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

 
FORM 10-K
 
(Mark one)
R
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014.

OR 
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)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange of which registered
Common Stock, par value $0.001 per share
 
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:
None
(Title of Class)

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

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

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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   R    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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 “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
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  
 
As of June 30, 2014, the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale price of such shares on the New York Stock Exchange on June 30, 2014) was $2,614,923,113.

On February 23, 2015, 141,489,172 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.


DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant's 2015 Annual Meeting of Stockholders, to be filed within 120 days of the Registrant's fiscal year ended December 31, 2014, are incorporated by reference into Part III of this Form 10-K.



RACKSPACE HOSTING, INC.
TABLE OF CONTENTS
 
Page
 
 
 
Item 1.
 4
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
 
 
 
 
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
 
 
 
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
 
 
 
 
Item 15.
 
 
 
 



SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

We have made forward-looking statements in this Annual Report on Form 10-K that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 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.

TRADEMARKS AND SERVICE MARKS

Rackspace®, Fanatical Support®, and RackConnect® are service marks of Rackspace US, Inc. registered in the United States and other countries. OpenStack® is either a registered trademark or trademark of OpenStack, LLC in the United States and/or other countries. Net Promoter, Net Promoter Score and NPS are trademarks of Satmetrix Systems, Inc., Bain & Company, Inc. and Fred Reichheld. EVA® is a registered trademark of Stern Stewart & Co. and EVA Dimensions. Other trademarks and tradenames appearing in this report are the property of their respective holders. We do not intend our use or display of other companies’ tradenames, trademarks, or service marks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.



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PART I

ITEM 1 - BUSINESS

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the related Notes for additional information regarding the business and our operating results.

Overview

Rackspace is the world leader in the managed cloud segment of the business IT market. We serve more than 300,000 business customers, including a majority of the enterprises in the Fortune 100, 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. We free them from the expense of hiring or contracting with engineers who do not differentiate their businesses. We allow them to concentrate on their core business and keep their operations fast and lean.

Our focus on the managed cloud separates us from the big providers of unmanaged, commodity cloud computing, who provide access to raw cloud infrastructure and then expect customers to do everything required to operate that infrastructure, as well as the many complex tools and applications that run on top of it, including data engines and e-commerce platforms. The unmanaged providers offer economies of scale. We add economies of expertise. We have developed specialized skills in the most popular cloud tools and applications, as well as in cloud infrastructure, and we deliver it to customers 24/7, with a results-obsessed, can-do attitude known throughout our industry as Fanatical Support.

We are also a pioneer and leader in hybrid computing, which helps each business customer find the IT infrastructure that best fits its unique needs and makes it all work together. Our broad portfolio of products and specialized expertise enables each customer to run each of its workloads where it will achieve the highest performance, security, and cost efficiency. This emphasis on the best fit for each workload differentiates Rackspace from big one-size-fits-all providers who offer only multi-tenant public cloud.

We offer a broad portfolio of integrated IT solutions for common business needs, including for ecommerce, web content management, website hosting, data services, office mail and collaboration, and private clouds. We also offer advisory services for technology strategy, security and compliance, application assessment and migration, and DevOps automation.

We offer our solutions across a variety of IT form factors, including multi-tenant public cloud, dedicated single-tenant servers, private cloud, and hybrid cloud - all delivered with a commitment to leading open and standard technologies. The equipment (servers, routers, switches, firewalls, load balancers, cabinets, wiring, etc.) and software required to deliver services is typically purchased and managed by us.

We are committed to delivering managed services, specialized expertise, and Fanatical Support across our entire product portfolio. We will continue to pursue our vision - to be considered one of the world’s great service companies - and our company's statement of purpose: to make computing simple and powerful for business.

We were incorporated in Delaware in March 2000, but our operations began in 1998 as a limited partnership, which became our subsidiary through a corporate reorganization completed in August 2001.

Our Industry

The cloud computing industry can be broadly described as one that delivers computing, storage, and applications as a service over the Internet. It allows business customers to get the computing they need without having to make capital investments in computer hardware and software.

This industry is fast-growing and crowded, and Rackspace has earned a well-defined role within it, as leader of the managed cloud segment. We are a company of specialists, with expertise in key skill-sets around hybrid cloud configurations, the deployment and operation of leading technologies such as OpenStack, Linux, VMware and Windows, and the management of complex applications ranging from MongoDB to Hybris and SharePoint. Our employees, who we call Rackers, are available to customers around the clock, and deliver industry-leading customer service.


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To understand the growth and segmentation of our industry, it's useful to consider the five ways in which businesses can fulfill their IT requirements:

1.
The first approach is in-house IT. This is the legacy approach in which a business retains complete ownership and responsibility for ongoing maintenance and management of servers, software, networking equipment, IT staff, etc. Companies may choose to house this equipment in their own data centers or server closets or may rent data center space from a colocation provider. Many companies that handle all of their computing in-house are noticing that, regardless of how much they spend on hardware and software, they spend even more on IT payrolls. Their need for engineering talent has expanded exponentially in recent years, with the proliferation of complex cloud tools and applications - a trend that shows no sign of easing.

