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EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-322_093014.htm
EXCEL - IDEA: XBRL DOCUMENT - RACKSPACE HOSTING, INC.Financial_Report.xls
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-311_093014.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-321_093014.htm
EX-10.1 - AMENDED AND RESTATED EMPLOYMENT AGREEMENT WITH WILLIAM TAYLOR RHODES - RACKSPACE HOSTING, INC.raxex-101_093014.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-312_093014.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 FORM 10-Q
(Mark one)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014.
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 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.)

1 Fanatical Place
City of Windcrest
San Antonio, Texas 78218
(Address of principal executive offices, including zip code)

(210) 312-4000
(Registrant’s 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   R    No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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   R    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 definitions of “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer R
 
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 R  
 
On November 6, 2014, 143,554,418 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:
 
 
 
Unaudited Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2013 and 2014
 
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2014
 
Item 2.
Item 3.
Item 4.
 
 
 
Part II - Other Information
 
Item 1.
Item 1A.
Item 6.
 
 
 
 



PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 
December 31,
2013
 
September 30,
2014
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
259,733

 
$
349,480

Accounts receivable, net of allowance for doubtful accounts and customer credits of $3,891 as of December 31, 2013 and $4,650 as of September 30, 2014
 
123,898

 
134,555

Deferred income taxes
 
12,637

 
11,061

Prepaid expenses
 
30,782

 
42,349

Other current assets
 
11,918

 
16,509

Total current assets
 
438,968

 
553,954

 
 
 
 
 
Property and equipment, net
 
890,776

 
1,014,168

Goodwill
 
81,084

 
81,084

Intangible assets, net
 
23,880

 
18,241

Other non-current assets
 
57,089

 
57,095

Total assets
 
$
1,491,797

 
$
1,724,542

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
122,047

 
$
139,501

Accrued compensation and benefits
 
62,459

 
80,580

Income and other taxes payable
 
11,388

 
24,316

Current portion of deferred revenue
 
22,868

 
19,562

Current portion of capital lease obligations
 
37,885

 
20,144

Current portion of debt
 
1,861

 
160

Total current liabilities
 
258,508

 
284,263

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Deferred revenue
 
3,662

 
1,875

Capital lease obligations
 
25,048

 
11,168

Finance lease obligations for assets under construction
 

 
67,046

Debt
 
124

 

Deferred income taxes
 
69,729

 
47,924

Deferred rent
 
43,046

 
49,233

Other liabilities
 
36,268

 
39,261

Total liabilities
 
436,385

 
500,770

 
 
 
 
 
COMMITMENTS AND CONTINGENCIES
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 141,123,904 shares issued and outstanding as of December 31, 2013; 143,547,558 shares issued and outstanding as of September 30, 2014
 
141

 
144

Additional paid-in capital
 
636,660

 
736,208

Accumulated other comprehensive loss
 
(4,536
)
 
(9,364
)
Retained earnings
 
423,147

 
496,784

Total stockholders’ equity
 
1,055,412

 
1,223,772

Total liabilities and stockholders’ equity
 
$
1,491,797

 
$
1,724,542


See accompanying notes to the unaudited condensed consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In thousands, except per share data)
 
2013
 
2014
 
2013
 
2014
 
 
 
 
 
 
 
 
 
Net revenue
 
$
388,636

 
$
459,776

 
$
1,126,683

 
$
1,321,935

Costs and expenses:
 
 
 
 
 
 
 
 
Cost of revenue
 
127,404

 
142,954

 
358,672

 
428,422

Research and development
 
23,773

 
30,718

 
65,364

 
85,621

Sales and marketing
 
50,869

 
60,582

 
152,952

 
178,421

General and administrative
 
78,075

 
86,702

 
218,392

 
239,276

Depreciation and amortization
 
80,753

 
98,307

 
225,324

 
276,671

Total costs and expenses
 
360,874

 
419,263

 
1,020,704

 
1,208,411

Income from operations
 
27,762

 
40,513

 
105,979

 
113,524

Other income (expense):
 
 
 
 
 
 
 
 
Interest expense
 
(689
)
 
(445
)
 
(2,462
)
 
(1,469
)
Interest and other income (expense)
 
440

 
(2,191
)
 
336

 
(1,755
)
Total other income (expense)
 
(249
)
 
(2,636
)
 
(2,126
)
 
(3,224
)
Income before income taxes
 
27,513

 
37,877

 
103,853

 
110,300

Income taxes
 
11,202

 
12,137

 
37,914

 
36,663

Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

 
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
$
11,893

 
$
(13,265
)
 
$
(36
)
 
$
(4,828
)
Other comprehensive income (loss)
 
11,893

 
(13,265
)
 
(36
)
 
(4,828
)
Comprehensive income
 
$
28,204

 
$
12,475

 
$
65,903

 
$
68,809

 
 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
 
Basic
 
$
0.12

 
$
0.18

 
$
0.48

 
$
0.52

Diluted
 
$
0.11

 
$
0.18

 
$
0.46

 
$
0.51

 
 
 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
 
 
Basic
 
138,714

 
142,978

 
138,140

 
142,036

Diluted
 
143,543

 
144,895

 
142,699

 
144,310

 
See accompanying notes to the unaudited condensed consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Nine Months Ended September 30,
(In thousands)
 
