Attached files

file filename
EX-10.1 - RULES OF THE RACKSPACE HOSTING INC 2010 HM REVENUE & CUSTOMS UK APPROVED SUB-PLAN - RACKSPACE HOSTING, INC.ex10-1.htm
EX-10.2 - FORM OF THE 2010 HM REVENUE & CUSTOMS UK APPROVED SUB-PLAN NOTICE OF GRANT OF STOCK OPTION - RACKSPACE HOSTING, INC.ex10-2.htm
EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.rax32-2.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.rax32-1.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.rax31-1.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.rax31-2.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
FORM 10-Q

 
 
(Mark one)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2010.
 
 
o
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
(Registrants Telephone Number, Including Area Code)
 
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 o

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes   o    No o
 
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 o
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No þ  
 
On April 23, 2009, 124,463,625 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.
 
 

 
RACKSPACE HOSTING, INC.
 
TABLE OF CONTENTS

Part I - Financial Information
 
Item 1.
Financial Statements:
 
  3
  4
  5
  6
Item 2.
17
Item 3.
29
Item 4.
30
     
Part II - Other Information
 
Item 1.
31
Item 1A.
31
Item 2.
48
Item 3.
 48
Item 3.
 48
Item 5.
  48
Item 6.
49
     
  50 

 
 

 

PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS
 
(In thousands, except share and per share data)
 
December 31,
   
March 31,
 
   
2009
   
2010
 
         
(Unaudited)
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 125,425     $ 131,297  
Accounts receivable, net of allowance for doubtful accounts and customer credits of
               
$4,298 as of December 31, 2009, and $3,402 as of March 31, 2010
    38,732        39,149  
Income taxes receivable
    7,509       10,754  
Deferred income taxes
    9,764       7,745  
Prepaid expenses and other current assets
    10,239       11,023  
Total current assets
    191,669       199,968  
                 
Property and equipment, net
    432,971       448,583  
Goodwill
    22,329       23,329  
Intangible assets, net
    10,790       9,243  
Other non-current assets
    10,886       10,606  
Total assets
  $ 668,645     $ 691,729  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Accounts payable and accrued expenses
  $ 89,773     $ 92,828  
Current portion of deferred revenue
    17,113       16,276  
Current portion of obligations under capital leases
    46,415       49,129  
Current portion of debt
    4,893       4,661  
Total current liabilities
    158,194       162,894  
                 
Non-current deferred revenue
    2,331       1,768  
Non-current obligations under capital leases
    63,287       63,544  
Non-current debt
    52,791       52,183  
Non-current deferred income taxes
    30,850       26,945  
Other non-current liabilities
    11,765       13,970  
Total liabilities
    319,218       321,304  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
Stockholders' equity:
               
Common stock, $0.001 par value per share: 300,000,000 shares
               
authorized; 123,773,977 shares issued and outstanding
               
as of December 31, 2009, 124,361,064 shares issued and
               
outstanding as of March 31, 2010
    124       124  
Additional paid-in capital
    251,337       266,696  
Accumulated other comprehensive loss
    (10,257 )     (14,430 )
Retained earnings
    108,223       118,035  
Total stockholders’ equity
    349,427       370,425  
Total liabilities and stockholders’ equity
  $ 668,645     $ 691,729  

See accompanying notes to the unaudited consolidated financial statements.

 
- 3 -

 

CONSOLIDATED STATEMENTS OF INCOME – (Unaudited)
 
   
Three Months Ended March 31,
 
(In thousands, except per share data)
 
2009
   
2010
 
             
Net revenue
  $ 145,077     $ 178,805  
Costs and expenses:
               
Cost of revenue
    46,210       57,007  
Sales and marketing
    20,502       21,977  
General and administrative
    37,540       46,395  
Depreciation and amortization
    27,804       36,698  
Total costs and expenses
    132,056       162,077  
Income from operations
    13,021       16,728  
Other income (expense):
               
Interest expense
    (2,535 )     (2,144 )
Interest and other income
    (91 )     185  
Total other income (expense)
    (2,626 )     (1,959 )
Income before income taxes
    10,395       14,769  
Income taxes
    3,807       4,957  
Net income
  $ 6,588     $ 9,812  
                 
Net income per share
               
Basic
  $ 0.06     $ 0.08  
Diluted
  $ 0.05     $ 0.07  
                 
Weighted average number of shares outstanding
               
Basic
    117,608       123,981  
Diluted
    121,889       132,439  
 
See accompanying notes to the unaudited consolidated financial statements.

 
- 4 -

 

CONSOLIDATED STATEMENTS OF CASH FLOWS – (Unaudited)   
 
(In thousands)
 
Three Months Ended March 31,
 
   
2009
   
2010
 
Cash Flows From Operating Activities
           
Net income
  $ 6,588     $ 9,812  
Adjustments to reconcile net income to net cash provided by operating activities
               
Depreciation and amortization
    27,804       36,698  
Loss on disposal of equipment, net
    176       148  
Provision for bad debts and customer credits
    2,309       536  
Deferred income taxes
    2,507       (1,721 )
Deferred rent
    (107 )     1,804  
Share-based compensation expense
    4,237       5,978  
Other non-cash compensation expense
    85       104  
Excess tax benefits from share-based compensation arrangements
    -       (7,015 )
Changes in certain assets and liabilities
               
Accounts receivable
    (6,336 )     (1,366 )
Income taxes receivable
    (257 )     3,770  
Accounts payable and accrued expenses
    (6,551 )     3,407  
Deferred revenue
    304       (1,074 )
All other operating activities
    40       (188 )
Net cash provided by operating activities
    30,799       50,893  
                 
Cash Flows From Investing Activities
               
Purchases of property and equipment, net
    (25,589 )     (39,622 )
Net cash used in investing activities
    (25,589 )     (39,622 )
                 
