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EX-32.2 - SECTION 906 CFO CERTIFICATION - RACKSPACE HOSTING, INC.dex322.htm
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EX-31.1 - SECTION 302 CEO CERTIFICATION - RACKSPACE HOSTING, INC.dex311.htm
EX-23.1 - CONSENT OF KPMG LLP - RACKSPACE HOSTING, INC.dex231.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - RACKSPACE HOSTING, INC.dex312.htm
EX-10.46 - EMPLOYMENT AGREEMENT - RACKSPACE HOSTING, INC.dex1046.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark one)

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2009.

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (No Fee Required)

For the transition period from              to             .

Commission file number 001-34143

 

 

RACKSPACE HOSTING, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   74-3016523

(State or Other Jurisdiction of

Incorporation or Organization)

 

(IRS Employer

Identification No.)

5000 Walzem Rd.

San Antonio, Texas 78218

(Address of principal executive offices, including Zip Code)

(210) 312-4000

(Registrant’s Telephone Number, Including Area Code)

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange of which registered

Common Stock, par value $0.001 per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of Class)

 

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No   þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer, large accelerated filer and a smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  þ    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ

As of June 30, 2009, the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale price of such shares on the New York Stock Exchange on June 30, 2009) was $1,225,461,450.

On February 19, 2010, 123,837,979 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant’s 2010 Annual Meeting of Stockholders to be filed within 120 days of the Registrant’s fiscal year ended December 31, 2009 are incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

RACKSPACE HOSTING, INC.

TABLE OF CONTENTS

 

          Page

PART I

     

Item 1.

   Business    3

Item1A.

   Risk Factors    9

Item 1B.

   Unresolved Staff Comments    27

Item 2.

   Properties    27

Item 3.

   Legal Proceedings    27

Item 4.

   Submission of Matters to Vote of Security Holders    27

PART II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   28

Item 6.

   Selected Financial Data    30

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operation    31

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    57

Item 8.

   Financial Statements and Supplementary Data    58

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    94

Item 9A.

   Controls and Procedures    94

Item 9B.

   Other Information    95

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance    96

Item 11.

   Executive Compensation    96

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   96

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    96

Item 14.

   Principal Accountant Fees and Services    96

PART IV

     

Item 15.

   Exhibits and Financial Statement Schedules    96

SIGNATURES

   98


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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

We have made forward-looking statements in this Annual Report on Form 10-K 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. Before you invest in our common stock, 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.

 

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PART I

ITEM 1—BUSINESS

Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000 under the name Rackspace.com, Inc. However, our operations began in 1998 as a limited partnership, which became our subsidiary through a corporate reorganization completed on August 21, 2001. The company’s name was changed to Rackspace Hosting, Inc. on June 5, 2008 through a merger with one of its wholly-owned subsidiaries. Our principal executive offices are located at 5000 Walzem Rd., San Antonio, Texas 78218. Our telephone number is (210) 312-4000. Our website address is www.rackspace.com. References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the related Notes for additional information regarding the business and our operating results. Changes to our Business section from prior filings are a reflection of a competitive and changing business environment and our adaptations with respect to our product and services set.

Overview

Rackspace Hosting is the world leader in the hosting and cloud computing industry. Our rapid growth over the last decade has been fueled by our commitment to our unique brand of customer service known as Fanatical Support®.

Hosting is at the center of a multi-year shift that is changing the way businesses buy IT services. New cloud computing technologies, which deliver greater simplicity and more meaningful cost savings to businesses, make hosting even more compelling for a broader market. We are pioneering an emerging category, Hybrid Hosting, which combines the benefits of both traditional dedicated hosting and emerging cloud hosting. Hybrid Hosting provides businesses the best of both worlds, allowing IT departments to lower costs without sacrificing the benefits of dedicated hosting. As businesses move to on-demand IT and Hybrid Hosting, we believe Fanatical Support will be more valuable to them than ever before.

We are a global company. Our corporate headquarters is located in San Antonio, with operations located in the United States, the United Kingdom, the Netherlands, and Hong Kong. Our services are sold to businesses in more than 120 countries. In 2009 we had net revenue of $629.0 million and as of December 31, 2009, we served more than 90,000 business customers and we managed more than 56,000 servers, 1,600,000 email accounts, and 259,000 cloud hosting domains. No single customer accounted for more than 2% of net revenue in each of the past three years.

The Hosting Industry

We are the leader in hosting and cloud computing. Hosting is best described as IT services delivered on demand over the Internet. Hosting providers act as an extension of businesses’ IT departments.

Today, there are three ways that businesses can fulfill their IT requirements. The first is commonly called “do it yourself,” or DIY. DIY is an approach to managing IT services where a business retains complete ownership and responsibility for ongoing maintenance and management of servers, software, networking equipment, etc. Companies may choose to house this equipment in their own facilities, or may rent data center space from a colocation provider. The second approach is outsourcing, where businesses transfer full responsibility for their IT systems, operations, and employees to a third party. Hosting is the third approach, and we believe it delivers better quality and a more cost-competitive solution than do-it-yourself or outsourcing. Our portfolio of services provides customers the flexibility to choose the best combination of dedicated hosting and cloud computing services to meet their unique IT needs.

 

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The hosting industry emerged in the 1990’s to serve a need created by the rapid adoption of the Internet by consumers and businesses worldwide. Early hosting demand was driven by companies setting up simple websites during the “dot com” boom. Many companies did not have the skills or resources to connect their websites to the Internet, so they turned to hosting companies to perform this task. We believe demand for hosting will continue for three reasons:

 

1. Smaller companies still do not have in-house resources to manage complicated websites, and they do not want to purchase expensive hardware with their available capital. Yet they must have an increasingly robust, reliable online presence in order to succeed in today’s market.

 

2. Larger companies that do have specialized, dedicated IT resources would rather deploy these resources to more strategic areas of their business rather than managing servers or running a website.

 

3. As companies have experienced the benefits of using hosting providers to manage their web sites, they have become more comfortable with the concept of hosting providers managing additional IT services.

Today, the hosting market opportunity extends well beyond its roots and includes a broad continuum of services from simple websites to complex, mission-critical IT applications and support. We believe the trend toward on-demand IT services is in its infancy and will drive growth over the coming years.

Cloud Computing and Hosting

Cloud computing is one of the most widely discussed topics in IT today. We believe it is also central to the future of the hosting industry and have made it a key element of our hosting strategy. In simple terms, cloud computing refers to pooled computing resources, delivered on-demand, over the Internet. In the same manner that electricity is delivered on-demand from large scale power plants, cloud computing is delivered from large, centralized data centers to businesses all over the world.

Today, our core offering, managed hosting, requires dedicated servers for each customer deployment. Most of these dedicated resources, which are designed to meet peak processing demands, are underutilized during non-peak hours. Cloud technologies allow hosting providers to effectively provision and manage a pool of computing resources (or a “cloud”) across a larger base of customers. Cloud technologies deliver more computing resources to businesses when they need them. At the same time, cloud computing substantially lowers the cost of IT services. We believe these compelling benefits will continue to drive migration from server rooms and corporate data centers to the cloud.

We believe cloud computing is a paradigm shift in IT and we are investing heavily to take advantage of these new technologies. In addition to three acquisitions (Webmail.us, Slicehost, and Jungle Disk), we have built large teams of experts devoted to research and development around these technologies. We view cloud computing as a natural extension of our core hosting offering. We also believe our ability to provide Hybrid Hosting, backed by Fanatical Support, provides us a competitive advantage in the hosting marketplace.

Our Service Suite

We sell a portfolio of hosting and cloud computing offerings, all backed by Fanatical Support.

 

   

Dedicated Hosting. Dedicated hosting delivers a customer-specific, dedicated server, located in our secure, business-class data centers. Our customers have full administrator privileges and are responsible for most administrative functions. We provide a customer management portal and other management tools.

 

   

Managed Hosting—Our core service offering is managed hosting. This service removes the burden of managing the data center, network, hardware devices, and operating system software from the customer. We became an industry leader in the managed hosting category early in our

 

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company history, taking standard service expectations in the industry and exceeding them. Customers place high value on the added benefits of managed hosting, and continue to make us their preferred choice for managed hosting. Despite the emergence of cloud computing, we believe managed hosting will remain a key service offering as companies continue to demand dedicated equipment that will meet specific performance or security needs. We remain committed to innovating new products and services and have added several notable services to the core managed hosting offerings.

 

   

Private Cloud. Rackspace offers a Private Cloud service that allows large enterprises to virtualize their dedicated IT environments. Our Private Cloud provides the cost benefits of a virtualized infrastructure combined with the control and security advantages of dedicated hardware.

 

   

Managed Colocation—Managed colocation serves the demands of highly technical customers who require ordering and provisioning support. Managed colocation customers manage most or all of their software and applications. We manage the data centers, networks and some standard hardware devices. Our managed colocation service is often combined with traditional managed hosting, allowing customers the flexibility to specify service levels for each hosting service component.

 

   

Cloud Hosting. Our cloud hosting services allow businesses to run their applications, similar to managed hosting, but using the new technologies of cloud computing. There are multiple varieties of cloud hosting services that are priced on a pay-per-use basis and that can be quickly and easily scaled up or down on-demand. Today we offer Cloud Servers, Cloud Files, and Cloud Sites. Cloud Servers allow customers to purchase “slices” of servers, load their applications onto those virtual servers, and pay only for the capacity they use. Cloud Files allow customers to purchase storage services by the gigabyte. Cloud Sites allow customers to deploy their applications to a cluster of servers that will scale processing on-demand and as required by the application. Although these cloud services are emerging technologies and in the early phases of development, they offer the true promise of cloud computing—auto scaling, no hardware or software management, simple deployment.

 

   

Cloud Applications. This cloud category, often called “software-as-a-service”, delivers applications provisioned and ready for end-customers to use. These services require limited support from the customer’s IT department, and they remove the IT burden and expense of managing and maintaining software and hardware. We currently offer email, collaboration, and file back-up cloud applications. These cloud applications are priced on a pay-per-use basis, can be purchased and used quickly. Our cloud applications have experienced strong growth over the last year.

 

   

Hybrid Hosting. We believe that traditional dedicated hosting and emerging cloud computing services, when combined, are a powerful solution for IT departments. Each service has specific and unique customer benefits. As a result, we offer Hybrid Hosting, a suite of dedicated hosting and cloud computing services that can be easily combined to address the changing and diverse needs of our customers today and in the future.

Competition

Given the significant market potential of hosting and cloud computing, we operate in a rapidly evolving and highly competitive environment.

Our principal areas of competition include:

Do-it-Yourself Solutions. Businesses may choose to house and maintain their own IT systems, or use a colocation provider to house IT hardware and provide connectivity. Companies that provide colocation services include AT&T, Equinix, SAVVIS, Switch & Data, and other telecommunications companies. We believe that over time it will be hard for the vast majority of businesses to replicate the capabilities or achieve the low costs of service providers making the do-it-yourself option less attractive for many businesses.

 

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IT Outsourcing Providers. Businesses may choose to outsource their entire IT systems and staff to an outsourcing provider. Companies that provide IT outsourcing include CSC, HP, and IBM. Outsourcing has long been an option for only the largest companies due to the cost, complexity and duration of outsourcing contracts. Rarely is this a viable option for small and medium businesses with rapidly changing needs.

Hosting and Cloud Computing Providers. Businesses may choose to use a hosting or cloud computing provider other than us to provide services and support for their IT systems. Competitors include AT&T, British Telecom, SAVVIS, Terremark, The Planet, Verio, and others. We also face competition from large technology companies such as Amazon, Microsoft, Google, IBM and Salesforce.com, who are making investments in cloud computing.

Our Approach and Sources of Competitive Advantage

We are focused on creating sustainable competitive advantage in two key areas. First, our vision is to be recognized as one of the world’s great service companies. Since companies must trust their hosting provider with their mission critical IT assets, service reputation is a key selection criterion. Second, we operate with a financial discipline that keeps costs low, thereby generating returns that exceed our cost of capital. While companies will pay a premium for a high level of service, keeping the commodity elements of our business at a low cost is a critical element of success. These two key principles form the foundation of our business model, which includes the following elements:

Fanatical Support—We believe that excellent customer service creates customer loyalty, which in turn leads to higher profits and growth. We call our unique, industry-leading customer service model “Fanatical Support,” because our entire company is focused on going above and beyond expectations in order to delight the customer. Fanatical Support builds loyalty, which in turn delivers three key benefits:

 

  1. Loyal customers buy more. Customer loyalty increases the tenure of customers and the longer they stay the more they tend to buy from us, leading to higher revenue and a higher revenue per customer ratio.

 

  2. Loyal customers stay with us longer, which means that loyal customers are more profitable. Further, loyal customers refer other customers. Both help in saving customer acquisition costs and reduce the amount of sales and marketing costs that we need to spend to generate revenue growth.

 

  3. Loyal customers can be served more cost effectively. After initial provisioning, the average cost of serving a customer is reduced, leading to higher average profits and profit margins over time.

As a measure of customer satisfaction, we use the Net Promoter Score® (NPS), developed by Bain & Company, Inc., Fred Reichheld, and Satmetrix Systems, Inc. to track the likelihood that customers will refer us to friends or colleagues. Surveys are conducted on an ongoing basis with results summarized monthly and analyzed to determine areas for improvement. We work with our customers to understand what they consider “must haves,” and what they would like to see in terms of incremental improvements to our service offerings.

Fanatical Support is a result of our unique culture. Employees are called Rackers, and are rewarded for going above and beyond to serve customers. The highest form of recognition is the Straightjacket Award, which is given to the employee who best demonstrates Fanatical Support in action. We are also very selective in our hiring process. Our philosophy is that technical and functional literacy can be taught, but personality is ingrained. We strive to hire employees with the personality traits which fit well within our culture and our teams. Periodically, we conduct employee engagement surveys as a measure of cultural health, and reward those managers that create an engaging and high-performance environment. In 2008 and 2009, Fortune magazine ranked us in the top 50 of its list of “100 Best Companies to Work For.” We firmly believe that our unique culture is a point of sustained differentiation, because corporate culture cannot be easily or quickly replicated by competitors.

 

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Hosting and Cloud Computing Specialist—We are focused exclusively on providing computing power using dedicated and shared technologies. Modern computing infrastructure is complex and ever-changing, so this specialist focus has allowed the company to build a productized set of services that are repeatable, efficient, high-quality and valuable to customers. Our employees, systems, management practices and organizational processes are tuned to continuously improve our high-volume hosting and cloud computing offerings. Many of our competitors have to balance their hosting and cloud computing lines of business with other areas of focus. These other products and services compete internally for the resources and talent needed to make hosting successful. Our exclusive focus on hosting enables us to more rapidly and accurately deploy, upgrade and scale our systems and services. This focus has generated industry-leading revenue growth, profitability and customer satisfaction.

Portfolio of Services—Our Hybrid Hosting model allows customers the flexibility to combine both traditional and emerging services for a solution that best addresses their unique IT requirements.

Many hosting providers offer a limited set of services, or rely on third party reselling relationships to complete their hosting portfolio. Our portfolio of services allows us to deliver the right offering at the right budget for the customer. Additionally, customers who host their entire environment with us benefit from the simplicity of working with one hosting specialist, rather than managing multiple providers.

Research and Development

For the years ended December 31, 2007, 2008, and 2009, we recognized $8.6 million, $10.8 million, and $12.6 million of research and development expense, respectively. Our research and development efforts are focused on developing new services including:

 

   

Deployment of new technologies to address emerging trends, such as cloud computing;

 

   

Development and enhancement of proprietary tools;

 

   

Development and enhancement of processes for sales and support; and

 

   

Development and enhancement of data center operations.

Intellectual Property Rights

We rely on a combination of patent, copyright, trademark, service mark and trade secret laws in the U.S., the European Union, and various countries in Asia, South America, and elsewhere, and contractual restrictions to establish and protect certain proprietary rights in our data, applications, and services. We also currently have one patent and no patent applications in the U.S. We have trademarks registered or pending in the U.S., the European Union, and various countries in Asia, South America, and elsewhere for our name and certain words and phrases that we use in our business. We rely on copyright laws to protect software and certain other elements of our proprietary technologies, although to date we have not registered for copyright protection. We also enter into confidentiality and invention assignment agreements with our employees and consultants and confidentiality agreements with other third parties, and we actively monitor access to our proprietary technologies.

In addition, we license third-party software and other technologies that are used in the provision of or incorporated into some elements of our services.

Employees

As of December 31, 2009, we employed 2,774 Rackers, a net increase of 163, or 6.2%, compared to December 31, 2008. None of our employees are represented by a collective bargaining agreement, nor have we experienced any work stoppages. We believe that our relations with our employees are good.