2.
The second approach to IT is outsourcing, where businesses transfer full responsibility for their computing systems, operations, and employees to a third party; often a systems integrator such as HP, IBM or CSC. This approach helps the client company focus on its core business. It is typically more costly than other alternatives to in-house computing, and can require very long lead times to deliver new projects or capabilities.

3.
The third approach is do-it-all-yourself cloud computing, where business customers access computer hardware and software, on demand over the Internet from an unmanaged cloud provider. They receive few assurances in terms of business outcomes, and little in the way of specialized expertise, advice or support. Rather than focus on their core business, they take on the full burden of operating IT infrastructure and learning to use the fast-expanding set of tools necessary to leverage cloud computing. For most companies, this approach requires hiring and retaining expensive engineers with specialized expertise in the latest cloud technologies.

4.
The fourth approach is for the business customer to access raw infrastructure from one or more vendors (for instance, one for public cloud and one for dedicated servers) and then contract with additional vendors for managed services, specialized expertise and support. In this scenario, the customer benefits from low infrastructure costs, and can focus most of its IT staff on its core business. Management, however, must essentially take on the role of a general contractor and must constantly mediate among multiple vendors.

5.
The fifth approach is managed cloud, where business customers access not only raw computing infrastructure but also managed services, specialized expertise, advice and support, along with explicit assurances of business outcomes through Service Level Agreements. This approach allows customers to focus their leaders and their scarce technical talent on tasks that differentiate their businesses.

We believe that managed cloud, delivered with exceptional customer support and specialized expertise, provides higher quality IT and better value than do the other approaches to business IT. We believe demand for managed cloud will continue to grow for four reasons:

1.
Lack of In-House IT Expertise. As business IT applications grow in number and complexity, most companies do not have the IT staff needed to deliver a robust, reliable online presence, and to leverage their data for insights about customer behavior and internal operations. Today's ecommerce platforms and Big Data applications are especially complex and fast-changing. As a result, many companies have difficulty finding and hiring the specialized engineers that they need.

2.
Strategic Resource Utilization. Larger companies that do have specialized, dedicated IT engineers would typically rather focus these expensive resources on strategic areas that differentiate their business rather than managing servers or databases or running a website.

3.
Market Acceptance. As companies have experienced the benefits of using managed cloud providers to handle some of their IT workloads, they have become more comfortable having those providers manage additional IT services. This trend will accelerate as various barriers to adoption are broken down. The expansion of open and standard technologies, for example, is removing business customers' fears of being locked into the proprietary software - and subject to the pricing - of a particular cloud provider. Similarly, advances such as software-defined networking, API-accessible single-tenant servers, and hybrid cloud are easing customers' concerns about the security of cloud computing. As time goes by, we believe businesses will move more and more of their IT workloads to managed cloud.

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4.
Accelerated Business Creation. Cloud computing has removed many of the traditional barriers to new business formation through the low cost nimbleness, and capital efficiency that it brings to IT infrastructure. Managed cloud does the same thing for the costs associated with infrastructure management and application expertise. Managed cloud is driving innovation and new business formation at a rapid rate, in much the way that the iPhone has driven a fast-growing market for consumer applications. The rising supply of powerful, easy-to-use cloud computing is creating new demand.

Our Business

We are a global company, selling our services to business customers in more than 120 countries. Our corporate headquarters is located in San Antonio. We also have operations located in multiple cities across the United States, as well as in London, Amsterdam, Zurich, Hong Kong, Sydney, and Mexico City. In 2014 we had net revenue of $1.8 billion. As of December 31, 2014, we served more than 300,000 business customers, and we managed more than 112,000 servers. No single customer accounted for more than 2% of our net revenue in any of the past three years.

We are focused on the segment of the cloud computing market that demands, and is willing to pay for, the value for performance that can only be achieved when management services, specialized expertise, and strong support are delivered on top of raw computing infrastructure. Our services are productized and repeatable, which enables us to operate IT systems for our customers with high levels of up-time, rapid deployment of new systems and significant cost savings, which in turn allows our customers' IT departments to focus on their core business.

Our service offering combines hosting on dedicated single-tenant hardware and on multi-tenant pools of virtualized hardware (widely known as public cloud) in a way that best suits each customer’s requirements. We have adopted a portfolio approach to our services, which allows customers the flexibility to choose the best combination of support level, dedicated servers, public cloud and private cloud to meet their unique IT needs. The major components of our products and services are described in greater detail below:

Our Customer Service

Fanatical Support, our unique approach to the customer experience, is backed by a complex business process that we have built and refined over the past 16 years, and it distinguishes our company in the market. Our process for delivering Fanatical Support involves everything from the way we recruit, interview and test prospective employees; to the way we continuously train new and veteran Rackers alike; to the way we make the specialized expertise of U.S. and U.K. based technicians available to customers 24/7 by phone, email or chat; to the way we empower those Rackers to serve our customers; to the way we measure customer satisfaction and churn on a daily basis, team by team; to the way we reward and celebrate successful teams and managers; to the way we design and implement hardware and software solutions and processes to make our services highly reliable and easy for the customer to use and navigate.