Cash Flows From Financing Activities
               
Principal payments of capital leases
    (9,838 )     (12,796 )
Principal payments of notes payable
    (751 )     (840 )
Payments on line of credit
    (100,000 )     -  
Proceeds from employee stock plans
    2,235       2,262  
Excess tax benefits from share-based compensation arrangements
    -       7,015  
Net cash provided by (used in) financing activities
    (108,354 )     (4,359 )
                 
Effect of exchange rate changes on cash and cash equivalents
    (243 )     (1,040 )
                 
Increase (decrease) in cash and cash equivalents
    (103,387 )     5,872  
                 
Cash and cash equivalents, beginning of period
    238,407       125,425  
                 
Cash and cash equivalents, end of period
  $ 135,020     $ 131,297  
                 
Supplemental cash flow information:
               
Acquisition of property and equipment by capital leases
  $ 11,683     $ 15,766  
                 
Shares issued in business combinations
  $ 765     $ -  
Cash payments for interest, net of amount capitalized
  $ 2,543     $ 2,144  
Cash payments for income taxes
  $ 759     $ 3,414  
 
See accompanying notes to the unaudited consolidated financial statements.

 
- 5 -

 
 
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. Overview and Basis of Presentation
Nature of Operations

As used in this report, the terms “Rackspace”, “Rackspace Hosting”, “we”, “our company”, “the company”, “us,” or “our” refer to Rackspace Hosting, Inc. and its subsidiaries.  Rackspace Hosting, Inc., through its operating subsidiaries, is a provider of hosting solutions.  We provide IT as a service, managing web-based IT systems for small and medium-sized businesses as well as large enterprises.  We focus on providing a service experience for our customers, which we call Fanatical Support®.

Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000. However, our operations began in 1998 as a limited partnership which became our subsidiary through a corporate reorganization completed on August 21, 2001.

We operate consolidated subsidiaries which include, among others, Rackspace US, Inc., our domestic operating entity, and Rackspace Limited, our United Kingdom operating entity.
 
Basis of Consolidation

The consolidated financial statements include the accounts of our wholly owned subsidiaries located in the United States of America (U.S.), the United Kingdom (U.K.), the Netherlands, and Hong Kong. Intercompany transactions and balances have been eliminated in consolidation.
 
Basis of Presentation
 
The accompanying consolidated financial statements as of March 31, 2010, and for the three months ended March 31, 2009 and 2010, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all financial information and disclosures required by GAAP for complete financial statements and certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted.  The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and in the opinion of management, reflect all adjustments, which include normal recurring adjustments, necessary for a fair statement of our financial position as of March 31, 2010, our results of operations for the three months ended March 31, 2009 and 2010, and our cash flows for the three months ended March 31, 2009 and 2010.
 
These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2009 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 26, 2010.  The results of the three months ended March 31, 2010 are not necessarily indicative of the results to be expected for the year ending December 31, 2010, or for any other interim period, or for any other future year.

Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation.
 
Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and customer credits, property and equipment, fair values of intangible assets and goodwill, useful lives of intangible assets, fair value of stock options, contingencies, and income taxes, among others. We base our estimates on historical experience and on other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We engaged third party valuation consultants to assist management in the purchase price allocation of significant acquisitions.
 
 
- 6 -

 
2. Summary of Significant Accounting Policies
 
The accompanying financial statements reflect the application of certain significant accounting policies. There have been no material changes to our significant accounting policies that are disclosed in our audited consolidated financial statements and notes thereto as of December 31, 2009 included in our Annual Report on Form 10-K.
 
Recently Adopted Accounting Pronouncements

In December 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2009-17, which codified Statement of Financial Accounting Standard (SFAS) 167, Amendments to FASB Interpretation No. 46(R), issued in June 2009. This guidance amends FASB Interpretation No. 46 (revised December 2003) to address the elimination of the concept of a qualifying special purpose entity. ASU 2009-17 also replaces the quantitative-based risks and rewards calculation for determining which enterprise has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity and the obligation to absorb losses of the entity or the right to receive benefits from the entity. Additionally, ASU 2009-17 provides more timely and useful information about an enterprise’s involvement with a variable interest entity. ASU 2009-17 became effective for us this quarter.  This ASU did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures,” which amends the disclosure requirements related to recurring and nonrecurring fair value measurements.  The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). ASU 2010-06 became effective for us this quarter, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for us in the first annual reporting period that begins after December 15, 2010 and for interim periods within that annual reporting period. Other than requiring additional disclosures, adoption of this new guidance will not have a material impact on our financial statements.
 
Recent Accounting Pronouncements

In September 2009, the FASB issued two Accounting Standards Updates (ASU): (i) ASU 2009-13 (EITF 08-1), Multiple-Deliverable Revenue Arrangements, and (ii) ASU 2009-14 (EITF 09-3), Certain Revenue Arrangements that Include Software Elements, which will be effective prospectively for revenue arrangements, entered into or materially modified in fiscal years beginning on or after June 15, 2010.  ASU 2009-13 amends ASC Subtopic 605-25 to eliminate the requirement that all undelivered elements in a multiple-element revenue arrangement have vendor-specific objective evidence (VSOE) or third-party evidence (TPE) before an entity can recognize the portion of an overall arrangement fee that is attributable to items that already have been delivered.  In the absence of VOSE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, entities will be required to estimate the selling prices of those elements.  The overall arrangement fee will be allocated to each element (both delivered and undelivered items) based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on the entity’s estimated selling price.  Application of the “residual method” of allocating an overall arrangement fee between delivered and undelivered elements will no longer be permitted upon adoption.  ASU 2009-14 amends ASC Subtopic 985-605 to exclude from its scope tangible products that contain both software and non-software components that function together to deliver a product’s essential functionality.  We do not expect the adoption of ASU 2009-13 or 2009-14 to have a material impact on our consolidated financial statements.
 