2013
 
2014
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
65,939

 
$
73,637

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
225,324

 
276,671

Loss on disposal of equipment, net
 
892

 
159

Provision for bad debts and customer credits
 
3,843

 
4,323

Deferred income taxes
 
10,305

 
(30,140
)
Deferred rent
 
9,285

 
6,297

Share-based compensation expense
 
42,457

 
49,839

Excess tax benefits from share-based compensation arrangements
 
(17,383
)
 
(45,311
)
Changes in certain assets and liabilities:
 
 
 
 
Accounts receivable
 
(24,129
)
 
(15,729
)
Prepaid expenses and other current assets
 
(18,560
)
 
(17,199
)
Accounts payable and accrued expenses
 
26,948

 
93,882

Deferred revenue
 
1,191

 
(4,952
)
All other operating activities
 
8,430

 
147

Net cash provided by operating activities
 
334,542

 
391,624

 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(325,873
)
 
(323,126
)
Acquisitions, net of cash acquired
 
(6,203
)
 

All other investing activities
 
(1,808
)
 
1,945

Net cash used in investing activities
 
(333,884
)
 
(321,181
)
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
Principal payments of capital leases
 
(51,208
)
 
(32,502
)
Principal payments of notes payable
 
(1,863
)
 
(1,866
)
Payments for deferred acquisition obligations
 
(1,296
)
 
(168
)
Receipt of Texas Enterprise Fund grant
 

 
5,500

Common shares withheld for employee withholding taxes
 

 
(13,620
)
Proceeds from employee stock plans
 
14,846

 
18,021

Excess tax benefits from share-based compensation arrangements
 
17,383

 
45,311

Net cash provided by (used in) financing activities
 
(22,138
)
 
20,676

 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
(586
)
 
(1,372
)
 
 
 
 
 
Increase (decrease) in cash and cash equivalents
 
(22,066
)
 
89,747

 
 
 
 
 
Cash and cash equivalents, beginning of period
 
292,061

 
259,733

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
269,995

 
$
349,480

 
 
 
 
 
Supplemental Cash Flow Information:
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
415

 
$
929

Increase in property and equipment in accounts payable and accrued expenses
 
23,194

 
6,455

Non-cash purchases of property and equipment
 
$
23,609

 
$
7,384

 
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
2,599

 
$
1,399

Cash payments for income taxes
 
$
12,674

 
$
7,144

 
 
 
 
 
Shares issued in business combinations
 
$
4,457

 
$

Additional finance lease obligations for assets under construction and other
 
$

 
$
70,787


See accompanying notes to the unaudited condensed consolidated financial statements.

- 5 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies

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 cloud computing services, 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®.

Our operations began in 1998 as a limited partnership, and Rackspace Hosting, Inc. was incorporated in Delaware in March 2000.

Basis of Consolidation

The accompanying consolidated financial statements include the accounts of Rackspace Hosting, Inc. and our wholly-owned subsidiaries, which include, among others, Rackspace US, Inc., our domestic operating entity, and Rackspace Limited, our United Kingdom operating entity. Intercompany transactions and balances have been eliminated in consolidation.

Foreign currency translation adjustments arising from differences in exchange rates from period to period are included in the foreign currency translation adjustment account in accumulated other comprehensive income (loss). There was no income tax expense allocated to foreign currency translation adjustments during the three or nine months ended September 30, 2013 or 2014

Basis of Presentation
 
The accompanying consolidated financial statements as of September 30, 2014, and for the three and nine months ended September 30, 2013 and 2014, 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. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2013 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 3, 2014 (the "2013 Annual Consolidated Financial Statements"). The unaudited interim consolidated financial statements have been prepared on the same basis as the 2013 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 September 30, 2014, our results of operations for the three and nine months ended September 30, 2013 and 2014, and our cash flows for the nine months ended September 30, 2013 and 2014.
 
The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2014, or for any other interim period, or for any other future year.

- 6 -



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. 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 share-based compensation, contingencies, and income taxes, among others. Whenever possible, we base our estimates and assumptions on historical experience. However, certain estimates require us to make assumptions about expected future cash flow, events and usage patterns that we cannot influence or control. Our judgments, assumptions and estimates are based upon facts and circumstances known to us when we prepare the financial statements and that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities or recording revenue and expenses in our financial statements. Changes in facts and circumstances may cause us to change our assumptions and estimates in future periods, and it is possible that actual results could differ from our estimates. We have engaged third-party consultants to assist management in the valuation of acquired assets, including other intangibles, as well as share-based compensation.

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 the 2013 Annual Consolidated Financial Statements.

Recent Accounting Pronouncements Not Yet Adopted

In May 2014, the Financial Accounting Standards Board ("FASB") issued guidance to clarify principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and is to be applied retrospectively using one of two methods. One method is to apply the guidance retrospectively to each prior period presented with practical expedients available. The second method is to apply the guidance retrospectively with the cumulative effect of initially applying the Update recognized at the date of initial application. Early application is not permitted. We will adopt this standard in the first quarter of 2017, and we are evaluating the impact on our consolidated financial statements of adopting this new accounting standard.

In April 2014, the FASB issued guidance to revise the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity's operations and financial results. This guidance also requires expanded disclosures for discontinued operations and adds new disclosures for individually significant dispositions that do not qualify as discontinued operations. This guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2014. The impact of the adoption of this guidance will be dependent on the nature of dispositions, if any, occurring after adoption.