When we first launched Fanatical Support, it was mainly about answering the phone and providing extraordinary support when things went wrong with a customer's computing. But we quickly expanded our support to meet customer demands for expertise in Linux, Windows and network security. Our concept of Fanatical Support has continued to expand and evolve to include technological improvements that make our services more reliable and easier to use. We now offer prescriptive advice to customers and prospects about which applications work best on specific architectures, in public cloud and private cloud, on dedicated servers and in hybrid cloud.

Fanatical Support has moved up the technology stack to include specialist expertise in complex applications such as MongoDB, Hadoop, Redis, SQL Server, MySQL, MariaDB, Percona Server, Magento, Hybris, Sitecore, Adobe Experience Manager, Drupal, WordPress, SharePoint, Exchange, Office365, and Google Apps for Work.

Fanatical Support is also expanding outside our data centers. We offer private clouds powered by VMware, Microsoft, and OpenStack. We offer support for many technologies sold by Google, Microsoft, and VMware, and our list of partners and supported technologies is growing rapidly.

Many customers want to leverage technologies from multiple vendors and would rather do so through a provider with specialized expertise in those technologies, instead of diverting scarce in-house engineering resources from core tasks.


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We have built our business around an understanding, born of experience, that things go wrong in computing and always will in a field so complex and fast-changing. We believe that many business customers want a trusted partner who is available 24/7 to help them safely and reliably take advantage of the enhanced capabilities and cost savings available through cloud computing.

Our Product Categories

Everything that we do at Rackspace falls under the umbrella of cloud computing, broadly defined as the delivery of computing, storage, and applications over the Internet. All of our computer hardware is located in our secure, business-class data centers in the U.S., the U.K., Hong Kong, and Australia. Every service that we offer is managed. We do not just provide access to raw infrastructure.

Public cloud refers to multi-tenant pools of computing resources delivered on-demand over the Internet. Virtualization and other cloud technologies allow us to effectively provision and manage pools of computing resources across a large base of customers and deliver more resources to businesses when they need them. At the same time, pooled cloud computing substantially lowers the cost of IT services for some applications. There are multiple varieties of public cloud services that are priced on a pay-per-use basis and that can be quickly and easily scaled up or down on-demand. Today we offer Cloud Servers for computing, Cloud Sites for website hosting, Cloud Block Storage and Cloud Files for storage, Cloud Databases for hosting MySQL instances, Cloud Backup for file protection, Cloud Load Balancers for traffic management, Cloud Monitoring for infrastructure control, Cloud DNS for domain management, Cloud Networks for security enhancement, and Cloud Applications, which includes email, collaboration and file back-ups.

We continue to invest in our public cloud service and believe it is an important element of our future success. In July for example, we launched OnMetal, which provides large and fast-growing customers with a highly scalable solution that combines the performance and security of single-tenant servers with the agility and API addressability of the multi-tenant public cloud.

Dedicated cloud refers to IT services that we provide on a server or servers reserved for a specific customer. Our basic support level for this service frees the customer from the burden of managing the data center, network, hardware devices, and operating system software. We provide a customer management portal and other management tools. We also offer higher support levels that assume more cloud management tasks, including for many popular applications. Dedicated cloud hosting is largely a recurring, subscription-based business.

Private cloud refers to a pool of computing resources that is virtualized for greater efficiency and nimbleness but that is dedicated to one particular customer rather than being used by multiple customers. The hardware can be located in our data centers or in the customer's facilities. This approach is especially popular with some of our larger corporate customers who value the control, security, and compliance advantages that it offers. We offer private clouds powered by VMware, Microsoft, and OpenStack. The breadth of our portfolio, and our hybrid cloud approach, have generated significant interest in our private cloud offerings. Revenue for private cloud is included within dedicated cloud revenue in our Key Metrics table in Item 7 of Part II.

Hybrid cloud is an emerging category we are pioneering, which enables customers to easily and seamlessly utilize the benefits of both dedicated cloud servers and public cloud in its data centers or ours or those of a third-party. We are also working to add private cloud to the technologies that can be linked through our hybrid cloud. A customer using hybrid cloud is able to utilize any combination of dedicated and pooled resources and to manage them seamlessly through our innovative RackConnect service. Each cloud computing form factor has specific and unique customer benefits, and through hybrid cloud, the various technologies can be combined and adjusted to address each customer's changing and diverse needs. Furthermore, Rackspace’s set of managed support services and Fanatical Support are critical in this new world of computing as customers increasingly need help to make the transition and utilize these new services.

In recent years, our Key Metrics table has disclosed net revenue in two categories: public cloud and dedicated cloud. Because of rapid changes in technology and customer behavior, these categories have become less and less clear-cut and meaningful. More business customers are consuming both single-tenant dedicated computing and multi-tenant private cloud computing, in their data centers and ours, in ways that are increasingly seamless and difficult to separate in any meaningful way. As a result of these developments, beginning with our announcement of our financial results for the first quarter of 2015, we will stop disclosing net revenue as public cloud or dedicated cloud, and will only disclose consolidated net revenue.

See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 11Segment Information” for financial information related to our product categories.