- 7 -

 
3. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share:
 
   
Three Months Ended March 31,
 
(In thousands, except per share data)
 
2009
   
2010
 
             
Basic net income per share:
           
Net income
  $ 6,588     $ 9,812  
                 
Weighted average shares outstanding:
               
Common stock
    117,608       123,981  
Number of shares used in per share computations
    117,608       123,981  
                 
Earnings per share
  $ 0.06     $ 0.08  
Diluted net income per share:
               
Net income
  $ 6,588     $ 9,812  
                 
Weighted average shares outstanding:
               
Common stock
    117,608       123,981  
Stock options and awards
    4,281       8,458  
Number of shares used in per share computations
    121,889       132,439  
                 
Earnings per share
  $ 0.05     $ 0.07  
 
    We excluded 12.9 million and 1.2 million potential common shares from the computation of dilutive earnings per share for the three months ended March 31, 2009 and 2010, respectively, because the effect would have been anti-dilutive.

4. Cash and Cash Equivalents

Cash and cash equivalents consisted of:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
             
Cash deposits
  $ 64,716     $ 70,585  
Money market funds
    60,709       60,712  
Cash and cash equivalents
  $ 125,425     $ 131,297  
 
Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. We actively monitor the third-party depository institutions that hold our deposits. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those 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.
 
 
- 8 -

 
5.  Fair Value Measurements
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-tier fair value of hierarchy, which prioritizes the inputs used in measuring fair value as follows:
 
Level 1 – Observable inputs such as quoted prices in active markets for identical assets or liabilities;
 
Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
 
Level 3 – Unobservable inputs that are supported by little or no market activity, which require management judgment or estimation.
 
There have been no material changes to the valuation techniques utilized in the fair value measurement of assets and liabilities presented on our balance sheet as disclosed in our Form 10-K for the year ended December 31, 2009.
 
Assets and liabilities measured at fair value on a recurring basis are summarized by level below.  The table does not include assets and liabilities which are measured at historical costs or any other basis other than fair value.
 
(In thousands)
 
December 31, 2009
 
   
Quoted Prices in Active Markets for Identical Assets (Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
   
Total Assets/Liabilities at Fair Value
 
Assets:
       
 
         
 
 
Money market funds (1)
  $ 60,709     $ -     $ -     $ 60,709  
Rabbi trust (3)
    576       -       -       576  
     Total
  $ 61,285     $ -     $ -     $ 61,285  
                                 
Liabilities:
                               
Interest rate swap agreement (1)
  $ -     $ 1,818     $ -     $ 1,818  
Deferred compensation (2)
    586       -       -       586  
     Total
  $ 586     $ 1,818     $ -     $ 2,404  
 

(In thousands)
 
March 31, 2010
 
   
Quoted Prices in Active Markets for Identical Assets (Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
   
Total Assets/Liabilities at Fair Value
 
Assets:
       
 
         
 
 
Money market funds (1)
  $ 60,712     $ -     $ -     $ 60,712  
Rabbi trust (3)
    709       -       -       709  
     Total
  $ 61,421     $ -     $ -     $ 61,421  
                                 
Liabilities:
                               
Interest rate swap agreement (1)
  $ -     $ 1,445     $ -     $ 1,445  
Deferred compensation (2)
    693       -       -       693  
     Total
  $ 693     $ 1,445     $ -     $ 2,138  
                                 
(1) Money market funds are classified in cash and cash equivalents and the interest rate swap agreement is classified in accounts payable and accrued expenses.
 
(2) Obligations to pay benefits under a non-qualified deferred compensation plan are classified in other non-current liabilities.
         
(3) Investments in marketable securities held in a Rabbi Trust associated with a non-qualified deferred compensation plan located in other non-current assets.
 
 
 
- 9 -

 
 
6. Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consisted of:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
             
Prepaid expenses
  $ 7,505     $ 8,020  
Other current assets
    2,734       3,003  
Prepaid expenses and other current assets
  $ 10,239     $ 11,023  

7. Property and Equipment, net
 
Property and equipment consisted of:
 
(In thousands)
 
Estimated Useful Lives
   
December 31,
2009
   
March 31,
2010
 
                   
Computers, software and equipment
 
1-5 years
    $ 511,279     $ 544,439  
Furniture and fixtures
 
7 years
      22,311       23,342  
Buildings and leasehold improvements
 
2-30 years
      134,045       134,056  
Land
    --       13,860       13,860  
Property and equipment, at cost
            681,495       715,697  
Less accumulated depreciation and amortization
            (298,369 )     (322,443 )
Work in process
            49,845       55,329  
Property and equipment, net
          $ 432,971     $ 448,583  

    Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $26.3 million and $35.1 million for the three months ended March 31, 2009 and 2010, respectively.
 
At December 31, 2009, the work in process balance consisted of build outs of $35.7 million for office facilities, $8.0 million for data centers, and $6.1 million for capitalized software and other projects.  At March 31, 2010, the work in process balance consisted of build outs of $34.6 million for office facilities, $13.5 million for data centers, and $7.2 million for capitalized software and other projects.
 
Capitalized interest was $0.3 million and $0.1 million for the three months ended March 31, 2009 and 2010, respectively.
 
- 10 -

 
8. Business Combinations and Goodwill
 
In October 2008, we acquired two companies for a total purchase price of $28.0 million, which were accounted for as business combinations.  The initial purchase price of the combined acquisitions was $11.5 million paid in cash and stock, with up to $16.5 million in additional payouts of cash and stock based on certain earn-out provisions.  As of December 31, 2009 earn-outs totaling $15.5 million had been achieved and paid in a combination of cash and stock.  The final $1.0 million earn-out was achieved in March 2010 and was paid in April 2010 in a combination of cash and stock.  The earn-out was accounted for as additional goodwill.
 
The following table provides a roll forward of our goodwill balance.
 
