignificant amount of customers are invoiced in currencies other than the applicable functional currency, such as the euro. Therefore, our results of operations and cash flows are subject to fluctuations in foreign currency exchange rates.  We also have exposure to foreign currency transaction gains and losses as the result of certain receivables due from our foreign subsidiaries, which are denominated in both the U.S. dollar and the pound sterling.  During the first nine months of 2009, we recognized foreign currency losses of $(0.2) million within other income (expense).  We have not entered into any currency hedging contracts, although we may do so in the future. We recently amended our revolving credit facility agreement to provide us the ability to borrow from our credit facility in pounds sterling and euros, rather than restricting borrowings to U.S. dollars. We currently do not have borrowings in any alternative currencies from our credit facility. As we grow our international operations, our exposure to foreign currency risk could become more significant.

 

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ITEM 4.  - CONTROLS AND PROCEDURES