 

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Sales and Marketing

Our service suite is sold via direct sales teams, through third-party channel partners and via online ordering. Our direct sales model is based on centralized sales teams with leads generated primarily from customer referrals and corporate marketing efforts. This model also includes a centralized enterprise field sales force, which targets select businesses in that segment. Our channel partners include management and technical consultancies, technology integrators, software application providers, and web developers. Online sales occur for managed hosting, Cloud hosting and Cloud Applications via online stores located in the relevant sections of our website.

Our marketing efforts generate interest and market demand by communicating the advantages of our services and unique support model. Our marketing activities include web-based paid and natural search, participation in technology trade shows, conferences and customer events, advertisements in traditional and electronic (web- and email-based) media, and targeted regional public relations activities.

Our Support Team Structure

Our support teams generally consist of 12 to 20 Rackers, including an account manager who is a customer’s single point of contact and advocate within Rackspace Hosting. Each support team also includes technical specialists to meet ongoing customer needs.

Financial Information About Geographic Areas

Total net revenue from U.S. operations was $260.7 million, $383.5 million, and $467.9 million for 2007, 2008, and 2009, respectively. Net revenue from operations outside the U.S., substantially all of which was derived from sales by our U.K. operations, was $101.3 million, $148.4 million, and $161.1 million for 2007, 2008, and 2009, respectively. For information regarding certain risks relating to our foreign operations, please see the risk titled, “Our ability to operate and expand our business is susceptible to risks associated with international sales and operations” in the Risk Factor section.

Available Information

You can obtain copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and other filings with the Securities and Exchange Commission (SEC), and all amendments to these filings, free of charge from our website at www.rackspace.com as soon as reasonably practicable following our filing of any of these reports with the SEC. You can also obtain copies free of charge by contacting our Investor Relations department at our corporate headquarters.

You can also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains a website (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us.

 

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ITEM IA—RISK FACTORS

Risks Related to Our Business and Industry

Our physical infrastructure is concentrated in a few facilities and any failure in our physical infrastructure or services could lead to significant costs and disruptions and could reduce our revenue, harm our business reputation and have a material adverse effect on our financial results.

Our network, power supplies and data centers are subject to various points of failure, problems with our cooling equipment, generators, uninterruptible power supply, or UPS, routers, switches, or other equipment, whether or not within our control, could result in service interruptions for our customers as well as equipment damage. Because our hosting services do not require geographic proximity of our data centers to our customers, our hosting infrastructure is consolidated into a few large facilities. While data backup services and disaster recovery services are available as a part of our hosting services offerings, the majority of our customers do not elect to pay the additional fees required to have disaster recovery services store their backup data offsite in a separate facility, which could substantially mitigate the adverse effect to a customer from a single data center failure. Accordingly, any failure or downtime in one of our data center facilities could affect a significant percentage of our customers. The total destruction or severe impairment of any of our data center facilities could result in significant downtime of our services and the loss of customer data. Since our ability to attract and retain customers depends on our ability to provide customers with highly reliable service, even minor interruptions in our service could harm our reputation. The services we provide are subject to failure resulting from numerous factors, including:

 

   

Power loss;

 

   

Equipment failure;

 

   

Human error or accidents;

 

   

Sabotage and vandalism;

 

   

Failure by us or our vendors to provide adequate service or maintenance to our equipment;

 

   

Network connectivity downtime;

 

   

Improper building maintenance by the landlords of the buildings in which our facilities are located;

 

   

Physical or electronic security breaches;

 

   

Fire, earthquake, hurricane, tornado, flood, and other natural disasters;

 

   

Water damage; and

 

   

Terrorism.

Additionally, in connection with the expansion or consolidation of our existing data center facilities from time to time, there is an increased risk that service interruptions may occur as a result of server relocation or other unforeseen construction-related issues.

We have experienced interruptions in service in the past, due to such things as power outages, power equipment failures, cooling equipment failures, routing problems, hard drive failures, database corruption, system failures, software failures, and other computer failures. While we have not experienced a material increase in customer attrition following these events, the extent to which our reputation suffers is difficult to assess. We have taken and continue to take steps to improve our infrastructure to prevent service interruptions, including upgrading our electrical and mechanical infrastructure. However, service interruptions continue to be a significant risk for us and could materially impact our business.

Any future service interruptions could:

 

   

Cause our customers to seek damages for losses incurred;

 

   

Require us to replace existing equipment or add redundant facilities;

 

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Affect our reputation as a reliable provider of hosting services;

 

   

Cause existing customers to cancel or elect to not renew their contracts; or

 

   

Make it more difficult for us to attract new customers.

Any of these events could materially increase our expenses or reduce our revenue, which would have a material adverse effect on our operating results.

Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.

Because our hosting services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may exceed our liability insurance coverage by unknown but significant amounts, which could materially impair our financial condition.

We provide service level commitments to our customers, which could require us to issue credits for future services if the stated service levels are not met for a given period and could significantly decrease our revenue and harm our reputation.

Our customer agreements provide that we maintain certain service level commitments to our customers relating primarily to network uptime, critical infrastructure availability, and hardware replacement. If we are unable to meet the stated service level commitments, we may be contractually obligated to provide these customers with credits for future services. As a result, a failure to deliver services for a relatively short duration could cause us to issue these credits to a large number of affected customers. In addition, we cannot be assured that our customers will accept these credits in lieu of other legal remedies that may be available to them. Our failure to meet our commitments could also result in substantial customer dissatisfaction or loss. Because of the loss of future revenue through these credits, potential customer loss and other potential liabilities, our revenue could be significantly impacted if we cannot meet our service level commitments to our customers.

If we do not prevent security breaches, we may be exposed to lawsuits, lose customers, suffer harm to our reputation, and incur additional costs.

The services we offer involve the transmission of large amounts of sensitive and proprietary information over public communications networks, as well as the processing and storage of confidential customer information. Unauthorized access, computer viruses, accidents, employee error or malfeasance, fraudulent service plan orders, intentional misconduct by computer “hackers”, and other disruptions can occur that could compromise the security of our infrastructure, thereby exposing such information to unauthorized access by third parties and leading to interruptions, delays or cessation of service to our customers. Techniques used to obtain unauthorized access to, or to sabotage systems, change frequently and generally are not recognized until launched against a target. We may be unable to implement security measures in a timely manner or, if and when implemented, these measures could be circumvented as a result of accidental or intentional actions by parties within or outside of our organization. Any breaches that occur could expose us to increased risk of lawsuits, loss of existing or potential customers, harm to our reputation and increases in our security costs. Although we typically require our customers to sign agreements that contain provisions attempting to limit our liability for security breaches, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a security breach that they may

 

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ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may significantly exceed our liability insurance coverage by unknown but significant amounts, which could seriously impair our financial condition.

If we fail to hire and retain qualified employees and management personnel, our growth strategy and our operating results could be harmed.

Our growth strategy depends on our ability to identify, hire, train, and retain executives, IT professionals, technical engineers, operations employees, and sales and senior management personnel who maintain relationships with our customers and who can provide the technical, strategic, and marketing skills required for our company to grow. There is a shortage of qualified personnel in these fields, specifically in the San Antonio, Texas area, where we are headquartered and a majority of our employees are located. We compete with other companies for this limited pool of potential employees. There is no assurance that we will be able to recruit or retain qualified personnel, and this failure could cause our operations and financial results to be negatively impacted.

Our success and future growth also depends to a significant degree on the skills and continued services of our management team, especially Graham Weston, our Chairman, and A. Lanham Napier, our Chief Executive Officer and President. We do not have long-term employment agreements with any members of our management team, including Messrs. Weston and Napier. Mr. Napier is the only member of our management team on whom we maintain key man insurance.

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.

We believe that our success depends on our ability to provide customers with quality service that not only meets our stated commitments, but meets and then exceeds customer service expectations. If we are unable to provide customers with quality customer support in a variety of areas, we could face customer dissatisfaction, decreased overall demand for our services, and loss of revenue. In addition, our inability to meet customer service expectations may damage our reputation and could consequently limit our ability to retain existing customers and attract new customers, which would adversely affect our ability to generate revenue and negatively impact our operating results.

Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.

Customer contracts for our managed hosting services typically have initial terms of one to two years which, unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire. Moreover, our customers could cancel their managed hosting service agreements before they expire. In addition, most of our other services, such as our cloud computing services, are provided on a month to month basis and do not have an extended initial term at all. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.

Our corporate culture has contributed to our success, and if we cannot maintain this culture, we could lose the innovation, creativity, and teamwork fostered by our culture, and our operating results may be harmed.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity, and teamwork. If we implement more complex organizational management structures

 

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because of growth or other structural changes, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future operating results. In addition, being a publicly traded company may create disparities in personal wealth among our employees, which may adversely impact our corporate culture and employee relations.

If we are unable to manage our growth effectively, our financial results could suffer.

The growth of our business and our service offerings has strained our operating and financial resources. Further, we intend to continue expanding our overall business, customer base, headcount, and operations. Creating a global organization and managing a geographically dispersed workforce requires substantial management effort and significant additional investment in our operating and financial system capabilities and controls. If our information systems are unable to support the demands placed on them by our growth, we may be forced to implement new systems which would be disruptive to our business. We may be unable to manage our expenses effectively in the future due to the expenses associated with these expansions, which may negatively impact our gross margins or operating expenses. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies, and lost revenue opportunities, which may materially and adversely affect our operating results.

If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer.

Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way hosting services are marketed and delivered. These characteristics are magnified by the continued rapid growth of the Internet and the intense competition in our industry. The acceptance and growth of cloud computing illustrates these characteristics and the impact that they can have on our market.

To be successful, we must adapt to our rapidly changing market by continually improving the performance, features, and reliability of our services and modifying our business strategies accordingly. We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. For example, our data center infrastructure could require improvements due to (i) the development of new systems to deliver power to or eliminate heat from the servers we house, (ii) the development of new server technologies that require levels of critical load and heat removal that our facilities are not designed to provide, or (iii) a fundamental change in the way in which we deliver services. We may not be able to timely adapt to changing technologies, if at all. Our ability to sustain and grow our business would suffer if we fail to respond to these changes in a timely and cost-effective manner.

New technologies or industry standards have the potential to replace or provide lower cost alternatives to our hosting services. The adoption of such new technologies or industry standards could render some or all of our services obsolete or unmarketable. We cannot guarantee that we will be able to identify the emergence of all of these new service alternatives successfully, modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes. If and when we do identify the emergence of new service alternatives and bring new products and services to market, those new products and services may need to be made available at lower price points than our then-current services.

Our failure to provide services to compete with new technologies or the obsolescence of our services could lead us to lose current and potential customers or could cause us to incur substantial costs, which would harm our operating results and financial condition. Our introduction of new service alternative products and services that have lower price points than current offerings may result in our existing customers switching to the lower cost products, which could reduce our revenue and have a material, adverse effect of our operating results. For example, the emergence of cloud computing products that provide reasonable alternatives to our managed

 

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hosting solutions could cause a Rackspace managed hosting customer to take their business to an outside cloud computing provider or to transfer their solution to a Rackspace cloud product or service that is available at a lower price point.

We may not be able to continue to add new customers and increase sales to our existing customers, which could adversely affect our operating results.

Our growth is dependent on our ability to continue to attract new customers while retaining and expanding our service offerings to existing customers. Growth in the demand for our services may be inhibited and we may be unable to sustain growth in our customer base for a number of reasons, such as:

 

   

A reduction in the demand for our services due to the economic recession;

 

   

Our inability to market our services in a cost-effective manner to new customers;

 

   

The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;

 

   

Our inability to successfully communicate the benefits of hosting to businesses;

 

   

The decision of businesses to host their Internet sites and web infrastructure internally or in colocation facilities as an alternative to the use of our hosting services;

 

   

Our inability to penetrate international markets;

 

   

Our inability to expand our sales to existing customers;

 

   

Our inability to strengthen awareness of our brand; and

 

   

Reliability, quality or compatibility problems with our services.

A substantial amount of our past revenue growth was derived from purchases of service upgrades by existing customers. Our costs associated with increasing revenue from existing customers are generally lower than costs associated with generating revenue from new customers. Therefore, a reduction in the rate of revenue increase or a rate of revenue decrease from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue attracting new customers or grow our revenue from existing customers for a prolonged period of time could have a material adverse effect on our operating results.

We may not be able to compete successfully against current and future competitors.

The market for hosting and cloud computing services is highly competitive. We expect to face additional competition from our existing competitors as well as new market entrants in the future.

Our current and potential competitors vary by size, service offerings and geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:

 

   

Do-it-yourself solutions with a colocation partner such as AT&T, Equinix, SAVVIS, Switch & Data, and other telecommunications companies;

 

   

IT outsourcing providers such as CSC, HP, and IBM;

 

   

Hosting providers such as AT&T, British Telecom, SAVVIS, Terremark, The Planet, and Verio; and

 

   

Large technology companies such as Amazon, Microsoft, Google, IBM and Salesforce.com, who are making investments in cloud computing.

 

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The primary competitive factors in our market are: customer service and technical expertise; security reliability and functionality; reputation and brand recognition; financial strength; breadth of services offered; and price.

Many of our current and potential competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater brand recognition, and more established relationships in the industry than we do. As a result, some of these competitors may be able to:

 

   

Develop superior products or services, gain greater market acceptance, and expand their service offerings more efficiently or more rapidly;

 

   

Adapt to new or emerging technologies and changes in customer requirements more quickly;

 

   

Bundle hosting services with other services they provide at reduced prices;

 

   

Take advantage of acquisition and other opportunities more readily;

 

   

Adopt more aggressive pricing policies and devote greater resources to the promotion, marketing, and sales of their services; and

 

   

Devote greater resources to the research and development of their products and services.

Our operating results may be further adversely impacted by the current recession, worldwide political and economic uncertainties and specific conditions in the markets we address.

Recently, general worldwide economic conditions have experienced a deterioration due to among other things, credit conditions resulting from the financial crisis affecting the banking system and financial markets including: slower economic activity, concerns about inflation and deflation, volatility in energy costs, decreased consumer confidence, reduced corporate profits and capital spending, the ongoing effects of the war in Iraq and Afghanistan, recent international conflicts, terrorist and military activity, and the impact of natural disasters and public health emergencies. These conditions make it extremely difficult for both us and our customers to accurately forecast and plan future business activities. Additionally, they could cause U.S. and foreign businesses to slow spending on our services, which could delay and lengthen our new customer sales cycle and cause existing customers to do one or more of the following:

 

   

Cancel or reduce planned expenditures for our services;

 

   

Seek to lower their costs by renegotiating their contracts with us;

 

   

Move their hosting services in-house; or

 

   

Switch to lower-priced solutions provided by us or our competitors.

Customer collections are our primary source of cash. We have historically grown through a combination of an increase in new customers and revenue growth from our existing customers. We have experienced a decrease in our installed base growth and if the economic recession were to continue or deteriorate further, we may experience additional reductions in our installed base growth, increases in churn and/or longer new customer sales cycles. If these events were to occur, we could experience a decrease in revenue and a reduction in operating margins. Further, during challenging economic times, our customers may have difficulty gaining timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. We have experienced an increase in our allowance for doubtful accounts when the economic conditions were difficult, and if our customers’ ability to pay were to further erode, we may be required to increase our allowance for doubtful accounts. We cannot predict the timing, strength or duration of any economic slowdown or subsequent economic recovery. If the economy or markets in which we operate do not improve, we may record additional charges related to the impairment of goodwill and other long-lived assets, and our business, financial condition and results of operations could be materially and adversely affected.

 

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Finally, like many other companies, our stock price decreased during the onset of the recent economic downturn. Although our stock price has since recovered, if investors have concerns that our business, financial condition and results of operations will be negatively impacted by a continued or worsened worldwide economic downturn, our stock price could decrease again.

If we overestimate or underestimate our data center capacity requirements, our operating margins and profitability could be adversely affected.

The costs of construction, leasing, and maintenance of our data centers constitute a significant portion of our capital and operating expenses. In order to manage growth and ensure adequate capacity for new and existing customers while minimizing unnecessary excess capacity costs, we continuously evaluate our short and long-term data center capacity requirements. Due to the lead time in expanding existing data centers or building new data centers, we are required to estimate demand for our services as far as two years into the future. We currently plan to increase our infrastructure as required through the addition and expansion of data centers in the U.S. and internationally. In contrast to our data centers that we have established to date, several of which were acquired relatively inexpensively as distressed assets of third parties, our current expansion plans may require us to pay full market rates for new data center facilities. If we overestimate the demand for our services and therefore overbuild our data center capacity or commit to long term facility leases, our operating margins could be materially reduced, which would materially impair our profitability.

If we underestimate our data center capacity requirements, we may not be able to service the expanding needs of our existing customers. Additionally, we may be required to limit new customer acquisition while we work to increase data center capacity to satisfy demand, either of which may materially impair our revenue growth.

We rely on a number of third-party providers for data center space, equipment, maintenance and other services, and the loss of, or problems with, one or more of these providers may impede our growth or cause us to lose customers.