(In thousands)
     
Balance at December 31, 2009
  $ 22,329  
Earn-out payment for acquisition
    1,000  
Balance at March 31, 2010
  $ 23,329  
         
 
9. Accounts Payable and Accrued Expenses
 
Accounts payable and accrued expenses consisted of:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
             
Trade payables
  $ 24,597     $ 31,936  
Accrued compensation and benefits
    28,469       23,509  
Foreign income taxes payable
    6,340       6,665  
Vendor accruals
    17,806       17,714  
Other liabilities
    12,561       13,004  
Accounts payable and accrued expenses
  $ 89,773     $ 92,828  
- 11 -

 
10. Debt
 
Debt outstanding consisted of:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
             
Revolving credit facility
  $ 50,000     $ 50,000  
Notes payable
    7,684       6,844  
Total debt
    57,684       56,844  
Less current portion of debt
    (4,893 )     (4,661 )
Total non-current debt
  $ 52,791     $ 52,183  
 
Revolving Credit Facility
 
Our revolving credit facility includes an aggregate commitment of $245.0 million.  The facility provides for letters of credit up to $25.0 million. The interest is based on a floating rate, generally the London Interbank Offered Rate (LIBOR) plus a margin spread, which changes ratably from 0.675% to 1.55% dependent on the total funded debt to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio. We are required to pay a facility fee of 0.2% per annum on the full amount committed under the facility and a quarterly administrative fee. The facility has a 5-year term and matures in August 2012, and is fully secured by our domestic assets and a portion of our foreign subsidiary equity holdings and governed by financial and non-financial covenants.  Financial covenants under our facility include a minimum fixed charge coverage ratio of at least 1.50 to 1.00 and a maximum total funded debt to EBITDA ratio of not greater than 3.00 to 1.00. Also, our foreign cash balance is limited to a balance of $25 million. As of March 31, 2010, we were in compliance with all of the covenants under our facility.

The revolving credit facility agreement provides us with the ability to borrow under our credit facility in pounds sterling and euros in addition to U.S. dollars. We have the ability to borrow up to $75 million in alternate currencies.  As of March 31, 2010 we did not have any borrowings on our credit facility in alternate currencies.
 
As of March 31, 2010, the amount outstanding under the facility was $50.0 million, with an outstanding letter of credit of $0.6 million, resulting in an additional $194.4 million available for future borrowings.

Interest Rate Swap
 
We have a cash flow hedge to limit our exposure that may result from the variability of floating interest rates. Effective December 10, 2007, we entered into an interest rate swap agreement with a notional amount of $50.0 million.  The interest rate swap hedges the first $50.0 million of our outstanding floating-rate debt. This swap converts floating rate interest based on the LIBOR into fixed-rate interest as part of the arrangement with our primary lender and expires in December 2010.
 
We are required to pay the counterparty a stream of fixed interest payments at a rate of 4.135%, and in turn, receive variable interest payments based on 1-month LIBOR.  The margin spread as of March 31, 2010 was 1.05% resulting in an effective fixed rate of 5.185%.  The net receipts or payments from the swap are recorded as interest expense. The swap is designated and qualifies as a cash flow hedge. As such, the swap is accounted for as an asset or a liability in the accompanying consolidated balance sheets at fair value. We are utilizing the dollar offset method to assess the effectiveness of the swap. Under this methodology, the swap was deemed to be highly effective for the three months ended March 31, 2009 and 2010. There was no hedge ineffectiveness recognized in earnings for either period.  If the hedge becomes ineffective, or if certain terms of the facility change, the facility is extinguished, or if the swap is terminated prior to maturity, the fair value of the swap and subsequent changes in fair value may be recognized in the accompanying consolidated statements of income.  The fair value of the swap was estimated based on the yield curve as of December 31, 2009 and March 31, 2010, and represents its carrying value.  See Note 5 for further disclosure on the fair value of the interest rate swap and Note 15 for further information on comprehensive income.
 
The following table presents the impact of the interest rate swap on the consolidated balance sheets:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
Accounts payable and accrued expenses
  $ 1,818     $ 1,445  
Accumulated other comprehensive income
   (loss), net of tax
  $ (1,182 )   $ (940 )
                 
   
Three Months Ended March 31,
 
(In thousands)
  2009     2010  
Effective gain (loss) recognized in accumulated
   other comprehensive income, net of tax
  $ 66     $ 242  
 
As the interest rate swap expires in December 2010, the full amount of other comprehensive income related to the interest rate swap as of March 31, 2010 is expected to be reclassified to expense within the next 12 months.
 
As of March 31, 2010, we were in a liability position to the counterparty of the swap and therefore had limited counterparty credit risk.
 
- 12 -

 
11. Other Non-Current Liabilities
 
    Other non-current liabilities consisted of:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
             
Texas Enterprise Fund Grant
  $ 5,000     $ 5,000  
Deferred rent
    5,391       7,526  
Other
    1,374       1,444  
Other non-current liabilities
  $ 11,765     $ 13,970  

12. Commitments and Contingencies
 
Legal Proceedings
 
    We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, on October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston, was filed in the 37th District Court in Bexar County Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We do not expect the results of this claim or any other current proceeding to have a material adverse effect on our business, results of operations or financial condition.
 
13. Share-Based Compensation
 
In January 2010, an additional 5.7 million shares became available for future grant pursuant to the automatic share reserve increase or “evergreen” provision under our Amended and Restated 2007 Long-Term Incentive Plan.  As of March 31, 2010, the total number of shares authorized under all of our plans was 48.5 million shares, of which approximately 10.6 million shares were available for future grants.
 
Outstanding stock awards were as follows:
 
   
December 31,
 2009
   
March 31,
2010
 
Restricted stock units
    2,087,500       2,473,818  
Stock options
    16,841,232       16,931,312  
Total outstanding awards
    18,928,732       19,405,130  
 
The following table summarizes our restricted stock unit activity for the three months ended March 31, 2010:
 
   
Number of Units
   
Weighted Average Grant Date Fair Value
 
Outstanding at December 31, 2009
    2,087,500     $ 5.47  
Granted
    386,958     $ 19.43  
Released
    -     $ -  
Cancelled
    (640 )   $ 19.51  
Outstanding at March 31, 2010
    2,473,818     $ 7.65  
                 
Expected to vest after March 31, 2010 *
    2,382,967     $ 7.23  
                 
* Includes reduction of shares outstanding due to estimated forfeitures
 
 
In the three months ended March 31, 2010, our board approved grants of approximately 387 thousand restricted stock units (RSUs) to certain employees that vest so long as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date.  Stock-based compensation expense for these service vesting RSUs is measured based on the closing fair market value of the company’s common stock on the date of grant and is recognized ratably over the service period.
 