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Competition

Given the significant market potential of cloud computing and managed cloud, we operate in a rapidly evolving and highly competitive environment. Our principal areas of competition include:

In-house and Colocation. Businesses may choose to house and maintain their own IT systems or use a colocation provider to house IT hardware and provide connectivity. Companies that provide colocation services include AT&T, Equinix, CenturyLink, and other telecommunications companies. We believe that over time it will be difficult for the vast majority of businesses to replicate the economies of scale and economies of expertise achieved by specialized service providers, making the do-it-yourself option less attractive.

IT Outsourcing Providers. Businesses may choose to outsource their entire IT systems and staff to a provider such as CSC, HP or IBM. Outsourcing has long been an option for only the largest companies because of the cost, complexity and duration of outsourcing contracts. Rarely is this a viable option for small and medium-sized businesses with rapidly changing needs. Even some large corporations are questioning the cost-benefit ratio and the slow response times associated with the outsourcing approach.

Unmanaged Cloud Computing Providers. Businesses may choose to use an unmanaged cloud computing provider such as Amazon Web Services, Google or Microsoft. These providers essentially provide access to raw infrastructure and require the customer to either manage it alone or manage multiple providers of infrastructure and support. The unmanaged approach has been popular among early adopters of cloud computing such as software developers and founders of small technology startup companies. Other companies often find it difficult, expensive, and distracting to hire or contract with all of the specialized engineering talent that is required to manage raw infrastructure and all the complex cloud tools and applications that run on top of that infrastructure.

Managed Cloud Providers. Gartner Inc. last year distinguished for the first time between unmanaged, or “infrastructure as a service,” cloud providers, and those who deliver managed cloud. Its new report on the latter market segment, the Gartner Magic Quadrant for Cloud-Enabled Managed Hosting, ranked Rackspace as a leader, in both North America and Europe. Other major competitors in managed cloud include HP, IBM, and several large telecom companies. We believe that the addressable market for managed cloud is large and growing rapidly, including among large enterprise customers. In the second half of the year, there was an increased volume of deals with these customers.

Several of the unmanaged cloud providers are big, diversified technology companies that produce large cash flows from retailing, online ad sales, and sales of software, and are using those cash flows to make significant investments in cloud computing. Last spring, several of those unmanaged cloud providers sharply reduced the prices that they charge business customers for access to raw cloud infrastructure. These price cuts were part of a trend that led some industry observers to conclude that smaller providers would eventually be priced out of business. We see this trend very differently, as follows:

1.
The decline in cloud infrastructure prices has encouraged a proliferation of cloud tools and applications, just as the invention of the iPhone spawned thousands of mobile apps.

2.
Those cloud tools and applications are powerful; they can help companies earn more ecommerce revenue and leverage their data for valuable insights into their operations and customers.

3.
Those cloud applications are also complicated, and they keep coming at an accelerating pace. They are adding significant complexity for mainstream businesses, which often need help navigating this new landscape.

4.
As a consequence, the price of skilled cloud engineers is rising sharply. Many companies have trouble finding all the expertise that they need in various specialties and many can’t afford to hire or staff all the talent they need. Many companies would prefer to focus their resources on their core business.

5.
As a result, more businesses are turning to providers of managed cloud. During the last three quarters of 2014, when the big unmanaged cloud providers were slashing prices, Rackspace's revenue growth continued, margins expanded, and new large customers came on board at a higher rate.

The competitive environment, and the opportunity we face in managed cloud, has moved us to invest in additional hiring and training of Rackers so that they have the specialized expertise necessary to help customers with their most pressing needs, including on applications related to ecommerce, big data and security.

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Our Approach and Sources of Competitive Advantage

We are focused on creating a sustainable competitive advantage in four key areas. First, our vision is to be recognized as one of the world’s great service companies. Because companies must trust their cloud computing provider with their mission-critical IT assets, service reputation is a key selection criterion. Second, our specialist focus is to provide managed cloud services and expertise, which enables us to operate with a financial discipline that keeps costs low, thereby generating returns that exceed our cost of capital. Third, our broad and seamless portfolio, demonstrated by our leadership in the hybrid cloud, allows customers to select the solution that best fits their requirements. Fourth, we are committed to leading open and standard technologies, which address one of the main barriers to adoption of cloud computing: the customer's fear of being locked into a particular vendor who then wields great power to raise prices and stifle innovation. These key principles form the foundation of our business model, which is described in more detail below.

Service Reputation - We believe that an excellent customer experience creates customer loyalty and referrals, which in turn leads to higher profits and growth. We call our unique, industry-leading customer service model "Fanatical Support." Our entire company is focused on going above and beyond expectations to delight the customer. Fanatical Support builds customer loyalty, which in turn delivers three key benefits:

Loyal customers buy more, both as they grow and as they hand a larger proportion of their total IT workload over to us.

Loyal customers stay with us longer and refer other customers to us. Both factors help reduce customer acquisition costs and other sales and marketing costs.

Loyal customers can be served more cost effectively. The average cost of serving a customer is reduced after initial provisioning, and we can provide additional service levels that are not capital intensive, which lead both to higher average profits and profit margins over time.