We rely on third-party providers to supply data center space, equipment and maintenance. For example, we lease data center space from third party landlords, lease or purchase equipment from equipment providers, and source equipment maintenance through third parties. While we have entered into various agreements for these products and services, any failure to obtain additional capacity or space, equipment, or maintenance, if required, would impede the growth of our business and cause our financial results to suffer. For example, if a data center landlord does not adequately maintain its facilities, or provide services for which it is responsible, we may not be able to deliver services to our customers according to our standards or at all. Further, the equipment that we purchase could be deficient in some way, thereby affecting our products and services. If, for any reason, these providers fail to provide the required services, fail to deliver their equipment, or suffer other failures, we may incur financial losses and our customers may lose confidence in our company, and we may not be able to retain these customers.

We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.

We do not own the facilities occupied by our current data centers, but occupy them pursuant to commercial leasing arrangements. The initial terms of our main existing data center leases expire over a period ranging from 2012 to 2027, with each having at least one renewal period of no less than three years. Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

 

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Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.

We rely on third-party hardware that may be difficult to replace or could cause errors or failures of our service, which could adversely affect our operating results or harm our reputation.

We rely on hardware acquired from third parties in order to offer our services. This hardware may not continue to be available on commercially reasonable terms in quantities sufficient to meet our business needs, which could adversely affect our ability to generate revenue. Any errors or defects in third-party hardware could result in errors or a failure of our service, which could harm our reputation and operating results. Indemnification from hardware providers, if any, would likely be insufficient to cover any damage to our business or our customers resulting from such hardware failure.

We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.

We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software or inadequate or delayed support by the third party could result in errors or a failure of our service which could harm our operating results by adversely affecting our revenue or operating costs.

We engage and rely on third-party consultants who may fail to provide effective guidance or solutions which could result in increased costs and loss of business opportunity.

We engage third-party consultants who provide us with guidance and solutions relating to everything from overall corporate strategy to data center design to employee engagement. We engage these parties based on our perception of their expertise and ability to provide valuable insight or solutions in the areas that we believe need to be addressed in our business. However, these consultants may fail to provide us with effective guidance or solutions, which could result in a loss of resources, operational failures or a loss of critical business opportunities.

Increased energy costs, power outages, and limited availability of electrical resources may adversely affect our operating results.

Our data centers are susceptible to increased regional, national or international costs of power and to electrical power outages. Our customer contracts do not allow us to pass on any increased costs of energy to our customers, which could affect our operating margins. Further, power requirements at our data centers are increasing as a result of the increasing power demands of today’s servers. Increases in our power costs could impact our operating results and financial condition. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

 

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Increased Internet bandwidth costs and network failures may adversely affect our operating results.

Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.

As our customer base grows and their usage of telecommunications capacity increases, we will be required to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.

Our operating results may fluctuate significantly, which could make our future results difficult to predict and could cause our operating results to fall below investor or analyst expectations.

Our operating results may fluctuate due to a variety of factors, including many of the risks described in this section, which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our operating results for any prior periods as an indication of our future operating performance. Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our budgeted expense levels depend in part on our expectations of long-term future revenue. Given relatively fixed operating costs related to our personnel and facilities, any substantial adjustment to our expenses to account for lower than expected levels of revenue will be difficult and time consuming. Consequently, if our revenue does not meet projected levels, our operating expenses would be high relative to our revenue, which would negatively affect our operating performance.

If our revenue or operating results do not meet or exceed the expectations of investors or securities analysts, the price of our common stock may decline.

We could be required to repay substantial amounts of money to certain state and local governments if we lose tax exemptions or grants previously awarded to us, which could adversely affect our operating results.

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.

On July 27, 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements. Under the amendment, the grant has been divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a Job Target of 1,225 new jobs by December 2012 (in addition to the 1,436 jobs in place as of August 1, 2007 for a total of 2,661 jobs in Texas). We already have drawn $5.0 million of this grant. We can draw an additional $3.5 million when we reach 1,225 new jobs. If we do not create 1,225 new jobs in Texas by 2012, we will be required to repay the grant at a rate of $1,263 per job missed per year (clawback). As of December 31, 2009, we had created 617 new jobs. The maximum clawback

 

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would be the amounts we draw plus 3.4% interest on such amounts per year. The remaining three tranches are at our option. We can draw an additional $13.5 million, based on the following amounts and milestones: $5.5 million if we create a total of 2,100 new jobs in Texas; another $5.25 million if we create a total of 3,000 new jobs in Texas; and $2.75 million more if we create a total of 4,000 new jobs in Texas. We are responsible for maintaining the jobs through January 2022. If we eliminate jobs for which we have drawn funds, the clawback is triggered.

In October 2008, we received a grant in partnership with the State of Texas and Alamo Community College District, which will provide us the opportunity to be reimbursed for up to $4.7 million for certain training expenses conducted through Alamo Community College over the next three years. In order to fulfill our requirements, we must meet the employment requirements defined in the original Texas Enterprise Fund Grant agreement, which is unlikely. Although we have not received any reimbursements, we are in the process of evaluating this grant and the need to renegotiate its terms.

On August 3, 2007, we entered into a lease for approximately 67 acres of land and a 1.2 million square foot facility in Windcrest, Texas, which is in the San Antonio, Texas area, to house our corporate headquarters and potentially a future data center operation. In connection with this lease, we also entered into a Master Economic Incentives Agreement (“MEIA”) with the Cities of Windcrest and San Antonio, Texas, Bexar County, and certain other parties, pursuant to which we agreed to locate existing and future employees at the new facility location. The agreement requires that we meet certain employment levels each year, with an ultimate job requirement of 4,500 jobs by December 31, 2012, provided that if the job requirement in any grant agreement with the State of Texas is lower, then the job requirement under the MEIA is automatically adjusted downward. Consequently, because the Texas Enterprise Fund Grant agreement has been amended to reduce the state job requirement, we believe the job requirement under the MEIA has been reduced to 1,774. In addition, the MEIA requires that the median compensation of those employees be no less than $51,000 per year. In exchange for meeting these employment obligations, the parties agreed to enter into the lease structure, pursuant to which, as a lessee of the Windcrest Economic Development Corporation, we will not be subject to most of the property taxes associated with the property for a 14 year period. If we fail to meet these job creation requirements, we could lose a portion or all of the tax benefit being provided during the 14 year period by having to make payments in lieu of taxes (PILOT) to the City of Windcrest. The amount of the PILOT payment would be calculated based on the amount of taxes that would have been owed for that period if the property were not exempt, and then such amount would be adjusted pursuant to certain factors, such as the percentage of employment achieved compared to the stated requirements.

We have significant debt obligations that include restrictive covenants limiting our flexibility to manage our business; failure to comply with these covenants could trigger an acceleration of our outstanding indebtedness and adversely affect our financial position and operating results.

As of December 31, 2009, outstanding indebtedness under our credit facility totaled $50.0 million, with an outstanding letter of credit of $0.7 million. Our credit facility requires that we maintain specific financial ratios and comply with covenants, including financial covenants, which contain numerous restrictions on our ability to incur additional debt, pay dividends or make other restricted payments, sell assets, enter into affiliate transactions and take other actions. Our existing credit facility is, and any future financing arrangements may be, secured by all of our assets. If we are unable to meet the terms of the financial covenants or if we breach any of these covenants, a default could result under one or more of these agreements, which may require us to repay all amounts owed under our credit facility.

If we are unable to generate sufficient cash to repay our debt obligations when they become due and payable, either when they mature or in the event of a default, we may not be able to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to continue as a going concern.

 

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We also have substantial equipment lease obligations, the principal balance of which totaled approximately $109.7 million as of December 31, 2009. The payment obligations under these equipment leases are secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

We may require additional capital and may not be able to secure additional financing on favorable terms to meet our future capital needs, which could adversely affect our financial position and result in stockholder dilution.

In order to fund future growth, we will be dependent on significant capital expenditures. We may need to raise additional funds through equity or debt financings in the future in order to meet our operating and capital needs. We may not be able to secure additional debt or equity financing on favorable terms, or at all, at the time when we need such funding. If we are unable to raise additional funds, we may not be able to pursue our growth strategy and our business could suffer. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our common stock. In addition, any debt financing that we may obtain in the future could have restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions.

We are exposed to commodity and market price risks that have the potential to substantially influence our profitability and liquidity.

We are a large consumer of power. During 2009, we expensed approximately $17.5 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations and changes in energy prices. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically tracked the general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. We periodically evaluate the advisability of entering into fixed price utilities contracts. If we choose not to enter into a fixed price contract, we expose our cost structure to this commodity price risk.

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 December 31, 2009 we did not have exposure to interest rate risk as we only had $50.0 million outstanding on our revolving credit facility.

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. However, some of our customers are currently invoiced in currencies other than the applicable functional currency. As a result, we may incur foreign currency losses based on changes in exchange rates between the date of the invoice and the date of

 

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collection. In addition, large changes in foreign exchange rates relative to our functional currencies could increase the costs of our services to non-U.S. customers relative to local competitors, thereby causing us to lose existing or potential customers to these local competitors. Thus, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Further, as we grow our international operations, our exposure to foreign currency risk could become more significant. To date, we have not entered into any foreign currency hedging contracts, although we may do so in the future.

We may be accused of infringing the proprietary rights of others, which could subject us to costly and time-consuming litigation and require us to discontinue services that infringe the rights of others.

There may be intellectual property rights held by others, including issued or pending patents, trademarks, and service marks that cover significant aspects of our technologies, branding or business methods, including technologies and intellectual property we have licensed from third parties. Companies in the technology industry, and other patent and trademark holders seeking to profit from royalties in connection with grants of licenses, own large numbers of patents, copyrights, trademarks, service marks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. These or other parties could claim that we have misappropriated or misused intellectual property rights and any such intellectual property claim against us, regardless of merit, could be time consuming and expensive to settle or litigate and could divert the attention of our technical and management personnel. An adverse determination also could prevent us from offering our services to our customers and may require that we procure or develop substitute services that do not infringe. For any intellectual property rights claim against us or our customers, we may have to pay damages, indemnify our customers against damages or stop using technology or intellectual property found to be in violation of a third party’s rights. We may be unable to replace those technologies with technologies that have the same features or functionality and that are of equal quality and performance standards on commercially reasonable terms or at all. Licensing replacement technologies and intellectual property may significantly increase our operating expenses or may require us to restrict our business activities in one or more respects. We may also be required to develop alternative non-infringing technology and intellectual property, which could require significant effort, time, and expense.

Our use of open source software could impose limitations on our ability to provide our services, which could adversely affect our financial condition and operating results.

We utilize open source software, including Linux-based software, in providing a substantial portion of our services. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to offer our services. Additionally, the use and distribution of open source software can lead to greater risks than the use of third-party commercial software, as open source software does not come with warranties or other contractual protections regarding infringement claims or the quality of the code. From time to time parties have asserted claims against companies that distribute or use open source software in their products and services, asserting that open source software infringes their intellectual property rights. We could be subject to suits by parties claiming infringement of intellectual property rights with respect to what we believe to be open source software. In such event, we could be required to seek licenses from third parties in order to continue using such software or offering certain of our services or to discontinue the use of such software or the sale of our affected services in the event we could not obtain such licenses, any of which could adversely affect our business, operating results and financial condition. In addition, if we combine our proprietary software with open source software in a certain manner, we could, under some of the open source licenses, be required to release the source code of our proprietary software.

We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.

We rely primarily on copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only

 

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limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies, although to date we have not registered for copyright protection. We cannot assure you that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We currently have one patent in the U.S. Our patent may be contested, circumvented, found unenforceable or invalidated.

We endeavor to enter into agreements with our employees and contractors and agreements with parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. We may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed.

In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the U.S. Despite the measures taken by us, it may be possible for a third party to copy or otherwise obtain and use our technology and information without authorization. Policing unauthorized use of our proprietary technologies and other intellectual property and our services is difficult, and litigation could become necessary in the future to enforce our intellectual property rights. Any litigation could be time consuming and expensive to prosecute or resolve, result in substantial diversion of management attention and resources, and harm our business, financial condition, and results of operations.

We may be liable for the material that content providers distribute over our network and we may have to terminate customers that provide content that is determined to be illegal, which could adversely affect our operating results.

The law relating to the liability of private network operators for information carried on, stored on, or disseminated through their networks is still unsettled in many jurisdictions. We have been and expect to continue to be subject to legal claims relating to the content disseminated on our network, including claims under the Digital Millennium Copyright Act, other similar legislation and common law. In addition, there are other potential customer activities, such as online gambling and pornography, where we, in our role as a hosting provider, may be held liable as an aider or abettor of our customers. If we need to take costly measures to reduce our exposure to these risks, terminate customer relationships and the associated revenue or defend ourselves against such claims, our financial results could be negatively affected.

Government regulation of data networks is largely unsettled, and depending on its evolution, may adversely affect our operating results.

We are subject to varying degrees of regulation in each of the jurisdictions in which we provide services. Local laws and regulations, and their interpretation and enforcement, differ significantly among those jurisdictions. These laws can be costly to comply with, can be a significant diversion to management’s time and effort, and can subject us to claims or other remedies, as well as negative publicity. Many of these laws were adopted prior to the advent of the internet and related technologies and, as a result, do not contemplate or address the unique issues that the internet and related technologies produce. Some of the laws that do reference the internet and related technologies have been and continue to be interpreted by the courts, but their applicability and scope remain largely uncertain.

In addition, future regulatory, judicial, and legislative changes may have a material adverse effect on our ability to deliver services within various jurisdictions. National regulatory frameworks that are consistent with

 

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the policies and requirements of the World Trade Organization have only recently been, or are still being, put in place in many countries. Accordingly, many countries are still in the early stages of providing for and adapting to a liberalized telecommunications market. As a result, in these markets we may encounter more protracted and difficult procedures to obtain any necessary licenses or negotiate interconnection agreements, which could negatively impact our ability to expand in these markets or increase our operating costs in these markets.

Privacy concerns relating to our technology could damage our reputation and deter current and potential users from using our products and services.

Since our products and services are web based, we store substantial amounts of data for our customers on our servers (including personal information). Any systems failure or compromise of our security that results in the release of our customers’ data could (i) subject us to substantial damage claims from our customers, (ii) expose us to costly regulatory remediation and (iii) harm our reputation and brand. We may also need to expend significant resources to protect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand our hosting footprint.

Regulatory authorities around the world are considering a number of legislative proposals concerning data protection. In addition, the interpretation and application of data protection laws in Europe and elsewhere are still uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines, this could result in an order requiring that we change our data practices, which could have an adverse effect on our business. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business.

Our ability to operate and expand our business is susceptible to risks associated with international sales and operations.

We anticipate that, for the foreseeable future, a significant portion of our revenue will continue to be derived from sources outside of the U.S. A key element of our growth strategy is to further expand our customer base internationally and successfully operate data centers in foreign markets. We have limited experience operating in foreign jurisdictions other than the U.K. and expect to continue to grow our international operations. Managing a global organization is difficult, time consuming, and expensive. Our inexperience in operating our business globally increases the risk that international expansion efforts that we may undertake will not be successful. In addition, conducting international operations subjects us to new risks that we have not generally faced. These risks include:

 

   

Localization of our services, including translation into foreign languages and adaptation for local practices and regulatory requirements;

 

   

Lack of familiarity with and unexpected changes in foreign regulatory requirements;

 

   

Longer accounts receivable payment cycles and difficulties in collecting accounts receivable;

 

   

Difficulties in managing and staffing international operations;

 

   

Fluctuations in currency exchange rates;

 

   

Potentially adverse tax consequences, including the complexities of transfer pricing, foreign value added tax systems, and restrictions on the repatriation of earnings;

 

   

Dependence on certain third parties, including channel partners with whom we do not have extensive experience;

 

   

The burdens of complying with a wide variety of foreign laws and legal standards;

 

   

Increased financial accounting and reporting burdens and complexities;

 

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Political, social, and economic instability abroad, terrorist attacks and security concerns in general; and

 

   

Reduced or varied protection for intellectual property rights in some countries.

Operating in international markets also requires significant management attention and financial resources. The investment and additional resources required to establish operations and manage growth in other countries may not produce desired levels of revenue or profitability.

We rely on our Partner Network Program members for a significant portion of our revenues, and we benefit from our association with them. The loss of these members could adversely affect our business.

Our Partner Network Program drives a significant amount of revenue to our hosting services business. Most of our member partners offer services that are complementary to our hosting services. Some of the participants in our network, however, may actually compete with us in one or more of product or service offering. These network partners may decide in the future to terminate their agreements with us and to use a competitor’s or their own services, which would likely cause our revenue to decline.

Also, we derive tangible and intangible benefits from our association with some of our network partners, particularly high profile partners that reach a large number of companies through the internet. If a substantial number of these relationships terminate their relationship with us, our business could be adversely affected.

Our acquisitions may divert our management’s attention, result in dilution to our stockholders and consume resources that are necessary to sustain our business.