As of March 31, 2010, there were 2.0 million RSUs outstanding that were granted in 2009 to our chief executive officer and another member of the executive team.  The vesting of these RSUs is dependent on the company’s total shareholder return (TSR) on its common stock compared to other companies in the Russell 2000 Index. In addition, the company’s TSR must be positive for vesting to occur.
 
As of March 31, 2010, there was $13.4 million of total unrecognized compensation cost related to non-vested RSUs that we have granted, which will be amortized using the straight line method over a remaining weighted average period of 3.04 years.
 
- 13 -

 
The following table summarizes the stock option activity for the three months ended March 31, 2010:
 
   
Number of Shares
   
Weighted Average Exercise Price
   
Weighted Average Remaining Contractual Life
   
Aggregate Intrinsic Value (in thousands)
 
Outstanding at December 31, 2009
    16,841,232     $ 6.02       7.56     $ 249,801  
Granted
    817,494     $ 19.44                  
Exercised
    (582,076 )   $ 3.89                  
Cancelled
    (145,338 )   $ 7.20                  
Outstanding at March 31, 2010
    16,931,312     $ 6.73       7.46     $ 203,948  
                                 
Vested and exercisable at March 31, 2010
    7,040,044     $ 3.63       6.29     $ 106,305  
                                 
Vested and exercisable at March 31, 2010 and expected to vest thereafter *
    15,940,079     $ 6.51       7.38     $ 195,372  
* Includes reduction of shares outstanding due to estimated forfeitures
 
 
In the three months ended March 31, 2010, our board approved the grant of approximately 817 thousand stock options for certain employees with exercise prices of $18.75 and $19.51, depending on the date of the grant. The shares vest so long as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date and have a term of 10 years.
 
The total pre-tax intrinsic value of the stock options exercised during the three months ended March 31, 2009 and 2010, was $7.7 million and $8.7 million, respectively.
 
The weighted average fair value of stock options issued during the three months ended March 31, 2009 and 2010 was $2.97 and $10.79 respectively, using the Black-Scholes option pricing model with the following assumptions:
 
   
Three Months Ended March 31,
 
   
2009
   
2010
 
             
Expected stock volatility
    61%       56%  
Expected dividend yield
    0.0%       0.0%  
Risk-free interest rate
    2.24%       2.77% - 2.79%  
Expected life
   
6.25 years
     
6.25 years
 
 
    As of March 31, 2010, there was $39.3 million of total unrecognized compensation cost related to non-vested stock options that we have granted, which will be amortized using the straight line method over a weighted average period of 1.99 years.
 
Share-based compensation expense was recognized as follows:
 
   
Three Months Ended March 31,
 
(in thousands)
 
2009
   
2010
 
             
Cost of revenue
  $ 629     $ 969  
Sales and marketing
    698       880  
General and administrative
    2,910       4,129  
Pre-tax share-based compensation
    4,237       5,978  
Less: Income tax benefit
    (1,552 )     (2,006 )
Total share-based compensation
         
expense, net of tax
  $ 2,685     $ 3,972  
 
 
- 14 -

 
14. Income Taxes
 
We are subject to U.S. federal income tax and various state, local, and international income taxes in numerous jurisdictions. Our domestic and international tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions and the timing of recognizing revenue and expenses. Additionally, the amount of income taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we file.
 
We currently file income tax returns in the U.S., and all foreign jurisdictions in which we have entities, which are periodically under audit by federal, state, and international tax authorities. These audits can involve complex matters that may require an extended period of time for resolution. We remain subject to U.S. federal and state income tax examinations for the tax years 2005 through 2008, U.K. income tax examinations for the years 2002 through 2008, Netherlands income tax examinations for the years 2007 and 2008, and Hong Kong income tax examinations for the year 2008. There are no income tax examinations currently in process. Although the outcome of open tax audits is uncertain, in management’s opinion, adequate provisions for income taxes have been made. If actual outcomes differ materially from these estimates, they could have a material impact on our financial condition and results of operations. Differences between actual results and assumptions, or changes in assumptions in future periods are recorded in the period they become known. To the extent additional information becomes available prior to resolution, such accruals are adjusted to reflect probable outcomes. Our effective tax rate is impacted by earnings being realized in countries where we have lower statutory rates.
 
During the three months ended March 31, 2010 we received federal income tax refunds totaling $1.0 million related to the 2008 tax period.  In 2008 and 2009 we experienced taxable losses primarily as a result of the accelerated depreciation allowed under the 2008 Economic Stimulus Act passed in February 2008 and the 2009 American Recovery and Reinvestment Act passed in February 2009.  In 2008 Rackspace incurred $28.7 million tax net operating losses which were fully utilized as part of a tax carryback claim.  In 2009 Rackspace incurred $41.9 million tax net operating losses, of which $18.3 million will be utilized as part of a tax carryback claim.  As of March 31, 2010, our income tax receivable is $10.8 million and the remaining $23.6 million of tax net operating losses will be carried forward to future taxable years and will expire at various dates through 2030.
 
Rackspace takes certain non-income tax positions in the jurisdictions in which it operates and may be subject to audit from these jurisdictions. Rackspace is also involved in related non-income tax litigation matters. We believe our positions are supportable and we have accrued for known exposure; however, significant judgment is required in determining the ultimate outcome of such matters. In the normal course of business, our position and conclusion related to these non-income taxes may be challenged and assessments may be made. To the extent new information is obtained and changes our views on our positions, probable outcome of assessments, or litigation, changes in estimates to accrued liabilities would be recorded in the period the determination is made.