In August 2014, the FASB issued guidance that will require management to evaluate, at each annual and interim reporting period, whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern and provide related footnote disclosures in certain circumstances. This guidance is effective for the annual period ending after December 15, 2016 and for annual and interim periods thereafter with early adoption permitted. We do not expect the adoption of this guidance to have an impact on our consolidated financial statements.

- 7 -


2. Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In thousands, except per share data)
 
2013
 
2014
 
2013
 
2014
Basic net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
138,714

 
142,978

 
138,140

 
142,036

Number of shares used in per share computations
 
138,714

 
142,978

 
138,140

 
142,036

Net income per share
 
$
0.12

 
$
0.18

 
$
0.48

 
$
0.52

 
 
 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
138,714

 
142,978

 
138,140

 
142,036

Stock options, awards and employee share purchase plans
 
4,829

 
1,917

 
4,559

 
2,274

Number of shares used in per share computations
 
143,543

 
144,895

 
142,699

 
144,310

Net income per share
 
$
0.11

 
$
0.18

 
$
0.46

 
$
0.51


We excluded 3.9 million and 5.8 million potential common shares from the computation of dilutive net income per share for the three months ended September 30, 2013 and 2014, respectively, and 2.8 million and 5.6 million potential shares for the nine months ended September 30, 2013 and 2014, respectively, because the effect would have been anti-dilutive.


- 8 -


3. 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 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.

 Assets and liabilities measured at fair value on a recurring basis are summarized by level below. As of December 31, 2013 and September 30, 2014, we did not hold any financial instruments categorized as Level 2 or Level 3. Our Level 1 assets and liabilities are valued using quoted market prices.
 
(In thousands)
 
December 31, 2013
 
September 30, 2014
Level 1:
 
 
 
 
Assets:
 
 
 
 
Money market funds (1)
 
$
102,380

 
$
90,553

Rabbi trust (2)
 
835

 
1,123

     Total
 
$
103,215

 
$
91,676

 
 
 
 
 
Liabilities:
 
 
 
 
Deferred compensation (3)
 
$
540

 
$
829

     Total
 
$
540

 
$
829


(1)
Money market funds are classified in cash and cash equivalents.
(2)
Investments in marketable securities held in a Rabbi Trust associated with a non-qualified deferred compensation plan are classified in other non-current assets.
(3)
Obligations to pay benefits under a non-qualified deferred compensation plan are classified in other non-current liabilities.

Our Rabbi Trust was established in 2009, and we elected the fair value option, which allows for the recognition of gains and losses to be recorded in the Consolidated Statement of Comprehensive Income in the same period as the gains and losses are incurred as part of the non-qualified deferred compensation plan. During the three and nine months ended September 30, 2013 and September 30, 2014, we recognized minimal net gains and losses as interest and other income (expense).


- 9 -


4. Property and Equipment, net
 
Property and equipment consisted of: 
(Dollar amounts in thousands)
 
Estimated Useful Lives
 
December 31,
2013
 
September 30,
2014
Computers, software and equipment
 
1
-
5
years
 
$
1,488,106

 
$
1,743,301

Furniture and fixtures
 
7
years
 
55,681

 
56,529

Buildings and leasehold improvements
 
2
-
30
years
 
236,255

 
258,636

Land
 
 
 
 
 
 
28,566

 
28,436

Property and equipment, at cost
 
 
 
 
 
 
1,808,608

 
2,086,902

Less accumulated depreciation and amortization
 
 
 
 
 
 
(983,618
)
 
(1,186,882
)
Work in process
 
 
 
 
 
 
65,786

 
114,148

Property and equipment, net
 
 
 
 
 
 
$
890,776

 
$
1,014,168

 
At December 31, 2013, the work in process balance consisted of build outs of $32.6 million for office facilities, $2.4 million for data centers, and $30.7 million for capitalized software and other projects. At September 30, 2014, the work in process balance consisted of build outs of $38.6 million for office facilities, $52.7 million for data centers, and $22.9 million for capitalized software and other projects.

5. Leases

We have entered into multiple complex real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects. While the independent developers legally own the real estate projects and must finance the overall construction, we agreed to fund certain structural improvements and/or retain obligations related to certain potential construction cost overruns which have triggered an accounting requirement to include construction costs in progress and a related long-term finance lease liability on our consolidated balance sheets as though we are the owner of the asset during the construction period. We do not depreciate the cost of the real estate projects or expect to fund this long-term finance lease liability during the construction period.

Upon completion of construction, we perform a sale-leaseback analysis pursuant to ASC 840, Leases, to determine if we can remove the asset and liability from our consolidated balance sheet. If the asset and corresponding liability can be derecognized, then the lease will be accounted for as an operating lease, and we will recognize rent expense over the lease term. However, certain factors are considered “continuing involvement” which precludes derecognizing the asset and liability when construction is complete. If the sale-leaseback criteria are not met, the asset would be considered to be owned for accounting purposes during the lease term. At this time, the amount recorded as a finance lease obligation for assets under construction would be transferred to a capital lease obligation. Accordingly, the asset would be depreciated and rental payments under the lease would be recorded as a reduction of the capital lease liability and interest expense.

During the first quarter of 2014, construction of one of these real estate projects was completed, and we performed a sale-leaseback analysis. As a result of our continuing involvement in the project, we were precluded from derecognizing the asset and liability, and we will account for the lease as a capital lease obligation throughout the lease term. At the end of the lease term, we will derecognize the remaining lease obligation and asset balance.