We have made acquisitions and, if appropriate opportunities present themselves, we may make additional acquisitions or investments or enter into joint ventures or strategic alliances with other companies. Risks commonly encountered in such transactions include:

 

   

The difficulty of assimilating the operations and personnel of the combined companies;

 

   

The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;

 

   

The potential disruption of our ongoing business;

 

   

The diversion of management attention from our existing business;

 

   

The inability of management to maximize our financial and strategic position through the successful integration of the acquired businesses;

 

   

Difficulty in maintaining controls, procedures, and policies;

 

   

The impairment of relationships with employees, suppliers, and customers as a result of any integration;

 

   

The loss of an acquired base of customers and accompanying revenue; and

 

   

The assumption of leased facilities, other long-term commitments or liabilities that could have a material adverse impact on our profitability and cash flow.

As a result of these potential problems and risks, businesses that we may acquire or invest in may not produce the revenue, earnings, or business synergies that we anticipated. In addition, there can be no assurance that any potential transaction will be successfully identified and completed or that, if completed, the acquired business or investment will generate sufficient revenue to offset the associated costs or other potential harmful effects on our business.

 

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Concerns about greenhouse gas emissions and the global climate change may result in environmental taxes, charges, assessments or penalties.

The effects of human activity on the global climate change have attracted considerable public and scientific attention, as well as the attention of the United States government. Efforts are being made to reduce greenhouse emissions, particularly those from coal combustion by power plants, some of which we may rely upon for power. The added cost of any environmental taxes, charges, assessments or penalties levied on these power plants could be passed on to us, increasing the cost to run our data centers. Additionally, environmental taxes, charges, assessments or penalties could be levied directly on us in proportion to our carbon footprint. Any enactment of laws or passage of regulations regarding greenhouse gas emissions by the United States, or any domestic or foreign jurisdiction we perform business in, could adversely affect our operations and financial results.

Terrorist activity throughout the world and military action to counter terrorism could adversely impact our operating results.

Terrorist attacks and other acts of violence, as well as governments’ responses to such activities, may have an adverse effect on business, financial, and general economic conditions internationally. Terrorist activities may disrupt our ability to provide our services or may increase our costs due to the need to provide enhanced security, which would have a material adverse effect on our business and results of operations. These circumstances may also adversely affect our ability to attract and retain customers, our ability to raise capital, and the operation and maintenance of our facilities. We may not have adequate property and liability insurance to cover catastrophic events or attacks brought on by terrorist attacks and other acts of violence. In addition, we depend heavily on the physical infrastructure, particularly as it relates to power, that exists in the markets in which we operate. Any damage to such infrastructure in these markets where we operate may materially and adversely affect our operating results.

We have and will continue to incur significant increased costs as a result of operating as a public company, and our management will be required to devote substantial time to new compliance initiatives.

As a public company, we have and will continue to incur significant legal, accounting, and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002 as well as rules subsequently implemented by the Securities and Exchange Commission, and the New York Stock Exchange, have imposed various requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel have and will need to continue to devote a substantial amount of time to these new compliance initiatives. Moreover, these rules and regulations have and are expected to continue to increase our legal and financial compliance costs, making some activities more time-consuming and costly. For example, these new rules and regulations make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantial costs to maintain the same or similar coverage. These rules and regulations could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers.

In order to respond to additional regulations applicable to public companies, such as Section 404 of the Sarbanes-Oxley Act, we have hired a number of finance and accounting personnel. In the future, we may be required to hire additional full-time accounting employees to fill these and other related finance and accounting positions. Some of these positions require candidates with public company experience, and we may be unable to locate and hire such individuals as quickly as needed, if at all. In addition, new employees will require time and training to learn our business and operating processes and procedures. If our finance and accounting organization is unable for any reason to respond adequately to the increased demands resulting from being a public company, the quality and timeliness of our financial reporting may suffer and we could experience internal control weaknesses. Any consequences resulting from inaccuracies or delays in our reported financial statements could have an adverse effect on the trading price of our common stock as well as an adverse effect on our business, operating results, and financial condition.

 

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Risks Related to the Ownership of Our Common Stock

The trading price of our common stock may be volatile.

The market price of our common stock has been highly volatile and could be subject to wide fluctuations in response to, among other things, the risk factors described in this periodic report, and other factors beyond our control, such as stock market volatility and fluctuations in the valuation of companies perceived by investors to be comparable to us.

Further, the stock markets have experienced price and volume fluctuations that have affected and continue to affect our stock price and the market prices of equity securities of many other companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock. We may experience additional volatility as a result of the limited number of our shares available for trading in the market.

In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

Our common stock has only been publicly traded since our initial public offering on August 7, 2008 and the price of our common stock has fluctuated substantially since then and may fluctuate substantially in the future.

Our common stock has only been publicly traded since our initial public offering on August 7, 2008. The trading price of our common stock has fluctuated significantly since then. For example, between December 31, 2008 and December 31, 2009, the closing trading price of our common stock was very volatile, ranging between $4.38 and $23.06 per share, including single-day increases of up to 12.9% and declines up to 11.7%. Our trading price could fluctuate substantially in the future due to the factors discussed in this Risk Factors section and elsewhere in this annual report on Form 10-K.

Contractual lock-up restrictions on the sale of approximately 99 million shares held by certain stockholders expired on February 3, 2009 and to the extent a stockholder is not an affiliate, its shares are now eligible for sale without restriction. Affiliate sales are subject to the volume, manner of sale and other restrictions of Rule 144 of the Securities Exchange Act of 1933 which allow the holder to sell up to the greater of 1% of our outstanding common stock or our average weekly trading volume during any three-month period. Shares beneficially held by Graham Weston, Wells Fargo and Company and certain other parties will be subject to such requirements to the extent they are deemed to be our “affiliates” as that term is defined in Rule 144. Additionally, Weston, Wells Fargo and Company and other holders possess registration rights with respect to some of the shares of our common stock that they hold. If they choose to exercise such rights, their sale of the shares that are registered would not be subject to the Rule 144 limitations. If a significant amount of the shares that become eligible for resale enter the public trading markets in a short period of time, the market price of our common stock may decline.

Additionally, certain of our large stockholders are entities that may from time to time distribute the shares of our stock held by them to their beneficial owners in order to provide them with liquidity with respect to their investment in our stock. The distributed shares may be eligible for immediate resale, in which case all or a significant portion of these shares may be sold by these beneficial owners in the public markets during a short period of time following their receipt of these shares, which may cause the market price for our stock to decline.

 

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The issuance of additional stock in connection with acquisitions, our stock option plans, or otherwise will dilute all other stockholdings.

We have a large number of shares of common stock authorized but unissued and not reserved for issuance under our stock option plans or otherwise. We may issue all of these shares without any action or approval by our stockholders. We intend to continue to actively pursue strategic acquisitions. We may pay for such acquisitions, partly or in full, through the issuance of additional equity. In addition, our Amended and Restated 2007 Stock Plan contains an evergreen provision, which annually increases the number of shares issuable under the plan. Any issuance of shares in connection with our acquisitions, the exercise of stock options or otherwise would dilute the percentage ownership held by our then existing stockholders.

Your ability to influence corporate matters may be limited because a small number of stockholders beneficially own a substantial amount of our common stock.

Our directors and executive officers and their affiliates beneficially own a significant portion of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. Although our directors and executive officers are not currently party to any agreements or understandings to act together on matters submitted for stockholder approval, this concentration of ownership could limit your ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change of control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.

Our restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors deemed undesirable by our board of directors that our stockholders might consider favorable. Some of these provisions:

 

   

Authorize the issuance of blank check preferred stock which can be created and issued by our board of directors without prior stockholder approval, with voting, liquidation, dividend, and other rights senior to those of our common stock;

 

   

Provide for a classified board of directors, with each director serving a staggered three-year term;

 

   

Prohibit our stockholders from filling board vacancies or increasing the size of our board, calling special stockholder meetings or taking action by written consent;

 

   

Provide for the removal of a director only with cause and by the affirmative vote of the holders of a majority of the shares then entitled to vote at an election of our directors; and

 

   

Require advance written notice of stockholder proposals and director nominations.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then current board of directors, including a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

 

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ITEM IB—UNRESOLVED STAFF COMMENTS

None.

ITEM 2—PROPERTIES

Office Space

Our corporate headquarter facility is located in San Antonio, Texas and consists of a 1.2 million square foot facility located on approximately 67 acres of land. We have remodeled and are currently using approximately 230,000 square feet of office space and will continue to remodel the formerly vacant facility as needed to facilitate our future growth and office requirements. Besides our corporate headquarters, we have additional U.S. office locations in Texas, Virginia, Missouri, Illinois and Georgia and additional office space located in the U.K., the Netherlands, and Hong Kong. As of December 31, 2009, we utilized approximately 568,000 square feet of our leased office space and used it for customer service, operations, sales, corporate and administrative functions.

Data Centers

As of December 31, 2009, we leased eight main data centers located in the U.S., the U.K., and in Hong Kong with approximately 220,000 available technical square feet, of which 162,800 were utilized. The six data centers in the U.S are located in Texas, Virginia and Illinois.

We believe that our existing office space and data center facilities are adequate for our current needs and that suitable additional or alternative space will be available in the future to meet our anticipated needs.

ITEM 3—LEGAL PROCEEDINGS

We are party to various legal proceedings which we consider routine and incidental to our business. 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.

ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2009.

 

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PART II

ITEM 5—MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information for Common Stock

Our common stock began trading on the New York Stock Exchange under the symbol “RAX” beginning on August 8, 2008. Prior to that time, there was no public market for our common stock.

The following table sets forth for the indicated periods the high and low closing prices for our common stock for the periods indicated, as reported by the New York Stock Exchange.

 

      High    Low
Fiscal Year 2009 Quarters:      

First Quarter

   $ 7.81    $ 4.38

Second Quarter

     14.50      7.37

Third Quarter

     18.33      12.24

Fourth Quarter

     23.06      16.75
Fiscal Year 2008 Quarters:      

Third Quarter (from August 8, 2008)

   $ 11.71    $ 8.24

Fourth Quarter

     8.33      4.79

The last reported sale price for our common stock on the New York Stock Exchange was $19.81 per share on February 19, 2010.

Dividend Policy

We have never paid any cash dividends on our common stock. Our board of directors currently intends to retain any future earnings to support operations and to finance the growth and development of our business and does not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination related to our dividend policy will be made at the discretion of our board.

Stockholders

As of February 19, 2010, there were 226 registered stockholders of record of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these stockholders of record.

Securities Authorized For Issuance Under Equity Compensation Plans

For information regarding securities authorized for issuance under equity compensation plans, see Part III “Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

 

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Stock Performance Graph

The graph set forth below compares the cumulative total stockholder return on our common stock between August 7, 2008 (the date of our initial public offering, or IPO) and December 31, 2009, with the cumulative total return of (i) the Russell 2000 Index and (ii) the Nasdaq Internet Total Return Index, over the same period. This graph assumes the investment of $100 on August 7, 2008 in our common stock at our IPO offering price of $12.50 per share, the Russell 2000 Index and the Nasdaq Internet Total Return Index, and assumes the reinvestment of dividends, if any. We are currently included in the Russell 2000 Index. The Nasdaq Internet Total Return Index consists of U.S. listed companies engaged in internet-related businesses.

The comparisons shown in the graph below are based upon historical data. We caution that the stock price performance shown in the graph below is not necessarily indicative of, nor is it intended to forecast, the potential future performance of our common stock.

LOGO

Recent Sales of Unregistered Securities

None

 

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ITEM 6—SELECTED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with the financial statements and the notes to those statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements included elsewhere in this document. The selected consolidated financial data in this section are not intended to replace the financial statements and are qualified in their entirety by the consolidated financial statements and related notes thereto included elsewhere in this document.

The statements of income and cash flow data for the fiscal years ended December 31, 2007, 2008 and 2009 and the balance sheet data as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements, which have been audited by KPMG, LLP, independent registered public accounting firm, and included elsewhere in this document. The statements of income data for the years ended December 31, 2005 and 2006 and the balance sheet data as of December 31, 2005, 2006 and 2007 have been derived from our audited consolidated financial statements, which have been audited by KPMG, LLP, independent registered public accounting firm, but are not included in this document. Historical results are not necessarily indicative of future results. See note 3 to the financial statements for an explanation of the method used to determine the number of shares used in computing basic and diluted net income per common share.

 

     Year Ended December 31,  
(In thousands, except per share data)    2005     2006     2007     2008     2009  

Net revenue

   $ 138,768      $ 223,966      $ 362,017      $ 531,933      $ 628,987   

Costs and expenses:

          

Cost of revenue

     40,987        64,889        118,225        172,583        200,943   

Sales and marketing

     21,837        35,667        53,930        80,323        79,458   

General and administrative

     38,968        59,832        102,777        148,706        168,116   

Depreciation and amortization

     20,193        32,335        56,476        90,172        125,229   
                                        

Total costs and expenses

     121,985        192,723        331,408        491,784        573,746   
                                        

Income from operations

     16,783        31,243        30,609        40,149        55,241   
                                        

Other income (expense):

          

Interest expense

     (808     (1,095     (3,643     (8,229     (8,950

Interest and other income

     633        572        828        768        255   
                                        

Total other income (expense)

     (175     (523     (2,815     (7,461     (8,695
                                        

Income before income taxes

     16,608        30,720        27,794        32,688        46,546   

Income taxes

     5,836        10,900        9,965        10,985        16,328   
                                        

Net income

   $ 10,772      $ 19,820      $ 17,829      $ 21,703      $ 30,218   
                                        

Net income per share

          

Basic

   $ 0.12      $ 0.20      $ 0.18      $ 0.20      $ 0.25   
                                        

Diluted

   $ 0.11      $ 0.19      $ 0.17      $ 0.19      $ 0.24   
                                        

Balance sheet data

          

Cash and cash equivalents

   $ 8,022      $ 8,374      $ 24,937      $ 238,407      $ 125,425   

Total assets

     83,645        132,983        301,813        685,261        668,645   

Long term obligations

     8,417        16,391        96,213        283,053        161,024   

Total stockholders’ equity

     46,713        70,490        96,873        269,684        349,427   

 

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ITEM 7—MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 the hosting and cloud computing industry. 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 portfolio of hosting services, including managed hosting, cloud hosting, and cloud 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. During 2009, 25.6% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, late in 2008, we began operating a Hong Kong data center and a sales office, which generated minimal revenue in 2008 and 2009. Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia.

As we grow our business, we believe our operations are exposed to certain risks and uncertainties, which could negatively impact our operating results and financial condition. See the section entitled “Risk Factors” for further discussion of these risks.

How We Earn Revenue and Measure Growth

Our subscription-based business model generates almost all of our revenue on a recurring basis. Our customers pay us a recurring fee based on the size and complexity of the IT systems we manage and the level of service intensity we provide, pursuant to service agreements that typically provide for monthly payments. Our cloud business offers pay-as-you go services that are earned and recognized as the services are provided. Revenue is reduced by credits issued to customers, primarily for service interruptions, and also includes revenue related to customers who have cancelled their service. Net revenue for the years ended December 31, 2007, 2008 and 2009 was $362.0 million, $531.9 million, and $629.0 million, respectively, representing year-over-year increases of 46.9% in 2008 and 18.3% in 2009.

Our revenue growth is primarily due to increased volume of services provided, both due to an increasing number of new customers and incremental services rendered to existing customers, as well as a broader suite of hosting services acquired through acquisitions and research and development activities. “Growth in installed base” is a metric we use to measure the growth of revenue derived only from our existing customer base.

The growth in installed base metric consists of “net upgrades” minus defection “churn”. Net upgrades measure the incremental monthly recurring revenue from customer upgrades less downgrades as a percentage of total monthly recurring revenue. Churn measures the reduction of monthly revenue as a percentage of total monthly recurring revenue due to customer terminations. Terminations typically result from customers who (i) no longer need hosting services, (ii) are unable to pay for hosting services, (iii) decide to provide their services in-house, or (iv) switch to another hosting provider. For the year ended December 31, 2009, our average monthly growth in installed base was 0.2%.

 

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We measure net upgrades at the time a customer upgrades or downgrades services with us and we measure churn in the month we stop providing services to the customer. Net upgrades and churn are expressed as percentage increases (decreases) in the contractual monthly recurring fee associated with a service agreement for a given customer.

Our net revenue is denominated in U.S. dollars as well as other foreign currencies including the pound sterling, the euro, and Hong Kong dollars. Changes in related currency exchange rates may affect our net revenue. The decrease in net revenue, due to foreign currency fluctuations, was approximately $28 million, or 5% in 2009.

Nature of Our Operating Expenses

Our operating expense categories include cost of revenue, sales and marketing, general and administrative, and depreciation and amortization.