We closely track customer retention, overall and by support team. We ask customers why they stay with us, why they spend more or less with us, and why they leave. We then strive to build on our areas of strength and relieve customer pain points. We also make extensive use of the Net Promoter Score ("NPS"), developed by Bain & Company, Inc., Fred Reichheld, and Satmetrix Systems, Inc. to track the likelihood that customers will refer us to friends or colleagues. Surveys are conducted on an ongoing basis and broken down by support team, with results summarized monthly and analyzed to determine areas for improvement. We work with our customers to understand what they consider “must haves” and what they would like to see in terms of incremental improvements to our service offerings.

Fanatical Support is a result of our unique culture. Rackers are rewarded for going above and beyond to serve customers. The highest form of recognition is the Straightjacket Award, which is given on a regular basis to the Racker who best demonstrates Fanatical Support in action. We are also very selective in our hiring process. Our philosophy is that technical and functional skills can be taught, but attitude and temperament are ingrained. We strive to hire employees with the personality traits that fit well within our culture and our teams. Periodically, we conduct employee engagement surveys as a measure of cultural health and reward those managers who create an engaging and high-performance environment. In six of the last seven years, Fortune magazine has honored us in its list of “100 Best Companies to Work For,” and at the end of 2014, we ranked #29. We believe that our unique workplace culture is a point of sustained differentiation because it cannot be easily or quickly replicated by large competitors.

Specialist Focus - We specialize exclusively in providing managed cloud computing that makes IT simple and powerful for business. Every service that we offer is managed, and backed by specialized expertise and Fanatical Support. We do not simply provide access to raw infrastructure. Modern computing infrastructure is complex and ever-changing, so this specialist focus has allowed us to build a productized set of services that are repeatable, efficient, high-quality and valuable to customers. Our employees, systems, management practices and organizational processes are constantly tuned to improve our high-volume cloud computing offerings. Many of our competitors have to balance their cloud computing lines of business with other areas of focus. These other products and services vie internally for the resources and talent needed to make cloud computing successful. Our exclusive focus on cloud computing enables us to concentrate our capital and our Rackers' talents on a single mission and purpose. We can more rapidly and accurately deploy, upgrade and scale our systems and services.


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Broad and Seamless Portfolio - Many hosting providers offer only public cloud services and take a one-size-fits-all approach to customer needs. Others, rely on third-party reselling relationships to complete their hosting portfolio. Our portfolio of services allows us to deliver the best fit for each customer's unique needs - the right offering at the right budget. Because of the breadth of our portfolio, customers can host their entire environment with us, allowing them to benefit from the simplicity of working with one hosting specialist rather than managing multiple providers. Our hybrid cloud approach allows customers the flexibility to combine both traditional and emerging services for a solution that best addresses their unique IT requirements, and our RackConnect product allows the customer to employ all of our services in a seamless, easy-to-use manner.

Leading Open and Standard Technologies - When we partnered with NASA in July 2010 to launch OpenStack, an open-source cloud computing platform, our goal was to provide an alternative to the proprietary software that then powered all of the major cloud-computing environments. We wanted to help overcome one of the major barriers to adoption of cloud computing: business customers' fear of vendor lock-in and rising prices. Over the past four and a half years, OpenStack has attracted support from more than 250 companies through 11 successful Design Summits with participants from six continents, and the successful release of multiple versions of the software. While we are strong supporters of OpenStack, we also are one of the world’s largest support providers for popular standard technologies created by Microsoft and VMware. We partner closely with those companies, as well as with Google and others, and our Rackers are regarded as thought leaders in the best ways to deploy and manage those companies’ technologies.

Research and Development

We believe that business adoption of managed cloud is a paradigm shift in IT, and we are investing heavily to take advantage of this opportunity. For the years ended December 31, 2012, 2013 and 2014, we incurred $56.7 million, $90.2 million and $117.0 million of research and development expense, respectively. Our research and development efforts are focused on developing new services including deployment of new technologies to address customer demands in public cloud, private cloud, hybrid cloud and dedicated server; and development and enhancement of proprietary tools.

Intellectual Property Rights

We rely on a combination of patent, copyright, trademark, service mark and trade secret laws in the U.S., the European Union, and various countries in Asia, South America, and elsewhere and contractual restrictions to establish and protect certain proprietary rights in our data, applications, and services. We have patents issued as well as patent applications pending in the U.S. and the European Union. We have trademarks registered or pending in the U.S., the European Union, and various countries in Asia, South America, and elsewhere for our name and certain words and phrases that we use in our business. We rely on copyright laws and licenses to use and protect software and certain other elements of our proprietary technologies. We also enter into confidentiality and invention assignment agreements with our employees and consultants and confidentiality agreements with other third parties, and we actively monitor access to our proprietary technologies. In addition, we license third-party software, open source software and other technologies that are used in the provision of or incorporated into some elements of our services. Many parts of our business are significantly reliant on proprietary technology and/or licensed technology. Although we rigorously protect our rights to use this technology, any significant impairment of, or third-party claim against, our intellectual property rights could harm our business or our ability to compete.

Employees

As of December 31, 2014, we employed 5,936 Rackers. None of our employees is represented by a collective bargaining agreement, nor have we experienced any work stoppages. We believe that our relations with our employees are good.