 
- 15 -

 
15. Comprehensive Income
 
Total comprehensive income was as follows:
 
   
Three Months Ended March 31,
 
(In thousands)
 
2009
   
2010
 
             
Net income
  $ 6,588     $ 9,812  
Derivative instrument, net of deferred taxes of $(36),
               
and $(130) for the three months ended March 31, 2009 and 2010.
    66       242  
Foreign currency cumulative translation adjustment,
               
net of taxes of $211 and $47 for the three months ended March 31, 2009 and 2010
    (780 )     (4,415 )
Total other comprehensive income (loss)
    (714 )     (4,173 )
Total comprehensive income
  $ 5,874     $ 5,639  
 
 
(In thousands)
 
Derivative Instrument
   
Translation Adjustment
   
Accumulated other comprehensive income (loss)
 
Balance at December 31, 2009
  $ (1,182 )   $ (9,075 )   $ (10,257 )
2010 changes in fair value
    242       -       242  
2010 translation adjustment
    -       (4,415 )     (4,415 )
Balance at March 31, 2010
  $ (940 )   $ (13,490 )   $ (14,430 )

16. Segment Information
 
Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information by reporting unit and geographic region for purposes of evaluating financial performance and allocating resources.  We are organized as, and operate three operating segments based on our product and service offerings, which we refer to as our lines of business.  The company’s service offerings all (i) provide computing power to similar types of customers, (ii) have similar production processes, (iii) deliver their services in a similar manner, and (iv) use the same data centers and similar technologies. As a result of our evaluation of the criteria for aggregation by products and services, we determined we have one reportable segment, which we describe as Hosting.
 
Revenue is attributed to geographic location based on the location of the operating entity that enters into the contractual relationship with the customer.  We break down the locations into either the U.S. or outside the U.S., which primarily consists of our business operations in the U.K.  Total net revenue by geographic region was as follows:
 
   
Three Months Ended March 31,
 
(In thousands)
 
2009
   
2010
 
United States
  $ 110,563     $ 132,186  
Outside United States
    34,514       46,619  
Total net revenue
  $ 145,077     $ 178,805  
 
Our long-lived assets are primarily located in the U.S. and U.K., and to a lesser extent Hong Kong.  Property and equipment, net by geographic region was as follows:
 
   
December 31,
   
March 31,
 
(In thousands)
 
2009
   
2010
 
United States
  $ 344,353     $ 365,682  
Outside United States
    88,618       82,901  
Total property and equipment, net
  $ 432,971     $ 448,583  

17. Related Party Transactions
 
We lease some facilities from a partnership controlled by our chairman of the board of directors. For these leases, we recognized $177 thousand and $94 thousand of rent expense on our consolidated statements of income for the three months ended March 31, 2009 and 2010, respectively.
 
18. Subsequent Events
 
On May 4, 2010, we entered into an agreement with Tarantula Ventures LLC, a subsidiary of DuPont Fabros Technology, Inc. to lease approximately 28,200 square feet of raised floor space and storage space in a data center facility located in the Chicago, Illinois area. The leased space will be provided with a maximum critical load power of 4.333 megawatts. The lease provides for a commencement date at the earlier of February 1, 2011 and the date on which Rackspace begins to conduct business at the site. The lease has a term of 15 years from the commencement date and a total estimated financial obligation of approximately $100 million to $110 million over the 15 year term, inclusive of base lease payments and Rackspace's pro-rata share of operating expenses. Upon the expiration of the 15 year term, Rackspace has the option to renew the lease for two successive five year periods. Upon renewal of the lease, the rent can be reviewed and adjusted to market level, as set out in the lease.
 
- 16 -

 

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries.  We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section and Section 21E of the Securities Exchange Act of 1934, as amended, are subject to the “safe harbor” created by those sections.  The forward-looking statements in this report are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “aspires,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this document in greater detail under the heading “Risk Factors.” We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The risks described in “Risk Factors” included in this report, as well as any other cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of the events described in “Risk Factors” and elsewhere in this report could harm our business.
 
Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this document completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
 
The following discussion should be read in conjunction with our consolidated financial statements and the related notes contained elsewhere in this document.
 
Overview of our Business

We are the world’s 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.

We offer 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. For the first three months of 2010, 26.1% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, we operate a data center in Hong Kong and sales offices in Hong Kong and the Netherlands, which generate minimal revenue.  Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. For the first three months of 2010, no individual customer accounted for greater than 2% of our net revenue.
 
- 17 -

 
Key Metrics

We carefully track several financial and operational metrics to monitor and manage our growth, financial performance, and capacity. Our key metrics are structured around growth, profitability, capital efficiency, infrastructure capacity, and utilization. The following data should be read in conjunction with the consolidated financial statements, the notes to the financial statements and other financial information included in this Quarterly Report on Form 10-Q.
 
     Three Months Ended  
     (Unaudited)  
(Dollar amounts in thousands, except annualized net
 
March 31,
   
June 30,
   
September 30,
   
December 31,
   
March 31,
 
revenue per average technical square foot)
 
2009
   
2009
   
2009
   
2009
   
2010
 
Growth
                             
Managed hosting customers at period end
    19,048       19,363       19,328       19,304       19,366  
Cloud customers at period end**
    43,030       51,440       61,616       71,621       80,080  
Number of customers at period end
    62,078       70,803       80,944       90,925       99,446  
                                         
Managed hosting, net revenue
  $ 134,204     $ 138,943     $ 147,065     $ 152,394     $ 159,536  
Cloud, net revenue
  $ 10,873     $ 13,052     $ 15,334     $ 17,122     $ 19,269  
Net revenue
  $ 145,077     $ 151,995     $ 162,399     $ 169,516     $ 178,805  
Revenue growth (year over year)
    21.3 %     16.2 %     17.4 %     18.4 %     23.2 %
                                         
Net upgrades (monthly average)
    0.9 %     1.2 %     1.2 %     1.3 %     1.1 %
Churn (monthly average)
    -1.1 %     -1.0 %     -1.1 %     -0.8 %     -0.9 %
Growth in installed base (monthly average) *
    -0.2 %     0.2 %     0.1 %     0.4 %     0.2 %
                                         