Employee related costs have historically been the primary driver of our operating expenses and we expect this trend to continue. Employee related costs include items such as wages, commissions, variable compensation, vacation, benefits, and share-based compensation. Employee variable compensation is dependent upon the financial results of the company, thus favorable changes in the financial results are partially offset by additional variable compensation expense and vice versa. We had 2,611 and 2,774 employees as of December 31, 2008 and 2009, respectively. The year-over-year increases were primarily attributable to increases in our customer and data center support teams. To maintain our service focus, our support teams have continued to grow with the growth of our business. Our headcount is expected to increase in 2010 as we continue to grow our business.

Cost of revenue primarily consists of employee related costs of our customer support teams and data center employees, as well as the costs to operate our data centers. The majority of our data center costs vary with the volume of services sold and include: power, bandwidth, and rent; costs associated with licenses; and costs related to maintenance and the replacement of IT equipment components. Our contracts with network operators for bandwidth capacity generally commit us to pay a monthly fee based on usage. Our data centers rely on local and regional utility companies as their primary source of power. We entered into a fixed-price power arrangement with the electricity provider of our Grapevine, Texas data center which expires in September 2011. We also entered into a fixed price contract for our Slough U.K. data center, which expires in May 2011. We enter into contracts with software providers that allow us to provide licenses to our customers. Our arrangements with these software vendors are typically one to three years in length and we generally pay a fixed fee per license.

Sales and marketing activities are directed toward both the acquisition of new customers and increasing our business with existing customers. We pay commissions to our sales representatives generally upon execution of a service agreement. Sales and marketing expense also includes compensation to our channel partners. Marketing expenditures are intended to communicate the advantages of our services and to generate customer demand. The majority of our marketing expenditures relate to lead generation through pay-per-click placements on major Internet search engines.

General and administrative activities are comprised of employee related costs, professional fees, general corporate costs and overhead. In 2008, we invested in our administrative infrastructure and personnel to support our continued growth and expenses related to becoming a publicly traded company, including increased audit and legal fees, costs of compliance with securities and other regulations, implementation costs for Sarbanes-Oxley certification and compliance with Section 404, investor relations expense, and higher insurance premiums. In late 2008 and continuing into 2009, we began to scale our administrative costs with a focus on operational excellence projects, process improvement initiatives and decreased discretionary spending.

Depreciation and amortization expense includes amortization of leasehold improvements associated with our data centers and corporate facilities, as well as depreciation of our data center infrastructure and equipment.

 

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Amortization expense is also comprised of the amortization of our customer based intangible assets related to acquisitions, internally developed technology, and software licenses purchased from third-party vendors.

Our operating expenses are denominated in U.S. dollars as well as other foreign currencies including the pound sterling, the euro, and Hong Kong dollar. Changes in related currency exchange rates may affect our operating results. The decrease in operating expenses, due to foreign currency fluctuations, was approximately $22 million, or 4%, in 2009.

Capital Expenditures

Our capital expenditures primarily relate to customer gear, data center infrastructure, corporate office build-outs, and internally developed software and other projects. Each category is defined below:

Customer gear—Includes servers, firewalls, load balancers, cabinets, switches, backup libraries, storage arrays and drives and network cabling.

Data center infrastructure—Includes generators, uninterruptible power supplies or UPS, power distribution units, mechanical and electrical plants, chillers, raised floor and other building improvements.

Corporate office build-outs—Includes demolition, raised floor, chillers, furniture and general building improvements.

Internally developed software and other—Includes salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects, and other projects that meet the criteria for capitalization.

In 2009, we expended cash or entered into lease arrangements for the purchase of customer gear of $108.8 million, data center infrastructure costs of $37.2 million, corporate office build-outs of $14.7 million and $25.0 million related to internally developed software and other capitalized projects. In 2010, we expect to have capital expenditures between $185 million and $235 million in the aggregate consisting of $140 million to $160 million for customer gear, $10 million to $20 million for data center infrastructure costs, $10 million to $20 million for office build-outs, and $25 million to $35 million for capitalized software and other projects.

Our data center infrastructure is built to accommodate future revenue growth. While we try to minimize the amount of excess capacity, we consider appropriate lead times for these build outs, which requires us to build capacity ahead of actual revenue growth. We also strive to align our investment in data center infrastructure with our revenue growth to keep utilization rates high. We measure our utilization rate as the power being consumed by all electrical equipment relative to the total available capacity in our data centers excluding portions of the data center that have not been placed on line. We pursue a modular build out strategy within our data centers that expands the operational footprint when needed. From time to time, we will be required to make significant investments in new data centers or enter into long-term facility leases to support expected growth beyond our ability to build out additional modules in existing facilities.

While many factors may influence our margins, in periods when we make large investments, margins may decrease. Such investments may be made in connection with data center and office expansion, as well as significant product and market development initiatives.

In February 2009 and July 2009, we entered into operating lease agreements with subsidiaries of 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. This current strategy of entering into operating lease agreements for data center space reduces the capital investments required to increase our data center square footage.

 

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Disciplined Use of Capital and Management of Profitability

We have achieved net income profitability since the first quarter of 2004 through focused management of capital and profitability. We use the Economic Value Added model (EVA®), which was developed by Stern Stewart & Co., as a tool to help ensure our growth and capital investments create stockholder value. Virtually all capital expenditures are evaluated against this metric using a standard cost of capital. EVA is calculated for our product offerings to evaluate our profitability.

We are also very careful with our facility and data center expansion practices. Currently, we sell to businesses in more than 120 countries. Unlike a colocation provider, we do not need to be located near our customers, allowing us to build or lease centralized, cost-optimized facilities with teams of highly-trained staff. We strive to locate our regional facilities and data centers in lower-cost locations, which reduces rent, power and labor costs. We also focus on either leasing or building sections of data centers in increments so that capital expenditures are more closely matched to revenue growth.

We have made significant investments in cloud computing. Over the last 3 years, we have made three acquisitions that have expanded our product set into cloud computing (cloud hosting and cloud applications). We will continue to identify and pursue strategic investments that have the potential to generate savings, enhance our competitive advantage, and increase our capabilities to serve customers.

Economies of Scale—We have achieved a critical mass that generates long term cost advantages. Like any service that moves from distributed to centralized production, scale is a factor in ensuring costs are low enough to drive mass adoption. We are able to generate significant cost advantages based on our large installed customer base and growth profile. We purchase large quantities of computing and data center assets, which allows us to negotiate higher volume pricing savings. We are also able to make larger R&D investments than many of our smaller competitors due to our ability to spread these costs across a larger base of revenue.

 

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Key Metrics

We carefully track several financial and operational metrics to monitor and control 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 Annual Report on Form 10-K.

 

     Year Ended  

(Dollar amounts in thousands, except annualized net

revenue per average technical square foot)

   December 31,
2007
    December 31,
2008
    December 31,
2009
 

Growth

      

Managed hosting customers at period end

     15,454        18,480        19,304   

Cloud customers at period end **

     13,739        34,820        71,621   
                        

Number of customers at period end

     29,193        53,300        90,925   

Managed hosting, net revenue

   $ 356,519      $ 506,855      $ 572,606   

Cloud, net revenue

   $ 5,498      $ 25,078      $ 56,381   
                        

Net revenue

   $ 362,017      $ 531,933      $ 628,987   

Revenue growth (year over year)

     61.6     46.9     18.2

Net upgrades (monthly average)

     2.5     1.8     1.2

Churn (monthly average)

     -0.9     -1.2     -1.0
                        

Growth in installed base (monthly average) *

     1.6     0.6     0.2

Number of employees (Rackers) at period end

     2,021        2,611        2,774   

Number of servers deployed at period end

     36,692        47,518        56,671   

Profitability

      

Income from operations

   $ 30,609      $ 40,149      $ 55,241   

Depreciation and amortization

   $ 56,476      $ 90,172      $ 125,229   

Share-based compensation expense

      

Cost of revenue

   $ 433      $ 2,465      $ 2,850   

Sales and marketing

   $ 598      $ 2,141      $ 2,884   

General and administrative

   $ 3,221      $ 10,411      $ 14,390   
                        

Total share-based compensation expense

   $ 4,252      $ 15,017      $ 20,124   
                        

Adjusted EBITDA (1)

   $ 91,337      $ 145,338      $ 200,594   
                        

Adjusted EBITDA margin

     25.2     27.3     31.9

Operating income margin

     8.5     7.5     8.8

Income from operations

   $ 30,609      $ 40,149      $ 55,241   

Effective tax rate

     35.9     33.6     35.1
                        

Net operating profit after tax (NOPAT) (1)

   $ 19,620      $ 26,659      $ 35,851   

NOPAT margin

     5.4     5.0     5.7

Capital efficiency and returns

      

Interest bearing debt

   $ 111,451      $ 300,413      $ 167,386   

Stockholders’ equity

   $ 96,873      $ 269,684      $ 349,427   

Less: Excess cash

   $ —        $ (200,620   $ (105,083
                        

Capital base

   $ 208,324      $ 369,477      $ 411,730   

Average capital base

   $ 144,783      $ 292,238      $ 390,472   

Capital turnover (annualized)

     2.50        1.82        1.61   

Return on capital (annualized) (1)

     13.6     9.1     9.2

Capital expenditures

      

Purchases of property and equipment, net

   $ 140,383      $ 165,396      $ 117,292   

Vendor financed equipment purchases

   $ 44,149      $ 85,490      $ 68,382   
                        

Total capital expenditures

   $ 184,532      $ 250,886      $ 185,674   

Customer gear

   $ 85,162      $ 105,606      $ 108,829   

Data center build outs

   $ 38,239      $ 79,820      $ 37,208   

Office build outs

   $ 35,383      $ 41,214      $ 14,672   

Capitalized software and other projects

   $ 25,748      $ 24,246      $ 24,965   
                        

Total capital expenditures

   $ 184,532      $ 250,886      $ 185,674   

Infrastructure capacity and utilization

      

Technical square feet of data center space at period end

     114,749        134,923        162,848   

Annualized net revenue per average technical square foot

   $ 3,604      $ 4,189      $ 3,929   

Utilization rate at period end

     60.9     70.4     65.3

 

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

 

** Beginning in 2009, amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third party storage solution are excluded.

 

(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.

 

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Executive 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 fiscal year. These sections should be read in conjunction with the more detailed discussion and analysis of our financial condition and results of operations in Item 7, our “Risk Factors” section included in Item 1A of Part I, and our audited consolidated financial statements and notes included in Item 8 of Part II of this report.

We have focused on three areas in 2009, which include the continued growth of our business (albeit at lower rates than in the past primarily due to the recent economic conditions), scaling our profits and returns, and focusing on the minimal use of cash to achieve our growth.

Growth of Our Business. Our business has grown in 2009 with net revenue year over year growth of $97.1 million, or 18.3%, to $629.0 million compared to $531.9 million in 2008. Our increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of new customers and incremental services rendered to existing customers. Year-over-year revenue increases were 13.0% for our managed hosting service and 124.8% for our cloud computing service. Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the pound sterling. Net revenue in 2009 would have been approximately $28 million higher had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.

Our 2009 performance was the result of a combination of continued market demand for our hosting services as well as our focused execution on our growth strategy. As of December 31, 2009, we served over 90,000 customers running on over 56,600 servers within our data centers in the U.S., the U.K., and Hong Kong, which represented incremental increases in each category as compared to 2008. The recent economic downturn caused many of our customers to respond with reductions in their IT spending. As a result, we experienced fewer upgrades from our installed base customers that resulted in slower revenue growth when compared to previous years. However, during 2009, we experienced a monthly average churn rate of 1.0%, which slightly decreased from 1.2% for 2008. Overall, our installed base continued to provide a portion of our growth in 2009, growing at an average rate of 0.2% in 2009, compared to 0.6% in 2008 and 1.6% in 2007, respectively. In the fourth quarter of 2009, our churn rate was 0.8% and installed base growth was 0.4%.

Despite the current challenging economic environment, we believe there are fundamental aspects of our business that will allow us to differentiate from our competitors. Our hosting services provide customers with a mission critical service and world class support and we believe this provides us with substantial growth opportunities, even in a more constrained spending environment. We also believe that the investments in our portfolio of services and our ability to deliver a superior service outcome to our customers will lead to an increase in market share once the economy begins to recover.

Our revenue growth has moved us into a new competitive landscape where our direct competitors are much larger and stronger financially. We will be competing more directly with Amazon, Microsoft, IBM and Google as hosting services become increasingly more virtualized. Accordingly, we anticipate increased infrastructure investments to complement and leverage Fanatical Support®, our principal differentiation from our competitors across our multiple service lines.

Scaling Profits and Returns. During 2008 and continuing into 2009, we implemented a series of operational excellence initiatives and began to experience the benefit in 2009 with a reduction in each cost category on a percentage of revenue basis as compared to the previous year resulting in improved margins. Our initiatives focused on scaling expenses, and redirecting our spend to areas that would provide more value, particularly in the area of sales and marketing. In addition, initiatives were put into place to more efficiently deploy our capital.

Income from operations increased $15.1 million, or 37.7%, to $55.2 million in 2009, compared to $40.1 million in 2008. Operating income margin was 8.8% in 2009 as compared to 7.5% in 2008. Adjusted EBITDA

 

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increased $55.3 million, or 38.1%, to $200.6 million in 2009, compared to $145.3 million in 2008. In addition, Adjusted EBITDA as a percentage of revenue was 31.9% in 2009 compared to 27.3% in 2008. See the following section on non-GAAP financial measures for a discussion of Adjusted EBITDA. Net income was $30.2 million or $0.24 per share on a diluted basis in 2009, compared to net income of $21.7 million, or $0.19 per share on a diluted basis in 2008. Net income margin was 4.8% in 2009 as compared to 4.1% in 2008.

Use of Cash. For the year ended December 31, 2009, we generated adjusted free cash flow of $13.8 million. See below for our discussion of Non-GAAP Financial Measures.

During 2009, except for $150 million of repayments of our line of credit, we were able to maintain a consistent level of cash and cash equivalents while growing our business by maintaining our disciplined use of capital. Our capital expenditures for 2009 were $185.7 million of which $68.4 million was vendor financed, while our cash provided by operating activities was $196.9 million. In 2009, we deployed an additional 9,153 servers, bringing our total servers to 56,671, an increase of 19.3%. We also completed the build out of our Grapevine, Texas and data center and the second phase of our Slough, U.K. data center, in the first half of the year. As of December 31, 2009, we had $64.7 million in cash deposits and $60.7 million in money market funds.

We will continue to focus on these three areas in 2010. We expect to grow our business by broadening our portfolio of offerings in dedicated hosting and cloud computing, and we will continue to look at growth opportunities through acquisitions. We will continue our focus on expense management while improving our resource allocation to fund investment in strategic initiatives related to our data center expansion efforts and further growth in our portfolio of services, while striving to minimize our use of cash.

Company Highlights and Developments

Cloud Computing Offerings

We continue to invest in our cloud computing business and believe it is a critical part of our future success. Cloud computing, which consists of Cloud Hosting and Cloud Applications, 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 cloud computing is the value proposition that it provides for businesses. It enables businesses to match costs directly to revenue to scale up and down on a real time basis as necessary. We do not believe that cloud computing will replace traditional dedicated hosting offerings, but rather complement them, allowing customers to choose from a portfolio of offerings to meet need their business needs.

During 2009, we released the specifications for our Cloud Servers and Cloud Files APIs under the Creative Commons 3.0 Attribution open source license and 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 May 2009, we launched a new release of our business-class email hosting service. Rackspace hosts over 1.6 million mailboxes across its hosted email offerings, Rackspace Email and Microsoft Exchange.

In February 2010, we launched a beta version of Cloud Servers for Windows. This offering combines Microsoft technology with utility pricing and on-demand service, which will allow Windows users to deploy servers in minutes and pay only for what they use. This offering expands the number of potential customers for our Cloud offering.

Data Center Infrastructure and Growth

During 2009, we continued to add to our existing data center footprint both in the U.S. and internationally to support our growth. We added an approximate net 27,900 technical square feet of data center space.

In June 2009 and December 2009, we experienced service interruptions in a portion of our data center operations in Grapevine, Texas. As a result, certain customers experienced downtime and in the second and

 

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fourth quarters we extended approximately $2.4 million and $1.3 million, respectively, in service credits to them. We have been working to reduce the likelihood of further incidents at this data center and our other data centers throughout the world. While we have not experienced larger than normal customer attrition following these interruptions, the extent of any damage to our reputation is difficult to access.