Sales and Marketing

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

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


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Our Support Team Structure

Our support teams are specifically structured based on our customers' product and service choices. Service teams are comprised of specialized experts who can address a wide range of business and technical issues for a customer and are available 24/7/365.

Financial Information About Geographic Areas

See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 11Segment Information” for financial information related to our geographic areas. For information regarding certain risks relating to our foreign operations, please see the risk titled, “Our ability to operate and expand our business is susceptible to risks associated with international sales and operations” in Item 1A, “Risk Factors.”

Available Information

The company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on the company's website at www.rackspace.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.

Our SEC filings are also available to the public at the SEC’s website at www.sec.gov. Additionally, our board committee charters and code of ethics are available on our website and in print to any stockholder who requests them. The information contained on our website is not incorporated herein by reference and does not comprise a part of this Annual Report on Form 10-K.


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ITEM 1A – RISK FACTORS
 
Risks Related to Our Business and Industry

If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer.
 
Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way our services are marketed and delivered. The adoption of new technologies, a change in industry standards or introduction of more attractive products or services could make some or all of our offerings less desirable or even obsolete. These potential changes are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by forecasting customer demands; improving the performance, features, and reliability of our products and services; and modifying our business strategies accordingly. We cannot guarantee that we will be able to identify the emergence of all of these new service alternatives successfully, modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes.

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

Finally, even if we succeed in adapting to a new technology or the changing industry standard and developing attractive products and services and successfully bringing them to market, there is no assurance that our use of the new technology or standard or our introduction of the new products or services would have a positive impact on our financial performance and could even result in lower revenue, lower margins and/or higher costs and therefore could negatively impact our financial performance.

Our failure to provide platforms, products and services to compete with new technologies or the obsolescence of our platforms, products or services would likely lead us to lose current and potential customers or cause us to incur substantial costs by attempting to catch our offerings up to the changed environment.

If we do not prevent security breaches and other interruptions to our infrastructure, we may be exposed to lawsuits, lose customers, suffer harm to our reputation, and incur additional costs.
 
The services we offer involve the transmission of large amounts of sensitive and proprietary information over public communications networks, as well as the processing and storage of confidential customer information. Unauthorized access, remnant data exposure, computer viruses, denial of service attacks, accidents, employee error or malfeasance, intentional misconduct by computer “hackers” and other disruptions can occur, and infrastructure gaps, hardware and software vulnerabilities, inadequate or missing security controls and exposed or unprotected customer data can exist that (i) interfere with the delivery of services to our customers, (ii) impede our customers' ability to do business, or (iii) compromise the security of systems and data, which exposes information to unauthorized third parties. We are a constant target of cyber attacks of varying degrees on a regular basis, and we have encountered security breaches in the past, although they did not have a material adverse effect on our operating results. There can be no assurance of a similar result in a future security breach.


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Techniques used to obtain unauthorized access to or to sabotage systems change frequently and generally are not recognized until launched against a target. We may be unable to implement security measures in a timely manner, or, if and when implemented, these measures could be circumvented as a result of accidental or intentional actions by parties within or outside of our organization. Any breaches that occur could expose us to increased risk of lawsuits, loss of existing or potential customers, harm to our reputation and increases in our security costs. Although we typically require our customers to agree to terms of service that contain provisions attempting to limit our liability for security breaches, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a security breach that they may ascribe to us. Additionally, we may decide to negotiate settlements with affected customers regardless of such contractual limitations. The outcome of any such lawsuit would depend on the specific facts of the case and legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may significantly exceed our liability insurance coverage by unknown but significant amounts, which could seriously impair our financial condition. The laws of some states and countries may also require us to inform any person whose data was accessed or stolen, which could harm our reputation and business. Complying with the applicable notice requirements in the event of a security breach could result in significant costs. We may also be subject to investigation and penalties by regulatory authorities and potential claims by persons whose information was disclosed, even if such person was not actually a customer.

We may not be able to compete successfully against current and future competitors.
 
The market for cloud computing is highly competitive. We expect to face intense competition from our existing competitors as well as additional competition from new market entrants in the future as the actual and potential market for hosting and cloud computing continues to grow.
 
Our current and potential competitors vary by size, service offerings and geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:
 
In-house and Colocation solutions with a colocation partner;
IT outsourcing providers;
Unmanaged cloud computing providers; and
Other managed cloud computing companies. 
The primary competitive factors in our market are: customer service and technical expertise, security reliability and functionality, reputation and brand recognition, financial strength, breadth of services offered, and price.
 
Many of our current and potential competitors have substantially greater financial, technical and marketing resources; larger customer bases; longer operating histories; greater brand recognition; and more established relationships in the industry than we do. As a result, some of these competitors may be able to:
 
Develop superior products or services, gain greater market acceptance, and expand their service offerings more efficiently or more rapidly;
Adapt to new or emerging technologies and changes in customer requirements more quickly;
Bundle hosting services with other services they provide at reduced prices;
Take advantage of acquisition and other opportunities more readily;
Adopt more aggressive pricing policies and devote greater resources to the promotion, marketing, and sales of their services, which could cause us to have to lower prices for certain products or services to remain competitive in the market; and
Devote greater resources to the research and development of their products and services.