As of December 31, 2013 and September 30, 2014 we had $0 and $67.0 million, respectively, of finance lease obligations for assets under construction recorded on our consolidated balance sheets related to real estate projects for which we are deemed the accounting owner during the construction period, with the corresponding construction costs in progress included in work in process within property and equipment, net.


- 10 -


6. Contingencies

We have contingent liabilities resulting from various litigation, claims and commitments. We record accruals for loss contingencies when losses are considered probable and can be reasonably estimated. The amount that will ultimately be paid related to these matters may differ from the recorded accruals, and the timing of such payments is uncertain. We were involved in the following legal proceeding:

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 alleged 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. This matter was settled as of February 19, 2014, and there was not a material difference between the settlement amount and the amount for which we had accrued for the matter in our consolidated financial statements.

We are a party to various claims that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, products, or services, and may also cause us to change our business practices and require development of non-infringing products or technologies, which could result in a loss of revenue for us and otherwise harm our business. We have disputed the allegations of wrongdoing in these proceedings and intend to vigorously defend ourselves in all such matters.

We cannot predict the impact, if any, that any of the matters described above may have on our business, results of operations, financial position, or cash flows. Because of the inherent uncertainties of such matters, including the early stage and lack of specific damage claims in many of them, we cannot estimate the range of possible losses from them.

We record to cost of revenue state sales taxes related to software licenses acquired to provide hosting services to customers. We also remit state sales taxes collected from our customers for hosting services invoiced to our customers, with such services including the use of the aforementioned software licenses. During the three months ended September 30, 2014, we recorded a $7 million benefit to cost of revenue for settlement of a dispute related to sales taxes paid on such software licenses for the period September 2007 through April 2014. 

7. Share-Based Compensation
 
We have granted equity awards to our employees and directors in the form of stock options and restricted stock. The exercise price of all stock options granted is not less than 100% of the fair market value of a share of common stock as of the date of grant. The stock options granted vest ratably over a four-year period. All stock options expire seven to ten years following the grant date. The restricted stock generally vests ratably over a four-year period. Certain key executives have received restricted stock grants that cliff-vest over various terms from one to three years. Vesting of these grants are generally based on predetermined market and/or performance conditions.

The composition of the equity awards outstanding as of December 31, 2013 and September 30, 2014 was as follows: 
 
 
December 31,
2013
 
September 30,
2014
Restricted stock
 
3,538,271
 
4,252,132
Stock options
 
9,487,570
 
7,499,819
     Total outstanding awards
 
13,025,841
 
11,751,951
 
We also have an Employee Stock Purchase Plan (the "ESPP"). Under the ESPP, eligible employees may purchase a limited number of shares of our common stock at the lesser of 85% of the market value on the enrollment date or 85% of the market value on the purchase date. The ESPP is made up of a series of offering periods. Each offering period has a maximum term of 24 months and is divided into semi-annual purchase intervals. The current ESPP began on July 1, 2013 and will conclude on June 30, 2015. Eligible employees may enroll at the beginning of any semi-annual purchase interval.


- 11 -


Share-Based Compensation Expense

Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in thousands)
 
2013
 
2014
 
2013
 
2014
Cost of revenue
 
$
3,453

 
$
4,175

 
$
8,707

 
$
12,093

Research and development
 
2,306

 
3,399

 
5,647

 
9,472

Sales and marketing
 
2,149

 
2,637

 
5,551

 
6,790

General and administrative
 
9,051

 
9,631

 
22,552

 
21,484

Pre-tax share-based compensation
 
16,959

 
19,842

 
42,457

 
49,839

Less: Income tax benefit
 
(6,578
)
 
(6,408
)
 
(15,500
)
 
(16,566
)
Total share-based compensation expense, net of tax
 
$
10,381

 
$
13,434

 
$
26,957

 
$
33,273


As of September 30, 2014, there was $193.2 million of total unrecognized compensation cost related to restricted stock, stock options and the ESPP, which will be amortized using the straight-line method over a weighted average period of 2.5 years.

8. 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. As such, our effective tax rate is impacted by the geographical distribution of income and mix of profits in the various jurisdictions. Additionally, the amount of income taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we file.
  
We expect a taxable profit in the U.S. and U.K. for the full year 2014 before consideration of excess tax benefits, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2014. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the current period.

9. Subsequent Event
 
On November 6, 2014, the Company's Board of Directors authorized the repurchase of up to $500.0 million of our common stock over the next two years.


- 12 -


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

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 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 and with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.
 
Overview of our Business

Rackspace is the world leader in the managed cloud segment of the business IT market. We serve hundreds of thousands of business customers from our data centers on four continents. We help them tap the power of cloud computing without the pain of having to become experts in dozens of complex technologies, and without the expense of hiring or contracting with engineers who do not differentiate their businesses.

Our focus on the managed cloud separates us from the big providers of unmanaged, commodity cloud computing, who rent out access to raw cloud infrastructure and then expect customers to do everything required to operate that infrastructure, as well as the many tools and applications that run on top of it, including data engines and e-commerce platforms.