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 periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

Consolidated Statements of Income:

 

     Year Ended December 31,  
(In thousands)    2007     2008     2009  

Net revenue

   $ 362,017      $ 531,933      $ 628,987   

Costs and expenses:

      

Cost of revenue

     118,225        172,583        200,943   

Sales and marketing

     53,930        80,323        79,458   

General and administrative

     102,777        148,706        168,116   

Depreciation and amortization

     56,476        90,172        125,229   
                        

Total costs and expenses

     331,408        491,784        573,746   
                        

Income from operations

     30,609        40,149        55,241   
                        

Other income (expense):

      

Interest expense

     (3,643     (8,229     (8,950

Interest and other income (expense)

     828        768        255   
                        

Total other income (expense)

     (2,815     (7,461     (8,695
                        

Income before income taxes

     27,794        32,688        46,546   

Income taxes

     9,965        10,985        16,328   
                        

Net income

   $ 17,829      $ 21,703      $ 30,218   
                        

Consolidated Statements of Income, as a Percentage of Net Revenue:

 

     Year Ended December 31,  
(Percent of net revenue)    2007     2008     2009  

Net revenue

   100.0   100.0   100.0

Costs and expenses:

      

Cost of revenue

   32.7   32.4   31.9

Sales and marketing

   14.9   15.1   12.6

General and administrative

   28.4   28.0   26.7

Depreciation and amortization

   15.6   17.0   19.9
                  

Total costs and expenses

   91.5   92.5   91.2
                  

Income from operations

   8.5   7.5   8.8
                  

Other income (expense):

      

Interest expense

   -1.0   -1.5   -1.4

Interest and other income (expense)

   0.2   0.1   0.0
                  

Total other income (expense)

   -0.8   -1.4   -1.4
                  

Income before income taxes

   7.7   6.1   7.4

Income taxes

   2.8   2.1   2.6
                  

Net income

   4.9   4.1   4.8
                  

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

 

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Years ended December 31, 2008 and December 31, 2009

Net Revenue

Our net revenue was $531.9 million during 2008 and $629.0 million during 2009, an increase of $97.1 million, or 18.3%. The increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of new 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 in 2009 compared to 2008. Net revenue for 2009 would have been approximately $28 million higher had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year 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.

Cost of Revenue

Our cost of revenue was $172.6 million during 2008 and $200.9 million during 2009, an increase of $28.3 million, or 16.4%. Of this increase, $12.8 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 data center costs of $6.8 million related to bandwidth, power and rent, and an increase in license costs of approximately $8.9 million. Included in the $6.8 million increase in bandwidth, power and rent is an increase of $2.3 million in rent expense primarily related to the data center operating leases entered into in Northern Virginia and the Chicago area. Impacting the $8.9 million increase in license costs was a $2.1 million decrease related to the reversal of a previously recorded obligation relating to an unresolved contractual issue with a vendor. During the fourth quarter of 2009, we concluded that the obligation was no longer probable, and accordingly, we reversed the liability, which reduced cost of revenue.

Sales and Marketing Expenses

Our sales and marketing expenses were $80.3 million during 2008 and $79.5 million during 2009, a decrease of $0.8 million, or 1.0%. The decrease was primarily attributable to a $7.1 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. Partially offsetting the decrease was a $6.2 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 $148.7 million during 2008 and $168.1 million during 2009, an increase of $19.4 million, or 13.0%. Of this increase, $12.0 million was attributable to an increase in salaries and benefits, of which share-based compensation expense increased by $4.0 million in 2009 as a result of stock option and restricted stock unit grants to employees in previous years. Bad debt expense increased $3.4 million primarily due to customers generally extending payment terms or not being able to pay as a result of the recent economic conditions. Also contributing to the increase in bad debt expense was a larger accounts receivable balance in conjunction with the 18.3% increase in revenue from 2008 to 2009.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $90.2 million during 2008 and $125.2 million during 2009, an increase of $35.0 million, or 38.8%. This 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

 

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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 $8.2 million during 2008 and $9.0 million during 2009, an increase of $0.8 million or 9.8%. This increase was primarily due to the increased level of indebtedness (including capital leases), which was mostly offset by decreased borrowing rates. Interest expense was partially offset by capitalized interest of $2.7 million during 2008 and $0.8 million during 2009.

Interest and other income (expense) was $0.8 million during 2008 and $0.3 million during 2009. In 2008, we recognized $1.4 million in interest income, partially offset by foreign currency losses of $0.6 million. In 2009, we recognized $0.4 million of interest and other income, partially offset by foreign currency losses of $0.2 million.

Income Taxes

Our effective tax rate increased from 33.6% for 2008 to 35.1% for 2009. The increase in the overall tax rate from 2008 to 2009 was primarily the result of a larger benefit recognized in 2008 with respect to the Research and Development credit. 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, 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.

For a full reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Item 8 of Part II, “Financial Statements and Supplementary Data— Note 18—Income Taxes.”

Years ended December 31, 2007 and December 31, 2008

Net Revenue

Our net revenue was $362.0 million during 2007 and $531.9 million during 2008, an increase of $169.9 million, or 46.9%. The 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. Revenue from our acquisitions was not significant.

Cost of Revenue

Our cost of revenue was $118.2 million during 2007 and $172.6 million during 2008, an increase of $54.4 million, or 46.0%. Of this increase, $26.7 million was attributable to an increase in salaries, benefits, and share-based compensation expense. The cost increase was further attributable to an increase in license costs of approximately $12.8 million, an increase in data center costs of $9.6 million related to bandwidth, power, and rent, as well as maintenance and the replacement of IT equipment parts in the amount of $5.2 million.

Sales and Marketing Expenses

Our sales and marketing expenses were $53.9 million during 2007 and $80.3 million during 2008, an increase of $26.4 million, or 49.0%. Of this increase, $13.9 million was primarily 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

 

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increased sales. An additional $12.5 million of this increase was primarily attributable to advertising, Internet-related marketing expenditures and partnership programs to support revenue growth for new and existing customer accounts.

General and Administrative Expenses

Our general and administrative expenses were $102.8 million during 2007 and $148.7 million during 2008, an increase of $45.9 million, or 44.6%. Of this increase, $33.1 million was attributable to an increase in salaries and benefits, of which share-based compensation expense increased from $3.2 million 2007 to $10.4 million in 2008 as a result of broad based stock option grants to employees in 2008. Our general overhead expenses increased approximately $4.0 million as a result of higher general corporate costs due to additional headcount. In addition, we experienced an increase in professional fees of $2.2 million and credit card fees of $1.4 million, as well as costs related to our overall growth, including property taxes, insurance and increased office rents of $5.2 million.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $56.5 million during 2007 and $90.2 million during 2008, an increase of $33.7 million, or 59.6%. This increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets, as well as intangible assets acquired in an acquisition.

Other Income (Expense)

Our interest expense was $3.6 million during 2007 and $8.2 million during 2008, an increase of $4.6 million or 127.8%. This relative increase was primarily due to the increased level of indebtedness partially offset by an increase in capitalized interest. We capitalized interest of $1.0 million during 2007 and $2.7 million during 2008, an increase of $1.7 million primarily due to data center and office build outs.

Interest and other income (expense) was $0.8 million during 2007 and $0.8 million during 2008. In 2008, we recognized $1.4 million in interest income, partially offset with foreign currency losses of $0.6 million due to the appreciation of the U.S. dollar against the pound sterling. In 2007, we recognized $0.8 million of interest income and minimal foreign currency gains or losses.

Income Taxes

Our effective tax rate decreased from 35.9% during 2007 to 33.6% during 2008, primarily a result of earnings in 2008 being realized in countries where we have lower statutory rates than in the previous year and research and development credits utilized by our U.S. subsidiaries in 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, the 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.

Quarterly Key Metrics and Results of Operations

The following tables set forth our unaudited quarterly key metrics and condensed consolidated statement of operations data in dollars and as a percentage of revenue for each of our most recent five quarters as of the period ended December 31, 2009. The quarterly data presented below has been prepared on a basis consistent with the audited consolidated financial statements included elsewhere in this document, and in the opinion of management reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information. You should read this information together with our consolidated financial statements and related notes included elsewhere in this document. Our quarterly results of operations may

 

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fluctuate in the future due to a variety of factors. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Our results for these quarterly periods are not necessarily indicative of the results of operations for a full year or any period.

 

    Three Months Ended  
    (Unaudited)  
(Dollar amounts in thousands, except annualized net
revenue per average technical square foot)
  December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
 

Growth

         

Managed hosting customers at period end

    18,480        19,048        19,363        19,328        19,304   

Cloud customers at period end **

    34,820        43,030        51,440        61,616        71,621   
                                       

Number of customers at period end

    53,300        62,078        70,803        80,944        90,925   

Managed hosting, net revenue

  $ 134,275      $ 134,204      $ 138,943      $ 147,065      $ 152,394   

Cloud, net revenue

  $ 8,862      $ 10,873      $ 13,052      $ 15,334      $ 17,122   
                                       

Net revenue

  $ 143,137      $ 145,077      $ 151,995      $ 162,399      $ 169,516   

Revenue growth (year over year)

    34.2     21.3     16.2     17.4     18.4

Net upgrades (monthly average)

    1.4     0.9     1.2     1.2     1.3

Churn (monthly average)

    -1.3     -1.1     -1.0     -1.1     -0.8
                                       

Growth in installed base (monthly average) *

    0.1     -0.2     0.2     0.1     0.4

Number of employees (Rackers) at period end

    2,611        2,661        2,648        2,730        2,774   

Number of servers deployed at period end

    47,518        50,038        52,269        54,655        56,671   

Profitability

         

Income from operations

  $ 12,125      $ 13,021      $ 13,403      $ 13,128      $ 15,689   

Depreciation and amortization

  $ 26,310      $ 27,804      $ 29,711      $ 32,696      $ 35,018   

Share-based compensation expense

         

Cost of revenue

  $ 678      $ 629      $ 675      $ 778      $ 768   

Sales and marketing

  $ 595      $ 698      $ 721      $ 826      $ 639   

General and administrative

  $ 2,871      $ 2,910      $ 3,621      $ 4,008      $ 3,851   
                                       

Total share-based compensation expense

  $ 4,144      $ 4,237      $ 5,017      $ 5,612      $ 5,258   
                                       

Adjusted EBITDA (1)

  $ 42,579      $ 45,062      $ 48,131      $ 51,436      $ 55,965   
                                       

Adjusted EBITDA margin

    29.7     31.1     31.7     31.7     33.0

Operating income margin

    8.5     9.0     8.8     8.1     9.3

Income from operations

  $ 12,125      $ 13,021      $ 13,403      $ 13,128      $ 15,689   

Effective tax rate

    27.7     36.6     36.2     33.9     34.0
                                       

Net operating profit after tax (NOPAT) (1)

  $ 8,766      $ 8,255      $ 8,551      $ 8,678      $ 10,355   

NOPAT margin

    6.1     5.7     5.6     5.3     6.1

Capital efficiency and returns

         

Interest bearing debt

  $ 300,413      $ 201,507      $ 210,284      $ 167,976      $ 167,386   

Stockholders’ equity

  $ 269,684      $ 282,880      $ 308,823      $ 330,392      $ 349,427   

Less: Excess cash

  $ (200,620   $ (117,611   $ (129,638   $ (83,462   $ (105,083
                                       

Capital base

  $ 369,477      $ 366,776      $ 389,469      $ 414,906      $ 411,730   

Average capital base

  $ 350,499      $ 368,127      $ 378,123      $ 402,188      $ 413,318   

Capital turnover (annualized)

    1.63        1.58        1.61        1.62        1.64   

Return on capital (annualized) (1)

    10.0     9.0     9.0     8.6     10.0

Capital expenditures

         

Purchases of property and equipment, net

  $ 32,547      $ 25,589      $ 31,027      $ 26,024      $ 34,652   

Vendor financed equipment purchases

  $ 14,848      $ 11,683      $ 23,637      $ 20,664      $ 12,398   
                                       

Total capital expenditures

  $ 47,395      $ 37,272      $ 54,664      $ 46,688      $ 47,050   

Customer gear

  $ 23,073      $ 19,255      $ 32,448      $ 28,705      $ 28,421   

Data center build outs

  $ 14,240      $ 11,386      $ 13,914      $ 4,028      $ 7,880   

Office build outs

  $ 8,340      $ 2,239      $ 1,651      $ 5,432      $ 5,350   

Capitalized software and other projects

  $ 1,742      $ 4,392      $ 6,651      $ 8,523      $ 5,399   
                                       

Total capital expenditures

  $ 47,395      $ 37,272      $ 54,664      $ 46,688      $ 47,050   

Infrastructure capacity and utilization

         

Technical square feet of data center space at period end ***

    134,923        157,523        177,371        167,821        162,848   

Annualized net revenue per average technical square foot

  $ 4,212      $ 3,969      $ 3,631      $ 3,764      $ 4,101   

Utilization rate at period end

    70.4     64.6     59.8     62.3     65.3

 

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

 

** Beginning March 31, 2009, amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third party storage solution are excluded.

 

*** The technical square feet in the second half of 2009 was impacted by the decommissioning of operations at U.K. data centers that were migrated to the Slough data center.

 

(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.

 

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Consolidated Statements of Income by Quarter:

 

    Three Months Ended  
(In thousands)   December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
 
    Unaudited  

Net revenue

  $ 143,137      $ 145,077      $ 151,995      $ 162,399      $ 169,516   

Costs and expenses:

         

Cost of revenue

    45,019        46,210        48,235        53,093        53,405   

Sales and marketing

    21,447        20,502        19,080        19,860        20,016   

General and administrative

    38,236        37,540        41,566        43,622        45,388   

Depreciation and amortization

    26,310        27,804        29,711        32,696        35,018   
                                       

Total costs and expenses

    131,012        132,056        138,592        149,271        153,827   
                                       

Income from operations

    12,125        13,021        13,403        13,128        15,689   
                                       

Other income (expense):

         

Interest expense

    (3,153     (2,535     (2,172     (2,147     (2,096

Interest and other income (expense)

    492        (91     (267     523        90   
                                       

Total other income (expense)

    (2,661     (2,626     (2,439     (1,624     (2,006
                                       

Income before income taxes

    9,464        10,395        10,964        11,504        13,683   

Income taxes

    2,620        3,807        3,973        3,900        4,648   
                                       

Net income

  $ 6,844      $ 6,588      $ 6,991      $ 7,604      $ 9,035   
                                       

Consolidated Statements of Income by Quarter, as a Percentage of Net Revenue:

 

     Three Months Ended  
(Percent of net revenue)    December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
 
     Unaudited  

Net revenue

   100.0   100.0   100.0   100.0   100.0

Costs and expenses:

          

Cost of revenue

   31.5   31.9   31.7   32.7   31.5

Sales and marketing

   15.0   14.1   12.6   12.2   11.8

General and administrative

   26.7   25.9   27.3   26.9   26.8

Depreciation and amortization

   18.4   19.2   19.5   20.1   20.7
                              

Total costs and expenses

   91.5   91.0   91.2   91.9   90.7
                              

Income from operations

   8.5   9.0   8.8   8.1   9.3
                              

Other income (expense):

          

Interest expense

   -2.2   -1.7   -1.4   -1.3   -1.2

Interest and other income (expense)

   0.3   -0.1   -0.2   0.3   0.1
                              

Total other income (expense)

   -1.9   -1.8   -1.6   -1.0   -1.2
                              

Income before income taxes

   6.6   7.2   7.2   7.1   8.1

Income taxes

   1.8   2.6   2.6   2.4   2.7
                              

Net income

   4.8   4.5   4.6   4.7   5.3
                              

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

 

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Fourth Quarter 2009 Overview

Revenue increased sequentially in each of the quarters presented due to increased sales of our services to new and existing customers. Net revenue for the three-month period ended December 31, 2009 was $169.5 million, up 18.4% from $143.1 million in the three-month period ended December 31, 2008. Throughout 2009, the growth rate was negatively impacted by the economic conditions and decreased IT spending by our customers. In the three months ended March 31, 2009 and December 31, 2009, the growth rate was negatively impacted by the strengthening U.S. dollar versus the pound sterling. For the three months ended June 30, 2009 and September 30, 2009 we experienced a favorable impact by a weakening U.S. dollar versus the pound sterling. For the twelve month period ended December 31, 2009, our average monthly growth in installed base was 0.2% per month.

Because of the growth of our revenue, total operating expenses increased sequentially in each of the quarters presented; however, most operating expense categories were relatively flat as a percentage of revenue. During the second half of 2008 and continuing into 2009 we focused on scaling our expenditures, which is evidenced in the reduction in sales and marketing 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 by 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 completion of the third phase of our Grapevine, Texas data center in January 2009, the second phase of our Slough U.K. data center in June 2009, and the addition of new data centers in Northern Virginia and the Chicago area, as well as capital expenditures related to the build out of the corporate facility.

During the fourth quarter of 2009, we recognized an increase in income from operations as compared to the previous quarter. Our operating income margin increased from 8.1% in third quarter 2009, to 9.3% in the fourth quarter 2009 and increased sequentially in each of the quarters presented. This change was, in a large part, due to the growth in revenue and decrease in operating expenses as a percentage of revenue, which was attributable to our efforts to better manage expenses. In addition, we previously recorded a $2.1 million charge to cost of revenue related to an unresolved contractual issue with a vendor. During 2009, we concluded that the obligation was no longer probable, and accordingly, during the fourth quarter of 2009 we reversed the liability, which reduced cost of revenue. Due to the lapsing of the associated contractual period, we believe the contingency has been resolved.