Number of employees (Rackers) at period end
    2,661       2,648       2,730       2,774       2,905  
Number of servers deployed at period end
    50,038       52,269       54,655       56,671       59,876  
                                         
Profitability
                                       
Income from operations
  $ 13,021     $ 13,403     $ 13,128     $ 15,689     $ 16,728  
Depreciation and amortization
  $ 27,804     $ 29,711     $ 32,696     $ 35,018     $ 36,698  
Share-based compensation expense
                                       
Cost of revenue
  $ 629     $ 675     $ 778     $ 768     $ 969  
Sales and marketing
  $ 698     $ 721     $ 826     $ 639     $ 880  
General and administrative
  $ 2,910     $ 3,621     $ 4,008     $ 3,851     $ 4,129  
Total share-based compensation expense
  $ 4,237     $ 5,017     $ 5,612     $ 5,258     $ 5,978  
Adjusted EBITDA (1)
  $ 45,062     $ 48,131     $ 51,436     $ 55,965     $ 59,404  
                                         
Adjusted EBITDA margin
    31.1 %     31.7 %     31.7 %     33.0 %     33.2 %
                                         
Operating income margin
    9.0 %     8.8 %     8.1 %     9.3 %     9.4 %
                                         
Income from operations
  $ 13,021     $ 13,403     $ 13,128     $ 15,689     $ 16,728  
Effective tax rate
    36.6 %     36.2 %     33.9 %     34.0 %     33.6 %
Net operating profit after tax (NOPAT) (1)
  $ 8,255     $ 8,551     $ 8,678     $ 10,355     $ 11,107  
NOPAT margin
    5.7 %     5.6 %     5.3 %     6.1 %     6.2 %
                                         
Capital efficiency and returns
                                       
Interest bearing debt
  $ 201,507     $ 210,284     $ 167,976     $ 167,386     $ 169,517  
Stockholders' equity
  $ 282,880     $ 308,823     $ 330,392     $ 349,427     $ 370,425  
Less: Excess cash
  $ (117,611 )   $ (129,638 )   $ (83,462 )   $ (105,083 )   $ (109,840 )
Capital base
  $ 366,776     $ 389,469     $ 414,906     $ 411,730     $ 430,102  
Average capital base
  $ 368,127     $ 378,123     $ 402,188     $ 413,318     $ 420,916  
Capital turnover (annualized)
    1.58       1.61       1.62       1.64       1.70  
                                         
Return on capital (annualized) (1)
    9.0 %     9.0 %     8.6 %     10.0 %     10.6 %
                                         
Capital expenditures
                                       
Purchases of property and equipment, net
  $ 25,589     $ 31,027     $ 26,024     $ 34,652     $ 39,622  
Vendor financed equipment purchases
  $ 11,683     $ 23,637     $ 20,664     $ 12,398     $ 15,766  
Total capital expenditures
  $ 37,272     $ 54,664     $ 46,688     $ 47,050     $ 55,388  
                                         
Customer gear
  $ 19,255     $ 32,448     $ 28,705     $ 28,421     $ 32,488  
Data center build outs
  $ 11,386     $ 13,914     $ 4,028     $ 7,880     $ 16,644  
Office build outs
  $ 2,239     $ 1,651     $ 5,432     $ 5,350     $ 1,220  
Capitalized software and other projects
  $ 4,392     $ 6,651     $ 8,523     $ 5,399     $ 5,036  
Total capital expenditures
  $ 37,272     $ 54,664     $ 46,688     $ 47,050     $ 55,388  
                                         
Infrastructure capacity and utilization
                                       
Technical square feet of data center space at period end ***
    157,523       177,371       167,821       162,848       169,998  
Annualized net revenue per average technical square foot
  $ 3,969     $ 3,631     $ 3,764     $ 4,101     $ 4,298  
Utilization rate at period end
    64.6 %     59.8 %     62.3 %     65.3 %     66.5 %
                                         
* Due to rounding, totals may not equal the sum of the line items in the table above.
 
** Amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third party storage solution are excluded.
 
*** Technical square footage excludes 30,250 square feet and 4,400 square feet for unused portions of the Chicago and Northern Virginia facilities, respectively.
 
(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.
 
 
- 18 -

 
Non-GAAP Financial Measures
 
Return on Capital (ROC) (Non-GAAP financial measure)
 
We define Return on Capital as follows: ROC = Net operating profit after tax (NOPAT) / Average capital base

 
NOPAT = Income from operations x (1 – Effective tax rate)

Average capital base = Average of (Interest bearing debt + stockholders’ equity – excess cash) = Average of (Total assets – excess cash – accounts payables and accrued expenses – deferred revenue– other non-current liabilities and deferred income taxes)
 
Year-to-date average balances are based on an average calculated using the quarter end balances at the beginning of the period and all other quarter ending balances included in the period.

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

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

Note that ROC is not a measure of financial performance under GAAP and should not be considered a substitute for return on assets, which we consider to be the most directly comparable GAAP measure. ROC has limitations as an analytical tool, and when assessing our operating performance, you should not consider ROC in isolation, or as a substitute for other financial data prepared in accordance with GAAP. Other companies may calculate ROC differently than we do, limiting its usefulness as a comparative measure.
 
ROC increased from 9.0% to 10.6% for the three months ended March 31, 2009 compared to the three months ended March 31, 2010, primarily due to a lower tax rate favorably impacting the ROC calculation for the three months ended March 31, 2010 as well as a reduction of operating costs as a percentage of revenue.  Included in the average capital base are capital expenditures of $15.9 million and $53.9 million related to the build out of our new corporate headquarters facility and data centers, respectively, since the beginning of 2009.
 
Return on assets increased from 4.1% for the three months ended March 31, 2009 to 5.8% for the three months ended March 31, 2010. This increase was primarily due to higher revenue and net income as well as a lower tax rate, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.