Rackspace helps each business customer find the IT infrastructure that best fits its unique needs. Our broad hybrid cloud portfolio and specialized expertise enables each customer to run each of its workloads where it will perform best and most cost-efficiently, whether on single-tenant servers or the multi-tenant public cloud, or a combination of these platforms. This emphasis on the best fit for each workload differentiates Rackspace from the one-size-fits-all providers who offer only multi-tenant public cloud.

We sell our services to small and medium-sized businesses, as well as large enterprises. The majority of our revenue is generated by our operations in the U.S. and U.K. Additionally, we have operations in Switzerland, Hong Kong and Australia, and recently opened an office in Mexico. Our growth strategy includes targeting additional international customers as we continue our expansion in continental Europe, the Asia-Pacific region and Latin America. For the first nine months of 2014, 32% of our net revenue was from non-U.S. customers, and no individual customer accounted for greater than 2% of our net revenue.

- 13 -



We believe that the segment of the cloud computing market on which we are focused is a large market that represents a significant opportunity. We see a high level of interest building from companies who want to focus their scarce engineering assets on their core business and want a trusted partner to manage their cloud. They want Fanatical Support every step of the way, they want specialized expertise in running the ever-expanding set of technologies that are at the heart of cloud scale applications, and they want a partner who is committed to open and standard technologies, so that they are not locked into any single vendor.

In order to take advantage of the long-term continued growth opportunities in the market, we have been making increased infrastructure investments to complement and leverage Fanatical Support, our principal differentiation from our competitors across our multiple service offerings. Our cloud computing services provide customers with a mission-critical service and world class support, and we believe this provides us with substantial growth opportunities. We believe that by offering a higher service level agreement and extending our support to additional technology platforms, our business becomes more capital efficient and our competitive advantage widens as our service capability increases. We expect to continue making these investments in research and development, data centers, corporate facilities, information technology infrastructure, and employees.

Recent Developments

In July 2014, we announced our new managed cloud strategy for delivering public cloud services to market, including enhanced service levels and a more transparent service-based pricing model. We also created developer+, a new program for developers that offers essential services needed to build scalable applications. The managed cloud strategy focuses on businesses and developers looking for a strong partner to help design, manage and scale their cloud operations.

Also in July 2014, we launched OnMetal Cloud Servers to reduce cloud complexity and help cloud applications scale. These API-driven bare metal servers can be spun up as quickly as virtual machines. OnMetal Cloud Servers are designed for customers with rapidly growing infrastructure footprints who value the agility and elasticity of cloud along with the simplicity and cost-efficiency of colocation.

While these new offerings are still in the early stages, we believe that these new capabilities and features could drive future incremental demand.

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, and infrastructure capacity and utilization.

- 14 -


 
 
Three Months Ended
(Dollar amounts in thousands, except average monthly revenue per server)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
 
 
 
 
Growth
 
 
 
 
 
 
 
 
 
 
Dedicated cloud, net revenue
 
$
280,215

 
$
291,265

 
$
299,689

 
$
310,647

 
$
319,601

Public cloud, net revenue
 
$
108,421

 
$
116,838

 
$
121,358

 
$
130,465

 
$
140,175

Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

Revenue growth (year over year)
 
15.7
 %
 
15.6
 %
 
16.2
 %
 
17.4
 %
 
18.3
 %
Net upgrades (monthly average)
 
1.5
 %
 
1.1
 %
 
0.9
 %
 
1.5
 %
 
1.4
 %
Churn (monthly average)
 
-0.8
 %
 
-0.7
 %
 
-0.6
 %
 
-0.7
 %
 
-0.6
 %
Growth in installed base (monthly average) (1)
 
0.7
 %
 
0.4
 %
 
0.3
 %
 
0.8
 %
 
0.8
 %
Number of employees (Rackers) at period end
 
5,450

 
5,651

 
5,743

 
5,798

 
5,939

Number of servers deployed at period end
 
101,967

 
103,886

 
106,229

 
107,657

 
110,453

Average monthly revenue per server
 
$
1,290

 
$
1,322

 
$
1,336

 
$
1,375

 
$
1,405

Profitability
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Depreciation and amortization
 
$
80,753

 
$
87,683

 
$
87,805

 
$
90,559

 
$
98,307

Share-based compensation expense
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
$
3,453

 
$
3,877

 
$
3,791

 
$
4,127

 
$
4,175

Research and development
 
$
2,306

 
$
2,521

 
$
2,780

 
$
3,293

 
$
3,399

Sales and marketing
 
$
2,149

 
$
1,766

 
$
2,091

 
$
2,062

 
$
2,637

General and administrative
 
$
9,051

 
$
9,024

 
$
4,070

 
$
7,783

 
$
9,631

Total share-based compensation expense
 
$
16,959

 
$
17,188

 
$
12,732

 
$
17,265

 
$
19,842

Adjusted EBITDA (2)
 
$
125,474

 
$
132,028

 
$
139,661

 
$
141,711

 
$
158,662

Adjusted EBITDA margin
 
32.3
 %
 
32.4
 %
 
33.2
 %
 
32.1
 %
 
34.5
 %
Operating income margin
 
7.1
 %
 
6.7
 %
 
9.3
 %
 
7.7
 %
 
8.8
 %
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Effective tax rate
 
40.7
 %
 
22.7
 %
 
34.6
 %
 
33.0
 %
 
32.0
 %
Net operating profit after tax (NOPAT) (2)
 