Also during the fourth quarter of 2009, our churn was 0.8%, which is our lowest level of churn since the fourth quarter of 2007. Installed base growth was 0.4% and bad debt expense was $436 thousand, a decrease of $1.8 million from the previous quarter.

Liquidity and Capital Resources

At December 31, 2009, we held $125.4 million in cash and cash equivalents. 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 generally sufficient to support business operations, capital expenditures, and management’s strategic initiatives.

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 provides some protection against fluctuations in currencies in the countries in which we do business. The credit facility also has financial covenants that include a minimum fixed charge coverage ratio of at least 1.25 to 1.00 until the three months ended December 31, 2009 and 1.50 to 1.00 for every quarter thereafter and a maximum funded debt to EBITDA of not greater than 3.00 to 1.00. Also, our foreign cash balance is limited to a balance of $25 million. As of December 31, 2009, we were in compliance with all of the covenants under our facility.

 

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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 December 31, 2009. The decrease in amounts outstanding under our line of credit was due to the repayment of $150.0 million in 2009. As of December 31, 2009, we had an additional $194.3 million available for future borrowings. Our credit facility expires in August 2012.

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 2009 we had $100.4 million and $117.4 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 most likely will continue to finance purchases through these arrangements.

Capital Expenditure Requirements

In 2010, we expect to have capital expenditures between $185 million and $235 million in the aggregate consisting of $140 million to $160 million for customer gear, $10 million to $20 million for data center infrastructure costs, $10 million to $20 million for office build-outs, and $25 million to $35 million for capitalized software and other projects.

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:

 

     Years Ended December 31,  
(In thousands)    2007     2008     2009  

Cash provided by operating activities

   $ 104,935      $ 136,582      $ 196,868   

Cash used in investing activities

   $ (140,721   $ (175,135   $ (124,114

Cash provided by (used in) financing activities

   $ 52,379      $ 255,413      $ (187,287

Acquisition of property and equipment by capital leases and equipment notes payable

   $ 44,149      $ 85,490      $ 68,382   

 

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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 $136.6 million in 2008 compared to $196.9 million in 2009, an increase of $60.3 million, or 44.1%. Net income increased from $21.7 million in 2008 to $30.2 million in 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 $90.2 million in 2008 compared to $125.2 million in 2009. The increase in depreciation and amortization was due to the purchases of servers, networking gear and computer software (internally developed technology), electrical equipment, and leasehold improvements primarily for data center expansion, as well as amortization of intangibles related to acquisitions.

 

   

Our provision for bad debts and customer credits increased from $4.1 million in 2008 to $10.3 million in 2009 primarily due to certain customers’ inability to pay as a result of the economic conditions throughout 2009 and increased service credits.

 

   

Share-based compensation expense was $15.0 million in 2008 compared to $20.1 million in 2009. The increase in expense was due to stock options and restricted stock units granted in 2008 and 2009.

 

   

The change in accounts receivable was a cash outflow of $12.2 million in 2008 compared to a cash outflow of $17.1 million in 2009. Our accounts receivable balance has increased during 2009 as a result of increased sales and slower customer payment patterns that are being influenced by the economic conditions throughout 2009.

 

   

The change in income taxes receivable was a cash outflow of $12.3 million in 2008 compared to a cash inflow of $4.8 million in 2009. As we anticipated a net loss on a tax basis in 2008, the December 31, 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 was a cash inflow of $13.4 million in 2008 compared to a cash inflow of $14.6 million in 2009. The change resulted from the timing of payments for trade payables.

 

   

The change in deferred revenue was a cash inflow of $1.9 million in 2008 compared to a cash outflow of $1.2 million in 2009. The change is primarily due to the company billing fewer customers for setup fees as well as fewer customers prepaying for their services.

Net cash provided by operating activities was $104.9 million in 2007 compared to $136.6 million in 2008, an increase of $31.7 million or 30.2%. Net income increased from $17.8 million in 2007 to $21.7 million in 2008.

During 2007 and 2008, we incurred depreciation and amortization charges in the amount of $56.5 million and $90.2 million, respectively. The increase in depreciation and amortization was due to the acquisition of servers, networking gear and computer software. We further incurred non-cash compensation expense in the amount of $4.4 million and $15.3 million in 2007 and 2008, respectively. The increase was mainly due to share-based compensation from stock option grants to certain strategic hires and employees, and increased fair values for granted stock options.

Our changes in certain assets and liabilities in 2008 compared to 2007 primarily consisted of the recognition of a $12.3 million income tax receivable in 2008 resulting from accelerated tax depreciation and research and development credits and cash inflows from accounts payable and accrued expenses. Cash inflows from accounts payable and accrued expenses were $39.2 million in 2007 compared to $13.4 million in 2008. The increases in accounts payable and accrued expenses are a direct result of the growth of our business, increases in headcount and timing of payments.

 

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Investing Activities

Net cash used in investing activities was primarily 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 $175.1 million during 2008 compared to $124.1 million during 2009, a decrease of $51.0 million, or 29.1%. This decrease in net cash used in investing activities comes from a decrease in the purchase of property and equipment of $48.1 million, and a $2.9 million decrease related to acquisitions. Cash outflows from earnout payments in 2009 relate to acquisitions that occurred in 2008.

The combined total of capital expenditures for property and equipment, net decreased from $250.9 million during 2008 to $185.7 million in 2009. Of the 2009 amount, $108.8 million was used to purchase dedicated customer equipment, $37.2 million for data center build outs, $14.7 million related to build out of office space and $25.0 million was invested in capitalized software, including internally developed software that is focused on improving our service offerings, and other purchases. Of the dedicated customer equipment, $68.4 million was vendor financed by capital leases and notes payable in 2009 compared to $85.5 million in 2008.

The decrease in capital expenditures from 2008 to 2009 was primarily comprised of decreases in spending on data center build outs and build outs of office space. The decrease in data center build outs was the result of capital expenditures made in 2008 for the completion of the last phase of the Grapevine, Texas data center that was completed in January 2009. Additionally, in 2009 we entered into leases for approximately 47,700 technical square feet in data center facilities in Northern Virginia and the Chicago area. The decrease in build outs of office space was the result of lower spending on our headquarters facility in 2009 as compared to 2008.

Our net cash used in investing activities was $140.7 million during 2007 compared to $175.1 million during 2008, an increase of $34.4 million, or 24.5%. This increase in net cash used in investing activities comes from an increase in the purchase of property and equipment of $25.0 million. The remaining increase of $9.4 million was related to the acquisition of Jungle Disk and Slicehost.

The combined total of capital expenditures for property and equipment, net increased from $184.5 million during 2007 to $250.9 million in 2008 to support our growth including an increase in customer gear of $20.4 million and data center build outs of $41.6 million. Of the 2008 amount, $105.6 million was used to purchase dedicated customer equipment, $79.8 million for data center build outs, $41.2 million related to build out of office space and $24.2 million was invested in capitalized software, including internally developed software that is focused on improving our service offerings, and other purchases. Of the dedicated customer equipment, $85.5 million was vendor financed by capital leases and notes payable in 2008 compared to $44.1 million during 2007.

Financing Activities

Net cash provided by (used in) financing activities was $255.4 million during 2008 compared to $(187.3) million during 2009, a change of $442.7 million. This change was due primarily to $144.6 million of funds received from the completion of our initial public offering in August 2008 plus net advances from our revolving line of credit of $142.7 million during 2008 compared to net payments of $150.0 million to our revolving line of credit during 2009. Our net leverage as of December 31, 2009 was 0.21 times. See below for our discussion of Non-GAAP Financial Measures.

Net cash provided by financing activities was $52.4 million during 2007 compared to $255.4 million during 2008, an increase of $203.0 million or 387.4%. This increase was due primarily to $144.6 million of funds received from the completion of our initial public offering plus net advances from our revolving line of credit of $142.7 million 2008 compared to net advances of $56.1 million from our revolving line of credit during 2007. Partially offsetting the cash inflows were principal payments related to capital leases and notes payable in the amounts of $17.8 million during 2007 and $39.2 million during 2008.

 

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Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of December 31, 2009:

 

(In thousands)    Total    2010    2011-2012    2013-2014    2015 and
Beyond
     (Unaudited)

Capital leases (1)

   $ 117,142    $ 52,698    $ 61,949    $ 2,495    $ —  

Operating leases

     235,358      16,585      38,387      35,245      145,141

Purchase commitments

     14,794      13,519      1,275      —        —  

Revolving credit facility (2)

     50,000      —        50,000      —        —  

Software and equipment notes (2)

     7,684      4,893      2,791      —        —  
                                  

Total contractual obligations

   $ 424,978    $ 87,695    $ 154,402    $ 37,740    $ 145,141
                                  

 

 

(1) Represents principal and interest.

 

(2) Represents principal only.

Leases

Capital leases are primarily related to expenditures for IT equipment. Our operating leases are primarily for office space and data center facilities.

In February 2009, Rackspace entered into an agreement to lease 11,000 technical square feet in a data center facility located in Northern Virginia. The lease has a term of 15 years from the commencement date and a total estimated financial obligation of approximately $75 to $80 million over the 15 year term, inclusive of base lease payments, power costs and Rackspace’s pro-rata share of operating expenses. Rackspace has a one-time option to terminate the lease after ten years.

In July 2009, Rackspace entered into an agreement to lease approximately 36,700 square feet of raised floor space and approximately 10,000 square feet of office and storage space in a data center facility located in the Chicago area. The lease has a term of 15 years from the commencement date and a total financial obligation of approximately $140 million to $150 million over the 15 year term, inclusive of base lease payments and Rackspace’s pro-rata share of operating expenses. Upon expiration of the 15 year term, Rackspace has the option to renew the lease for two successive five year periods.

Purchase Commitments

Our purchase commitments are primarily related to costs associated with our data centers including bandwidth and consulting services.

Revolving Credit Facility

We entered into our credit facility in March 2007. In February 2008, we amended the credit facility and increased the committed amount from $200.0 million to $245.0 million. As of December 31, 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. The credit facility has a variable interest rate, which is generally the London Interbank Offered Rate (LIBOR) margin plus a margin spread. The rate was equal to 1.29% at December 31, 2009.

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.

 

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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. The interest rates on the arrangements range from 0.0% to 6.0%.

Non-GAAP Financial Measures

Return on Capital (ROC) (Non-GAAP financial measure)

We define Return on Capital (ROC) 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)

Beginning in 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 Grapevine, Texas 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 decreased from 13.6% in 2007 to 9.1% in 2008 and increased to 9.2% in 2009. The overall decrease from 2007 is due to a proportionately larger increase in the average capital base compared to the increase in income from operations over the same time period. Beginning in 2008, the average capital base includes capital expenditures related to our new corporate headquarter facility and data centers that were or are in the process of being built out. Return on assets decreased from 8.5% in 2007 to 4.5% in 2008 and increased to 4.7% in 2009 due to the significant investments over the time periods. In addition, beginning in the second half of 2008 we had higher cash and cash equivalent balances due to our IPO in August 2008, and a draw on our revolving credit facility resulting from the uncertainty in the credit markets.

 

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

 

     Year Ended December 31,  
(Dollars in thousands)    2007     2008     2009  

Income from operations

   $ 30,609      $ 40,149      $ 55,241   

Effective tax rate

     35.9     33.6     35.1
                        

Net operating profit after tax (NOPAT)

   $ 19,620      $ 26,659      $ 35,851   

Net income

   $ 17,829      $ 21,703      $ 30,218   

Total assets at period end

   $ 301,813      $ 685,261      $ 668,645   

Less: Excess cash

     —          (200,620     (105,083

Less: Accounts payable and accrued expenses

     (76,494     (71,387     (89,773

Less: Deferred revenues (current and non-current)

     (19,762     (20,167     (19,444

Less: Other non-current liabilities and deferred taxes

     (9,624     (23,610     (42,615
                        

Capital base

   $ 195,933      $ 369,477      $ 411,730   

Average total assets

   $ 210,606      $ 487,183      $ 647,493   

Average capital base

   $ 144,783      $ 292,238      $ 390,472   

Return on assets (Net income/Average total assets)

     8.5     4.5     4.7

Return on capital (NOPAT/Average capital base)

     13.6     9.1     9.2

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

 

     Three Months Ended  
     (Unaudited)  
(In thousands, except financial metrics)    December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
 

Income from operations

   $ 12,125      $ 13,021      $ 13,403      $ 13,128      $ 15,689   

Effective tax rate

     27.7     36.6     36.2     33.9     34.0
                                        

Net operating profit after tax (NOPAT)

   $ 8,766      $ 8,255      $ 8,551      $ 8,678      $ 10,355   

Net income

   $ 6,844      $ 6,588      $ 6,991      $ 7,604      $ 9,035   

Total assets at period end

   $ 685,261      $ 601,434      $ 656,793      $ 625,330      $ 668,645   

Less: Excess cash

     (200,620     (117,611     (129,638     (83,462     (105,083

Less: Accounts payable and accrued expenses

     (71,387     (71,211     (87,316     (77,108     (89,773

Less: Deferred revenues (current and non-current)

     (20,167     (20,374     (20,011     (18,222     (19,444

Less: Other non-current liabilities and deferred taxes

     (23,610     (25,462     (30,359     (31,632     (42,615
                                        

Capital base

   $ 369,477      $ 366,776      $ 389,469      $ 414,906      $ 411,730   

Average total as-sets

   $ 685,236      $ 643,348      $ 629,114      $ 641,062      $ 646,988   

Average capital base

   $ 350,499      $ 368,127      $ 378,123      $ 402,188      $ 413,318   

Return on assets (annualized)

     4.0     4.1     4.4     4.7     5.6

Return on capital (annualized)

     10.0     9.0     9.0     8.6     10.0

 

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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 accounting principles generally accepted in the United States (GAAP) and should not be considered a substitute for net 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. See our annual Adjusted EBITDA reconciliation below.

 

     Year Ended December 31,  
(Dollars in thousands)    2007     2008     2009  

Net revenue

   $ 362,017      $ 531,933      $ 628,987   

Income from operations

   $ 30,609      $ 40,149      $ 55,241   

Net income

   $ 17,829      $ 21,703      $ 30,218   

Plus: Income taxes

     9,965        10,985        16,328   

Plus: Total other (income) expense

     2,815        7,461        8,695   

Plus: Depreciation and amortization

     56,476        90,172        125,229   

Plus: Share-based compensation expense

     4,252        15,017        20,124   
                        

Adjusted EBITDA

   $ 91,337      $ 145,338      $ 200,594   

Operating income margin

     8.5     7.5     8.8

Adjusted EBITDA margin

     25.2     27.3     31.9

See our quarterly Adjusted EBITDA reconciliation below.

 

     Three Months Ended  
     (Unaudited)  
(Dollars in thousands)    December 31,
2008
    March 31,
2009
    June 30,
2009
    September 30,
2009
    December 31,
2009
 

Net revenue

   $ 143,137      $ 145,077      $ 151,995      $ 162,399      $ 169,516   

Income from operations

   $ 12,125      $ 13,021      $ 13,403      $ 13,128      $ 15,689   

Net income

   $ 6,844      $ 6,588      $ 6,991      $ 7,604      $ 9,035   

Plus: Income taxes

     2,620        3,807        3,973        3,900        4,648   

Plus: Total other (income) expense

     2,661        2,626        2,439        1,624        2,006   

Plus: Depreciation and amortization

     26,310        27,804        29,711        32,696        35,018   

Plus: Share-based compensation expense

     4,144        4,237        5,017        5,612        5,258   
                                        

Adjusted EBITDA

   $ 42,579      $ 45,062      $ 48,131      $ 51,436      $ 55,965   

Operating income margin

     8.5     9.0     8.8     8.1     9.3

Adjusted EBITDA margin

     29.7     31.1     31.7     31.7     33.0

 

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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 vendor financed equipment purchases), 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.

 

(In thousands)    Year Ended
December 31,
2009
 

Adjusted EBITDA

   $ 200,594   

Non-cash deferred rent

     4,378   

Total capital expenditures

     (185,674

Cash payments for interest, net

     (8,005

Cash refunds (payments) for income taxes, net

     2,502   
        

Adjusted free cash flow

   $ 13,795   

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.

See our Net Leverage calculation below.

 

(Dollars in thousands)    As of December 31,
2009
 

Obligations under capital leases

   $ 109,702   

Debt

     57,684   
        

Total debt

   $ 167,386   

Less: Cash and cash equivalents

     (125,425
        

Net debt

   $ 41,961   
        

Adjusted EBITDA (trailing twelve months)

   $ 200,594   

Net leverage

     0.21x   

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. 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

 

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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. 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.

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.

Critical Accounting Policies

Revenue Recognition

Because we provide our hosting services to our customers and do not sell individual hardware and software products, we recognize revenue when all of the following conditions are met:

 

   

There is persuasive evidence that an arrangement exists;

 

   

The service has been provided to the customer;

 

   

The amount of fees to be paid by the customer is fixed or determinable; and

 

   

The collection of the fees is reasonably assured.