See our reconciliation of the calculation of return on assets to ROC in the following table:
 
     Three Months Ended  
     (Unaudited)  
(In thousands, except financial metrics)
 
March 31,
2009
   
June 30,
2009
   
September 30,
2009
   
December 31,
2009
   
March 31,
2010
 
Income from operations
  $ 13,021     $ 13,403     $ 13,128     $ 15,689     $ 16,728  
Effective tax rate
    36.6 %     36.2 %     33.9 %     34.0 %     33.6 %
Net operating profit after tax (NOPAT)
  $ 8,255     $ 8,551     $ 8,678     $ 10,355     $ 11,107  
                                         
Net income
  $ 6,588     $ 6,991     $ 7,604     $ 9,035     $ 9,812  
                                         
Total assets at period end
  $ 601,434     $ 656,793     $ 625,330     $ 668,645     $ 691,729  
Less: Excess cash
  $ (117,611 )   $ (129,638 )   $ (83,462 )   $ (105,083 )   $ (109,840 )
Less: Accounts payable and accrued expenses
  $ (71,211 )   $ (87,316 )   $ (77,108 )   $ (89,773 )   $ (92,828 )
Less: Deferred revenues (current and non-current)
  $ (20,374 )   $ (20,011 )   $ (18,222 )   $ (19,444 )   $ (18,044 )
Less: Other non-current liabilities and deferred taxes
  $ (25,462 )   $ (30,359 )   $ (31,632 )   $ (42,615 )   $ (40,915 )
Capital base
  $ 366,776     $ 389,469     $ 414,906     $ 411,730     $ 430,102  
                                         
Average total assets
  $ 643,348     $ 629,114     $ 641,062     $ 646,988     $ 680,187  
Average capital base
  $ 368,127     $ 378,123     $ 402,188     $ 413,318     $ 420,916  
                                         
Return on assets (annualized)
    4.1 %     4.4 %     4.7 %     5.6 %     5.8 %
Return on capital (annualized)
    9.0 %     9.0 %     8.6 %     10.0 %     10.6 %

 
- 19 -

 
Adjusted EBITDA (Non-GAAP financial measure)
 
We use Adjusted EBITDA as a supplemental measure to review and assess our performance.  We define Adjusted EBITDA as Net income, plus income taxes, total other income (expense), depreciation and amortization, and non-cash charges for share-based compensation.
 
Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.
 
    Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation, or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP.  Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. 
 
Adjusted EBITDA as a percentage of net revenue has increased from 31.1% for the three months ended March 31, 2009 to 33.2% for the three months ended March 31, 2010 due to revenue increasing at a faster rate than our operating costs.
 
Income from operations has been favorably impacted by cost containment initiatives, but was partially offset by higher depreciation and amortization expense resulting from capital investments, and increasing share-based compensation expense from grants of stock options and other stock awards to employees. Our operating income margin increased from 9.0% for the three months ended March 31, 2009 to 9.4% for the three months ended March 31, 2010.
 
    See our Adjusted EBITDA reconciliation below.
 
     Three Months Ended  
     (Unaudited)  
(Dollars in thousands)
 
March 31,
2009
   
June 30,
2009
   
September 30,
2009
   
December 31,
2009
   
March 31,
2010
 
Net revenue
  $ 145,077     $ 151,995     $ 162,399     $ 169,516     $ 178,805  
                                         
Income from operations
  $ 13,021     $ 13,403     $ 13,128     $ 15,689     $ 16,728  
                                         
Net income
  $ 6,588     $ 6,991     $ 7,604     $ 9,035     $ 9,812  
   Plus: Income taxes
  $ 3,807     $ 3,973     $ 3,900     $ 4,648     $ 4,957  
   Plus: Total other (income) expense
  $ 2,626     $ 2,439     $ 1,624     $ 2,006     $ 1,959  
   Plus: Depreciation and amortization
  $ 27,804     $ 29,711     $ 32,696     $ 35,018     $ 36,698  
   Plus: Share-based compensation expense
  $ 4,237     $ 5,017     $ 5,612     $ 5,258     $ 5,978  
Adjusted EBITDA
  $ 45,062     $ 48,131     $ 51,436     $ 55,965     $ 59,404  
                                         
Operating income margin
    9.0 %     8.8 %     8.1 %     9.3 %     9.4 %
                                         
Adjusted EBITDA margin
    31.1 %     31.7 %     31.7 %     33.0 %     33.2 %

 
- 20 -

 
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.
 
   
Three Months
Ended
 
(In thousands)
 
March 31,
2010
 
   
(Unaudited)
 
Adjusted EBITDA
  $ 59,404  
Non-cash deferred rent
    1,804  
Total capital expenditures
    (55,388 )
Cash payments for interest, net
    (2,098 )
Cash refunds (payments) for income taxes, net
    (2,284 )
Adjusted free cash flow
  $ 1,438  
 
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 March 31,
 
   
2010
 
   
(Unaudited)
 
Obligations under capital leases
  $ 112,673  
Debt
    56,844  
Total debt
  $ 169,517  
Less: Cash and cash equivalents
    (131,297 )
Net debt
  $ 38,220  
Adjusted EBITDA (trailing twelve months)
  $ 214,936  
         
Net leverage
    0.18 x

 
- 21 -

 
Results of Operations

The following tables set forth our results of operations for the specified periods and as a percentage of our revenue for those same periods. The period-to-period comparison of financial results is not necessarily indicative of future results.

Consolidated Statements of Income (Unaudited):

     Three Months Ended  
(In thousands)
 
March 31,
2009
   
June 30,
2009
   
September 30,
2009
   
December 31,
2009
   
March 31,
2010
 
                               
Net revenue
  $ 145,077     $ 151,995     $ 162,399     $ 169,516     $ 178,805  
Costs and expenses:
                                       
Cost of revenue
    46,210       48,235       53,093       53,405       57,007  
Sales and marketing
    20,502       19,080       19,860       20,016       21,977  
General and administrative
    37,540       41,566       43,622       45,388       46,395  
Depreciation and amortization
    27,804       29,711       32,696       35,018       36,698  
Total costs and expenses
    132,056       138,592       149,271       153,827       162,077  
Income from operations
    13,021       13,403       13,128       15,689       16,728  
Other income (expense):