$
16,463

 
$
20,992

 
$
25,587

 
$
22,704

 
$
27,549

NOPAT margin
 
4.2
 %
 
5.1
 %
 
6.1
 %
 
5.1
 %
 
6.0
 %
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
Interest bearing debt
 
$
72,579

 
$
64,918

 
$
53,326

 
$
41,747

 
$
31,472

Stockholders' equity
 
$
988,708

 
$
1,055,412

 
$
1,100,012

 
$
1,171,197

 
$
1,223,772

Less: Excess cash
 
$
(223,359
)
 
$
(210,761
)
 
$
(263,309
)
 
$
(287,411
)
 
$
(294,307
)
Capital base
 
$
837,928

 
$
909,569

 
$
890,029

 
$
925,533

 
$
960,937

Average capital base
 
$
821,155

 
$
873,749

 
$
899,799

 
$
907,781

 
$
943,235

Capital turnover (annualized)
 
1.89

 
1.87

 
1.87

 
1.94

 
1.95

Return on capital (annualized) (2)
 
8.0
 %
 
9.6
 %
 
11.4
 %
 
10.0
 %
 
11.7
 %
Capital expenditures
 
 
 
 
 
 
 
 
 
 
Cash purchases of property and equipment
 
$
100,496

 
$
126,723

 
$
84,953

 
$
114,044

 
$
124,129

Non-cash purchases of property and equipment (3)
 
$
17,062

 
$
(4,116
)
 
$
15,741

 
$
(1,651
)
 
$
(6,706
)
Total capital expenditures
 
$
117,558

 
$
122,607

 
$
100,694

 
$
112,393

 
$
117,423

Customer gear
 
$
73,784

 
$
65,291

 
$
60,688

 
$
64,767

 
$
78,677

Data center build outs
 
$
12,441

 
$
22,524

 
$
10,963

 
$
13,767

 
$
14,825

Office build outs
 
$
6,700

 
$
14,860

 
$
9,212

 
$
6,857

 
$
3,464

Capitalized software and other projects
 
$
24,633

 
$
19,932

 
$
19,831

 
$
27,002

 
$
20,457

Total capital expenditures
 
$
117,558

 
$
122,607

 
$
100,694

 
$
112,393

 
$
117,423

Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end
 
60.0

 
60.0

 
58.1

 
58.1

 
58.1

Megawatts available for use at period end
 
46.9

 
46.9

 
45.3

 
45.4

 
45.4

Megawatts utilized at period end
 
27.0

 
27.4

 
28.1

 
29.0

 
29.9

Annualized net revenue per average Megawatt of power utilized
 
$
58,662

 
$
60,015

 
$
60,691

 
$
61,802

 
$
62,448


- 15 -


(1)
Due to rounding, totals may not equal the sum of the line items in the table above.
(2)
See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures below.
(3)
Non-cash purchases of property and equipment represents changes in amounts accrued for purchases under vendor financing and other deferred payment arrangements.

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 payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable – deferred revenue – other non-current liabilities, deferred income taxes, deferred rent and finance lease obligations for assets under construction)
 
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 after-tax operating profits with the capital that is placed into service. It is therefore a performance metric that incorporates both the Statement of Comprehensive Income and the Balance Sheet. ROC measures how successfully capital is deployed within a company.

Note that ROC is not a measure of financial performance under GAAP and should not be considered a substitute for return on assets, which we calculate directly from amounts on the Statement of Comprehensive Income and the Balance Sheet. ROC has limitations as an analytical tool, and when assessing our operating performance, you should not consider ROC in isolation or as a substitute for other financial data prepared in accordance with GAAP. Other companies may calculate ROC differently than we do, limiting its usefulness as a comparative measure.
 
ROC increased from 8.0% for the three months ended September 30, 2013 to 11.7% for the three months ended September 30, 2014. This increase was primarily due to a 46% increase in income from operations between periods reflecting improved results driven by net revenue growth, partially offset by higher expenses. For further discussion of our operating results, see "Results of Operations" within this "Management's Discussion and Analysis of Financial Condition and Results of Operations." ROC was also positively impacted by a lower effective tax rate of 32.0% compared to 40.7% in the prior year period. These positive impacts were partially offset by a 15% increase in the average capital base between periods, as we continue to make infrastructure investments to support and enhance our growth opportunities. Return on assets increased from 4.6% for the three months ended September 30, 2013 to 6.1% for the three months ended September 30, 2014. This increase reflects our improved profitability as net income increased 58% between periods, partially offset by a 19% increase in average total assets.
 

- 16 -


See our reconciliation of the calculation of ROC to the calculation of return on assets in the table below: 
 
 
Three Months Ended
(In thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Effective tax rate
 
40.7
%
 
22.7
%
 
34.6
%
 
33.0
%
 
32.0
%
Net operating profit after tax (NOPAT)
 
$
16,463

 
$
20,992

 
$
25,587

 
$
22,704

 
$
27,549

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,451,769

 
$
1,491,797

 
$
1,566,949

 
$
1,647,975

 
$
1,724,542

Less: Excess cash
 
(223,359
)
 
(210,761
)
 
(263,309
)
 
(287,411
)
 
(294,307
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(213,268
)
 
(195,894
)
 
(224,423
)
 
(231,563
)
 
(244,397
)
Less: Deferred revenue (current and non-current)
 
(22,211
)
 
(26,530
)
 
(24,485
)
 
(23,248
)
 