We recognize hosting revenue, including implementation and set-up fees on a monthly basis, beginning on the date the customer commences use of our services. Implementation fees are amortized over the estimated average customer life. If a customer terminates their relationship with us before the expiration of the estimated average customer life, any unamortized installation fees are recognized as revenue at that time. Amounts that

 

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have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of prepaid service fees and set-up fees. Professional services are recognized in the period services are provided.

Our customers generally have the right to cancel their contracts by providing prior written notice to us of their intent to cancel the remainder of the contract term. In the event that a customer cancels their contract, they are not entitled to a refund for services already rendered.

Valuation of Accounts Receivable and Service Credits

Estimates that further impact revenue recognition relate primarily to allowance for doubtful accounts and customer service credits. Both estimates are relatively predictable based on historical experience.

We make judgments as to our ability to collect outstanding receivables and provide allowances when collection becomes doubtful. Judgment is required to assess the likelihood of ultimate realization of recorded accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of either their ability or willingness to make payments, an increase in the allowance for doubtful accounts would be required. Similarly, a change in the payment behavior of customers generally may require an adjustment in the calculation of the appropriate allowance. Each month, management reviews customer payment patterns, historical data and anticipated customer default rates of the various aging categories of accounts receivables in order to determine the appropriate allowance for doubtful accounts. We write off customer accounts receivable balances to the allowance for doubtful accounts when it becomes likely that we will not collect from the customer.

All of our customer agreements provide that we will achieve certain service levels. To the extent that such service levels are not achieved, we record service credits, which are a reduction to revenue, and a corresponding increase in the allowance for customer credits to provide for estimated adjustments to receivables. We base these provisions on historical experience and evaluate the estimate of service credits on a regular basis, and adjust the amount reserved accordingly.

Property, Equipment and Other Long Lived Assets

We utilize significant amounts of property and equipment in providing services to our customers. We use straight-line depreciation for property, equipment, and leasehold improvements over the estimated useful lives. We use estimated useful lives of three to five years for equipment and software. Changes in technology or changes in the intended use of property and equipment may cause the estimated useful life or the value of these assets to change. We periodically review the appropriateness of the estimated economic useful lives for each category of property and equipment.

Periodically we assess potential impairment of our property and equipment. We perform an impairment review whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or our overall business strategy, and significant industry or economic trends. When we determine that the carrying value of a long-lived asset may not be recoverable based upon the existence of one or more of the above indicators, we determine the recoverability by comparing the carrying amount of the asset to net future undiscounted cash flows that the asset is expected to generate. We recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair market value of the asset.

Goodwill and Intangible Assets

Goodwill, which consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired, is evaluated for impairment on an annual basis on October 1, or whenever events or

 

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circumstances indicate that impairment may have occurred. The goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. When evaluating goodwill for impairment we first compare the book value of net assets to the fair value of the related operations. If the fair value is determined to be less than book value, a second step is performed to compute the amount of impairment. We estimate fair value using a discounted cash flow methodology. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. We did not identify any triggering events in 2009 that would require an update to our annual impairment test. Additionally, upon conclusion of our 2009 annual test we noted that the fair value of each of our reporting units with goodwill was substantially in excess of the respective reporting unit’s carrying value of its net assets.

Intangible assets, including technology, contracts, customer relationships, license agreements, and non-compete agreements arising principally from acquisitions, are recorded at cost less accumulated amortization. Intangible assets deemed to have indefinite useful lives, such as certain tradenames, are not amortized and are subject to annual impairment tests or whenever events or circumstances indicate impairment may have occurred. An impairment exists if the carrying value of the indefinite-lived intangible asset exceeds its fair value. For other intangible assets subject to amortization, impairment is recognized if the carrying amount is not recoverable and the carrying amount exceeds the fair value of the intangible asset.

There are many assumptions and estimates used that directly impact the results of impairment testing, including an estimate of future expected revenue, earnings and cash flows, and discount rates applied to such expected cash flows in order to estimate fair value. Changes in these estimates and assumptions could materially affect the estimated fair value of an asset.

Contingencies

We accrue for contingent obligations, including estimated legal costs, when the obligation is probable and the amount is reasonably estimable. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include those related to tax, legal, and other regulatory matters, changes in the interpretation and enforcement of international laws, and the impact of local economic conditions and practices, which are all subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

Share-Based Compensation

Prior to January 1, 2006, we recognized compensation cost for share-based awards based on the minimum value taking into account the exercise price of the option and the fair value of our common stock on the date of grant. Effective January 1, 2006, we adopted a new accounting treatment for share-based awards and used the prospective-transition method, as required for nonpublic companies that previously used the minimum value method. As such, we continue to use the minimum value method in future periods to unvested equity awards outstanding at the date of adoption. All share-based payment awards made to employees and directors beginning January 1, 2006 are measured and recognized as compensation expense based on the estimated fair values on the grant date.

We use the Black-Scholes pricing model to determine the fair value of the stock options on the grant dates for share awards made on or after January 1, 2006. The Black-Scholes option valuation model requires the use of highly subjective and complex assumptions to determine the fair value of share-based awards, including the deemed fair value of the underlying common stock on the date of grant and the expected volatility of the stock over the expected term of the related grants. The value of the award is recognized as expense over the requisite service periods on a straight-line basis in our consolidated statements of income, and reduced for estimated forfeitures. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

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In addition to stock options, we also granted restricted stock units (RSUs) to our chief executive officer and another member of our executive team. The RSUs have either a three-year or five-year performance period and shares are issued at the end of the period if the performance measure is met. The performance measure is based 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. We use a Monte Carlo simulation to estimate the fair value of the awards. We have also granted RSUs to certain executives that vest ratably over the requisite service period.

Software Development

We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We amortize capitalized software development costs over periods ranging from 12 to 36 months, which represents the estimated useful lives of the software.

Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes and interest will be due. These reserves are established when we believe that certain positions are likely to be challenged and may not be sustained on review by tax authorities. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

Our effective tax rates have differed from the statutory rate primarily due to the tax impact of foreign operations, research and development tax credits, state taxes, and certain benefits realized related to stock option activity. Our effective tax rate was 35.9%, 33.6% and 35.1% for 2007, 2008 and 2009, respectively. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Recent Accounting Pronouncements

See Item 8 of Part II, “Financial Statements and Supplementary Data—Note 2—Summary of Significant Accounting Policies—Recent Accounting Pronouncements.”

 

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ITEM 7A—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Power Prices. We are a large consumer of power. During 2009, we expensed approximately $17.5 million that was paid to utility companies to power our data centers, representing 2.8% 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, and 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 original term of the contract was 19 months and allowed the provider an option to extend the contract for an additional 19 months. The provider opted to extend the option in January 2010 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 that has since been extended for an additional 12 months to expire in May 2011.

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 December 31, 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 December 31, 2009, we have a principal liability for these leases of $109.7 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. 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 U.S. dollars and the pound sterling. During 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 8—FINANCIAL STATEMENT AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Rackspace Hosting, Inc.:

We have audited the accompanying consolidated balance sheets of Rackspace Hosting, Inc. and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule II. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Rackspace Hosting, Inc. and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Rackspace Hosting, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 26, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/    KPMG LLP

San Antonio, Texas

February 26, 2010

 

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REPORT OF INDEPENDENT REGISTERED ACCOUNTING FIRM

The Board of Directors and Stockholders

Rackspace Hosting, Inc.:

We have audited Rackspace Hosting, Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Rackspace Hosting, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Rackspace Hosting, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Rackspace Hosting, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated February 26, 2010 expressed an unqualified opinion on those consolidated financial statements.

/s/    KPMG LLP

San Antonio, Texas

February 26, 2010

 

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONSOLIDATED BALANCE SHEETS

 

(In thousands, except share and per share data)    December 31,
2008
    December 31,
2009
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 238,407      $ 125,425   

Accounts receivable, net of allowance for doubtful accounts and customer credits of $3,295 as of December 31, 2008, and $4,298 as of December 31, 2009

     30,932        38,732   

Income taxes receivable

     12,318        7,509   

Deferred income taxes

     3,050        9,764   

Prepaid expenses and other current assets

     7,788        10,239   
                

Total current assets

     292,495        191,669   

Property and equipment, net

     362,042        432,971   

Goodwill

     6,942        22,329   

Intangible assets, net

     15,101        10,790   

Other non-current assets

     8,681        10,886   
                

Total assets

   $ 685,261      $ 668,645   
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable and accrued expenses

   $ 71,387      $ 89,773   

Current portion of deferred revenue

     16,284        17,113   

Current portion of obligations under capital leases

     38,909        46,415   

Current portion of debt

     5,944        4,893   
                

Total current liabilities

     132,524        158,194   

Non-current deferred revenue

     3,883        2,331   

Non-current obligations under capital leases

     50,781        63,287   

Non-current debt

     204,779        52,791   

Non-current deferred income taxes

     13,398        30,850   

Other non-current liabilities

     10,212        11,765   
                

Total liabilities

     415,577        319,218   

COMMITMENTS AND CONTINGENCIES

    

Stockholders’ equity:

    

Common stock, $0.001 par value per share: 300,000,000 shares authorized; 117,154,094 shares issued and outstanding as of December 31, 2008, 123,773,977 shares issued and outstanding as of December 31, 2009

     117        124   

Additional paid-in capital

     207,589        251,337   

Accumulated other comprehensive loss

     (16,027     (10,257

Retained earnings

     78,005        108,223   
                

Total stockholders’ equity

     269,684        349,427   
                

Total liabilities and stockholders’ equity

   $ 685,261      $ 668,645   
                

See accompanying notes to the consolidated financial statements.

 

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONSOLIDATED STATEMENTS OF INCOME

 

     Year Ended December 31,  
(In thousands, except per share data)    2007     2008     2009  

Net revenue

   $ 362,017      $ 531,933      $ 628,987   

Costs and expenses:

      

Cost of revenue

     118,225        172,583        200,943   

Sales and marketing

     53,930        80,323        79,458   

General and administrative

     102,777        148,706        168,116   

Depreciation and amortization

     56,476        90,172        125,229   
                        

Total costs and expenses

     331,408        491,784        573,746   
                        

Income from operations

     30,609        40,149        55,241   
                        

Other income (expense):

      

Interest expense

     (3,643     (8,229     (8,950

Interest and other income

     828        768        255   
                        

Total other income (expense)

     (2,815     (7,461     (8,695
                        

Income before income taxes

     27,794        32,688        46,546   

Income taxes

     9,965        10,985        16,328   
                        

Net income

   $ 17,829      $ 21,703      $ 30,218   
                        

Net income per share

      

Basic

   $ 0.18      $ 0.20      $ 0.25   
                        

Diluted

   $ 0.17      $ 0.19      $ 0.24   
                        

Weighted average number of shares outstanding

      

Basic

     101,278        108,528        120,570   
                        

Diluted

     106,618        115,406        127,420   
                        

See accompanying notes to the consolidated financial statements.

 

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,  
(In thousands)    2007     2008     2009  

Cash Flows From Operating Activities

      

Net income

   $ 17,829      $ 21,703      $ 30,218   

Adjustments to reconcile net income to net cash provided by operating activities

      

Depreciation and amortization

     56,476        90,172        125,229   

Loss on disposal of equipment, net

     1,895        2,888        1,027   

Provision for bad debts and customer credits

     4,094        4,149        10,347   

Deferred income taxes

     (3,479     12,099        9,379   

Deferred rent

     383        (211     4,378   

Share-based compensation expense

     4,252        15,017        20,124   

Other non-cash compensation expense

     156        289        565   

Excess tax benefits from share-based compensation arrangements

     (562     (3,212     —     

Changes in certain assets and liabilities

      

Accounts receivable

     (13,357     (12,202     (17,075

Income taxes receivable

     —          (12,318     4,809   

Accounts payable and accrued expenses

     39,192        13,398        14,603   

Deferred revenue

     6,578        1,931        (1,163

All other operating activities

     (8,522     2,879        (5,573
                        

Net cash provided by operating activities

     104,935        136,582        196,868   

Cash Flows From Investing Activities

      

Purchases of property and equipment, net

     (140,383     (165,396     (117,292

Acquisitions, net of cash acquired

     (338     (9,739     —     

Earnout payments for acquisitions

     —          —          (6,822
                        

Net cash used in investing activities

     (140,721     (175,135     (124,114

Cash Flows From Financing Activities

      

Principal payments of capital leases

     (13,877     (32,376     (44,680

Principal payments of notes payable

     (3,901     (6,851     (6,729

Borrowings on line of credit

     61,146        200,000        —     

Payments on line of credit

     (5,000     (57,301     (150,000

Payments for debt issuance costs

     (301     (158     (367

Proceeds from sale leaseback transactions

     8,456        1,543        —     

Receipt of Texas Enterprise Fund Grant

     5,000        —          —     

Proceeds from issuance of common stock at IPO net of offering expenses of $14,196

     —          144,554        —     

Proceeds from issuance of common stock, net

     —          548        —     

Proceeds from exercise of warrants

     —          278        —     

Proceeds from employee stock plans

     294        1,964        14,489   

Excess tax benefits from share-based compensation arrangements

     562        3,212        —     
                        

Net cash provided by (used in) financing activities

     52,379        255,413        (187,287

Effect of exchange rate changes on cash and cash equivalents

     (30     (3,390     1,551   
                        

Increase (decrease) in cash and cash equivalents

     16,563        213,470        (112,982

Cash and cash equivalents, beginning of period

     8,374        24,937        238,407   
                        

Cash and cash equivalents, end of period

   $ 24,937      $ 238,407      $ 125,425   
                        

Supplemental cash flow information:

      

Acquisition of property and equipment by capital leases

   $ 37,458      $ 73,556      $ 64,692   

Acquisition of property and equipment by notes payable

     6,691        11,934        3,690   
                        

Vendor financed equipment purchases

   $ 44,149      $ 85,490      $ 68,382   

Shares issued in business combinations

   $ 3,507      $ 1,785      $ 8,680   

Cash payments for interest, net of amount capitalized

   $ 3,148      $ 9,616      $ 8,213   

Cash payments for income taxes

   $ 13,945      $ 6,364      $ 8,651   

See accompanying notes to the consolidated financial statements.

 

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

 

    Years Ended December 31, 2007, 2008 and 2009  
    Preferred Stock     Common Stock   Treasury Stock     Additional
Paid-In
Capital
  Accumulated
other
comprehensive
income (loss)
    Retained
Earnings
  Total
stockholders’
equity
 
(In thousands except share data)   Shares     Amount     Shares   Amount   Shares     Amount          

Balance at December 31, 2006

  1,214,837      $ 1      99,750,483   $ 100   (82,705   $ (126   $ 31,312   $ 730      $ 38,473   $ 70,490   
                                                                 

Issuance of common stock

                   

Exercise of stock options (including excess tax benefit of $562)

  —          —        472,760     —     —          —          856     —          —       856   

Issuance of common stock to board of directors

  —          —        31,580     —     —          —          156     —          —       156   

Issuance of restricted stock to Mailtrust employees

  —          —        353,805     —     —          —          —       —          —       —     

Shares issued in business combination

  —          —        587,595     1   —          —          3,419     —          —       3,420   

Shares issued in Mosso equity acquisition

  —          —        15,000     —     —          —          87     —          —       87   
                                                       

Total issuance of common stock

  —          —        1,460,740     1   —          —          4,518     —          —       4,519   
                         

Share-based compensation expense

  —          —        —       —     —          —          4,252     —          —       4,252   

Comprehensive income:

                   

Net income

                    17,829     17,829   

Unrealized gain (loss) on derivative instrument, net of tax effect

                  (322       (322

Cumulative translation adjustment

                  105          105   
                         

Total comprehensive income

                      17,612   
                                                                 

Balance at December 31, 2007

  1,214,837      $ 1      101,211,223   $ 101   (82,705   $ (126   $ 40,082   $ 513      $ 56,302   $ 96,873   
                                                                 

Issuance of common stock

                   

Exercise of stock options (including excess tax benefit of $3,212)

  —          —        1,427,334     2       —          5,175     —          —       5,177   

Issuance of common stock to board of directors

  —          —        24,405     —         —          289     —          —       289   

Issuance of warrants at IPO offering

  —          —        268,750     —         —          278     —          —       278   

Proceeds from issuance of common stock net of offering costs of $14,196

  —          —        12,700,000     13       —          144,541     —          —       144,554   

Conversion of preferred shares to common stock at IPO offering

  (1,214,837     (1   1,214,837     1       —          —       —          —       —     

Sale of common stock for cash

  —          —        60,000     —         —          548     —          —       548   

Shares issued in business combination

  —          —        247,545     —     82,705        126        1,659     —          —       1,785   
                                                       

Total issuance of common stock

  (1,214,837     (1   15,942,871     16   82,705        126