(21,437
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for assets under construction
 
(155,003
)
 
(149,043
)
 
(164,703
)
 
(180,220
)
 
(203,464
)
Capital base
 
$
837,928

 
$
909,569

 
$
890,029

 
$
925,533

 
$
960,937

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,414,849

 
$
1,471,783

 
$
1,529,373

 
$
1,607,462

 
$
1,686,259

Average capital base
 
$
821,155

 
$
873,749

 
$
899,799

 
$
907,781

 
$
943,235

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
4.6
%
 
5.7
%
 
6.7
%
 
5.6
%
 
6.1
%
Return on capital (annualized)
 
8.0
%
 
9.6
%
 
11.4
%
 
10.0
%
 
11.7
%

Adjusted EBITDA (Non-GAAP financial measure)
 
We use Adjusted EBITDA as a supplemental measure to review and assess our performance. We define Adjusted EBITDA as net income, plus income taxes, total other (income) expense, depreciation and amortization, and non-cash charges for share-based compensation.

Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.
 
Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP. Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.
 
Adjusted EBITDA increased $33 million, or 26%, from the three months ended September 30, 2013 to the three months ended September 30, 2014. As a percentage of net revenue, Adjusted EBITDA increased from 32.3% for the three months ended September 30, 2013 to 34.5% for the three months ended September 30, 2014. The increase in Adjusted EBITDA margin was mainly due to improved operating results, as operating income margin also increased, from 7.1% for the three months ended September 30, 2013 to 8.8% for the three months ended September 30, 2014. Our improved operating results reflect an acceleration in revenue growth between periods, partially offset by higher expenses. For further discussion of our operating results, see "Results of Operations" within this "Management's Discussion and Analysis of Financial Condition and Results of Operations."


- 17 -


See our reconciliation of Adjusted EBITDA to net income in the table below: 

 
 
Three Months Ended
(Dollars in thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

   Plus: Income taxes
 
11,202

 
6,108

 
13,448

 
11,078

 
12,137

   Plus: Total other (income) expense
 
249

 
251

 
230

 
358

 
2,636

   Plus: Depreciation and amortization
 
80,753

 
87,683

 
87,805

 
90,559

 
98,307

   Plus: Share-based compensation expense
 
16,959

 
17,188

 
12,732

 
17,265

 
19,842

Adjusted EBITDA
 
$
125,474

 
$
132,028

 
$
139,661

 
$
141,711

 
$
158,662

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
7.1
%
 
6.7
%
 
9.3
%
 
7.7
%
 
8.8
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
32.3
%
 
32.4
%
 
33.2
%
 
32.1
%
 
34.5
%

Adjusted Free Cash Flow (Non-GAAP financial measure)
 
We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditures (including non-cash purchases of property and equipment), cash payments for interest, net, and cash payments for income taxes, net.
 
We believe that Adjusted Free Cash Flow is a performance metric used by investors to evaluate the strength and performance of a company's ongoing business. 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 reconciliation of Adjusted Free Cash Flow to Adjusted EBITDA below, as well as our reconciliation of Adjusted EBITDA to net income provided above. 

 
Three Months Ended
 
Nine Months Ended
(In thousands)
September 30,
2013
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
Adjusted EBITDA
$
125,474

 
$
158,662

 
$
373,760

 
$
440,034

Non-cash deferred rent
3,801

 
1,928

 
9,285

 
6,297

Total capital expenditures
(117,558
)
 
(117,423
)
 
(349,482
)
 
(330,510
)
Cash payments for interest, net
(661
)
 
(360
)
 
(2,487
)
 
(1,312
)
Cash payments for income taxes, net
(2,605
)
 
(1,356
)
 
(12,355
)
 
(6,818
)
Adjusted free cash flow
$
8,451

 
$
41,451

 
$
18,721

 
$
107,691

 

- 18 -


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:
 
 
Three Months Ended
(In thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
127,404

 
133,821

 
140,417

 
145,051

 
142,954

Research and development
 
23,773

 
24,849

 
25,192

 
29,711

 
30,718

Sales and marketing
 
50,869

 
55,465

 
57,359

 
60,480

 
60,582

General and administrative
 
78,075

 
79,128

 
71,150

 
81,424

 
86,702

Depreciation and amortization
 
80,753

 
87,683

 
87,805

 
90,559

 
98,307

Total costs and expenses
 
360,874

 
380,946

 
381,923

 
407,225

 
419,263

Income from operations
 
27,762

 
27,157

 
39,124

 
33,887

 
40,513

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(689
)
 
(656
)
 
(495
)
 
(529
)
 
(445
)
Interest and other income (expense)
 
440

 
405

 
265

 
171

 
(2,191
)
Total other income (expense)
 
(249
)
 
(251
)
 
(230
)
 
(358
)
 
(2,636
)
Income before income taxes
 
27,513

 
26,906

 
38,894

 
33,529

 
37,877

Income taxes
 
11,202

 
6,108

 
13,448

 
11,078

 
12,137

Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
 
Three Months Ended
(Percent of net revenue)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
32.8
 %
 
32.8
 %
 
33.3
 %
 
32.9
 %
 
31.1
 %
Research and development
 
6.1
 %
 
6.1
 %
 
6.0
 %
 
6.7
 %
 
6.7
 %
Sales and marketing
 
13.1
 %
 
13.6
 %
 
13.6
 %
 
13.7
 %
 
13.2
 %
General and administrative
 
20.1
 %
 
19.4
 %
 
16.9
 %
 
18.5
 %
 
18.9
 %
Depreciation and amortization
 
20.8
 %
 
21.5
 %
 
20.9
 %
 
20.5
 %
 
21.4
 %
Total costs and expenses
 
92.9
 %
 
93.3
 %
 
90.7
 %
 
92.3
 %
 
91.2
 %
Income from operations
 
7.1
 %
 
6.7
 %
 
9.3
 %
 
7.7
 %
 
8.8
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.2
)%
 
(0.2
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
Interest and other income (expense)
 
0.1
 %
 
0.1
 %
 
0.1
 %
 
0.0
 %
 
(0.5
)%
Total other income (expense)
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.6
)%
Income before income taxes
 
7.1
 %
 
6.6
 %
 
9.2
 %
 
7.6
 %
 
8.2
 %
Income taxes
 
2.9
 %
 
1.5
 %
 
3.2
 %
 
2.5
 %
 
2.6
 %
Net income
 
4.2
 %
 
5.1
 %
 
6.0
 %
 
5.1
 %
 
5.6
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

- 19 -


Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013
 
Net Revenue

Net revenue increased $71 million, or 18%, primarily due to both new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased 14% while net revenue for public cloud increased 29%. Overall, our installed base grew at a monthly average rate of 0.8% in the three months ended September 30, 2014, compared to 0.7% in the three months ended September 30, 2013.

Contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the three months ended September 30, 2014 would have been approximately $8 million lower had foreign exchange rates remained constant from the prior year.
  
Cost of Revenue

Cost of revenue increased $16 million, or 12%. Of this increase, $12 million was attributable to employee-related expenses, such as salaries, benefits and incentive compensation, driven by an increase in headcount to support business growth. Data center costs increased $3 million due to higher maintenance and bandwidth expenses. License costs increased $1 million, as higher expenses of $8 million related to our growth were mostly offset by a $7 million benefit related to a refund of sales tax paid on previous license purchases. As a percentage of net revenue, cost of revenue decreased 170 basis points, from 32.8% in the three months ended September 30, 2013 to 31.1% in the three months ended September 30, 2014. Of the 170 basis point decline, the sales tax refund of $7 million represented 150 basis points.

Research and Development Expenses

Research and development expenses increased $7 million, or 29%, due to increased employee-related expenses, such as salaries, benefits and incentive compensation. We have invested in additional headcount to support research and development activities to enhance our existing offerings and develop new products and services.

Sales and Marketing Expenses

Sales and marketing expenses increased $10 million, or 19%. Employee-related expenses increased $6 million primarily due to increased headcount and higher sales commissions consistent with our revenue growth. The remaining increase was primarily due to increased spending on marketing and promotional activities such as online advertising, customer events and sponsorships.

General and Administrative Expenses

General and administrative expenses increased $9 million, or 11%. Included in general and administrative expenses was $3 million of expenses, primarily legal and other professional fees, incurred in connection with a formal evaluation by our Board of Directors of the Company's long-term strategic alternatives during the three months ended September 30, 2014. Employee-related expenses increased $6 million, due mainly to increased headcount and salaries. Internal software support and maintenance expenses increased $2 million to support the growth of our business. Offsetting these increases was a $3 million decrease in professional and consulting fees and a benefit from the reversal of a previously recorded sales and use tax accrual. As a percentage of net revenue, general and administrative expenses decreased 120 basis points, from 20.1% in the three months ended September 30, 2013 to 18.9% in the three months ended September 30, 2014.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $18 million, or 22%. During the three months ended September 30, 2014, we recorded a $4 million abandonment charge related to an unimproved portion of our corporate headquarters' building that we intend to demolish and redevelop. The remaining increase was due to an increase in property and equipment to support the growth of our business, which included increases in customer gear and internally developed and purchased software. As a percentage of net revenue, depreciation and amortization expenses increased 60 basis points, from 20.8% in the three months ended September 30, 2013 to 21.4% in the three months ended September 30, 2014. The headquarters building abandonment charge represented 90 basis points of the change between periods.




- 20 -


Other Income (Expense)

Other expense was $2.6 million and $0.2 million for the three months ended September 30, 2014 and 2013, respectively. The increase in other expense of $2.4 million between periods was driven by the unfavorable impact of foreign exchange rate movements and increased accretion expense related to our asset retirement obligations.

Income Taxes

Our effective tax rate decreased from 40.7% for the three months ended September 30, 2013 to 32.0% for the three months ended September 30, 2014 due primarily to Research and Development tax incentives in the State of Texas and a higher portion of earnings being generated outside the U.S. where earnings are generally taxed at lower rates. Overall, differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, certain tax credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items.

Net Income

Net income increased $9 million, or 58%, driven by higher net revenue and the positive impact of a lower effective tax rate, partially offset by higher expenses as we continue to make investments to support future growth. Net income per diluted share was $0.18 in the three months ended September 30, 2014, an increase of $0.07 from the same period of 2013.


- 21 -


Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013

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:
 
 
Nine Months Ended
(In thousands)
 
September 30,
2013
 
September 30,
2014
Net revenue
 
$
1,126,683

 
$
1,321,935

Costs and expenses:
 
 
 
 
Cost of revenue
 
358,672

 
428,422

Research and development