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Our physical infrastructure is concentrated in a few facilities, and any failure in our physical infrastructure or services could lead to significant costs and disruptions and could reduce our revenue, harm our business reputation and have a material adverse effect on our financial results.
 
Our network, power supplies and data centers are subject to various points of failure. Problems with our cooling equipment, generators, uninterruptible power supply ("UPS"), routers, switches, or other equipment, whether or not within our control, could result in service interruptions for our customers as well as equipment damage. Because our hosting services do not require geographic proximity of our data centers to our customers, our infrastructure is consolidated into a few large facilities. While data backup services and disaster recovery services are available as a part of our hosting services offerings, the majority of our customers do not elect to pay the additional fees required to have disaster recovery services store their backup data offsite in a separate facility, which could substantially mitigate the adverse effect to a customer from a single data center failure. Accordingly, any failure or downtime in one of our data center facilities could affect a significant percentage of our customers. The total destruction or severe impairment of any of our data center facilities could result in significant downtime of our services and the loss of customer data. Since our ability to attract and retain customers depends on our ability to provide customers with highly reliable service, even minor interruptions in our service could harm our reputation. The services we provide are subject to failure resulting from numerous factors, including:
 
Power loss;
Equipment failure;
Human error or accidents;
Sabotage and vandalism;
Failure by us or our vendors to provide adequate service or maintenance to our equipment;
Network connectivity downtime;
Security breaches to our infrastructure;
Improper building maintenance by the landlords of the buildings in which our facilities are located;
Physical or electronic security breaches;
Fire, earthquake, hurricane, tornado, flood, and other natural disasters;
Water damage; and
Terrorism. 
Additionally, in connection with the expansion or consolidation of our existing data center facilities from time to time, there is an increased risk that service interruptions may occur as a result of server relocation or other unforeseen construction-related issues.
 
We have experienced interruptions in service in the past due to such things as power outages, power equipment failures, cooling equipment failures, routing problems, security issues, hard drive failures, database corruption, system failures, software failures, and other computer failures. While we have not experienced a material increase in customer attrition following these events, the extent to which our reputation suffers is difficult to assess. We have taken and continue to take steps to improve our infrastructure to prevent service interruptions, including upgrading our electrical and mechanical infrastructure. However, service interruptions continue to be a significant risk for us and could materially impact our business.
 
Any future service interruptions could:
 
Cause our customers to seek damages for losses incurred;
Require us to replace existing equipment or add redundant facilities;
Affect our reputation as a reliable provider of hosting services;
Cause existing customers to cancel or elect to not review their contracts; or
Make it more difficult for us to attract new customers.

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

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

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

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

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

Our growth strategy depends on our ability to identify, hire, train, and retain executives, IT professionals, technical engineers, software developers, operations employees, and sales and senior management personnel who maintain relationships with our customers and who can provide the technical, strategic, and marketing skills required for our company to grow. There is a shortage of qualified personnel in these fields, specifically in the San Antonio, Texas area, where we are headquartered and a majority of our employees are located. We compete with other companies for this limited pool of potential employees. In addition, as our industry becomes more competitive, it could become especially difficult to retain personnel with unique in-demand skills and knowledge, whom we would expect to become recruiting targets for our competitors. There is no assurance that we will be able to recruit or retain qualified personnel, and this failure could cause a dilution of our service-oriented culture and our inability to develop and deliver new products and services, which could cause our operations and financial results to be negatively impacted.

Our success and future growth also depends to a significant degree on the skills and continued services of our management team, including Taylor Rhodes, our Chief Executive Officer and President. We do not have long-term employment agreements with our senior management team, including Mr. Rhodes.

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

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


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Failure to maintain adequate internal systems could cause us to be unable to properly provide service to our customers, causing us to lose customers, suffer harm to our reputation, and incur additional costs.

Some of our enterprise systems have been designed to support individual products, resulting in a fragmentation among various internal systems, making it difficult to serve customers who use multiple service offerings. This causes us to implement manual processes to overcome the fragmentation, which can result in increased expense and manual errors.

We have systems initiatives underway that span infrastructure, products and business transformation. These initiatives are likely to drive significant change in both infrastructure and business processes and contain overlaps and dependencies among the programs. Our inability to manage competing priorities, execute multiple parallel program tracks, plan effectively, manage resources effectively and meet deadlines and budgets could result in us not being able to implement the systems needed to deliver our services in a compelling manner to our customers.

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

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.
 
We believe that our success depends on our ability to provide customers with quality service that not only meets our stated commitments, but meets and then exceeds customer service expectations. We refer to this high quality of customer service as Fanatical Support. If we are unable to provide customers with quality customer support in a variety of areas, we could face customer dissatisfaction, dilution of our brand, weakening of our main market differentiator, decreased overall demand for our services, and loss of revenue. In addition, our inability to meet customer service expectations may damage our reputation and could consequently limit our ability to retain existing customers and attract new customers, which would adversely affect our ability to generate revenue and negatively impact our operating results.
 
Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.
 
Customer contracts for our dedicated cloud services typically have initial terms of one to two years which, unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire on these contracts. In addition, many of our other services and products, including most of our public cloud products and services, are generally provided on a month-to-month basis with no extended initial term at all. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.
 
Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.
 
Because our services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot be assured that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may exceed our liability insurance coverage by unknown but significant amounts, which could materially impair our financial condition.

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Our use of open source software and contributions to open source projects could impose limitations on our ability to provide our services, expose us to litigation, and cause us to impair some assets, which could adversely affect our financial condition and operating results.
 
We utilize open source software, including Linux-based software, in providing a substantial portion of our services. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to offer our services. Additionally, the use and distribution of open source software can lead to greater risks than the use of third-party commercial software, as open source software does not come with warranties or other contractual protections regarding infringement claims or the quality of the code. From time to time parties have asserted claims against companies that distribute or use open source software in their products and services, asserting that open source software infringes their intellectual property rights. We have been subject to suits, and could be subject to suits in the future, by parties claiming infringement of intellectual property rights with respect to what we believe to be open source software. In such an event, we could be required to seek licenses from third parties in order to continue using such software or offering certain of our services or to discontinue the use of such software or the sale of our affected services in the event we could not obtain such licenses, any of which could adversely affect our business, operating results and financial condition. In addition, if we combine our proprietary software with open source software in a certain manner, we could, under some of the open source licenses, be required to release the source code of our proprietary software.
 
We also participate in the OpenStack Foundation, which we initially founded to foster the emergence of cloud computing technology standards and cloud interoperability. Our participation included the release of our previously proprietary core cloud storage code, and we continue to participate through ongoing code contributions. In addition, we also participate in other open source projects and plan to continue to do so in the future. Our utilization of open source software and open data center design projects like the Facebook Open Compute project could cause us to use open source solutions as opposed to existing proprietary solutions and could result in an impairment of design and development assets.

In addition, our activities with these open source projects could subject us to additional risks of litigation, including indirect infringement claims based on third-party contributors because of our participation in these projects.
 
We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.
 
We rely primarily on patent, copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies. We cannot be assured that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We currently have patents issued and patent applications pending in the U.S. and the European Union. Our patent applications may be challenged and/or ultimately rejected, and our issued patents may be contested, circumvented, found unenforceable or invalidated.
 
We endeavor to enter into agreements with our employees, contractors, and parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. We may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed. 

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


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Our corporate culture has contributed to our success, and if we cannot maintain this culture, we could lose the innovation, creativity, and teamwork fostered by our culture, and our operating results may be harmed.
 
We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity, and teamwork. If we implement more complex organizational management structures because of growth or other structural changes or create disparities in personal wealth among our employees through our compensation philosophy and benefit plan utilization, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. If we cannot maintain a favorable corporate culture, then we can lose employee engagement, which can cause employees to lose the desire to innovate, foster teamwork and strive to delight our customers. Ultimately, we believe that the delivery of exceptional service to our customers by our employees is what produces customer "promoters" and fuels our growth aspirations. Therefore, if the corporate culture is not maintained, it could negatively impact our future operating results.
 
If we are unable to manage our growth effectively, our financial results could suffer.
 
The growth of our business and our service offerings could strain our operating and financial resources. Further, we intend to continue expanding our overall business, customer base, headcount, and operations. Creating a global organization and managing a geographically dispersed workforce requires substantial management effort and significant additional investment in our operating and financial system capabilities and controls. If our information systems are unable to support the demands placed on them by our growth, we may be forced to implement new systems, which would be disruptive to our business. We may be unable to manage our expenses effectively in the future due to the expenses associated with these expansions, which may negatively impact our gross margins or operating expenses. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies, and lost revenue opportunities, which may materially and adversely affect our operating results.
 
We may not be able to continue to add new customers and increase sales to our existing customers, which could adversely affect our operating results.
 
Our growth is dependent on our ability to continue to attract new customers while retaining and expanding our service offerings to existing customers. Growth in the demand for our services may be inhibited, and we may be unable to sustain growth in our customer base for a number of reasons, such as:
 
A reduction in the demand for our services due to macroeconomic factors in the markets in which we operate;
Our inability to market our services in a cost-effective manner to new customers;
The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;
Our inability to successfully communicate the benefits of our services to businesses;
The decision of businesses to host internally or in colocation facilities as an alternative to the use of our services;
Our inability to penetrate international markets;
Our inability to provide compelling services or effectively market them to existing customers;
Our inability to strengthen awareness of our brand; and
Reliability, quality or compatibility problems with our services.
A substantial amount of our revenue growth is derived from purchases of service upgrades and additional services by existing customers. Our costs associated with increasing revenue from existing customers are generally lower than costs associated with generating revenue from new customers. Therefore, a reduction in the rate of revenue increase or a revenue decrease from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins.

Any failure by us to continue attracting new customers or grow our revenue from existing customers for a prolonged period of time could have a material adverse effect on our operating results.
 

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

The costs of building out, leasing, and maintaining our data centers constitute a significant portion of our capital and operating expenses. In order to manage growth and ensure adequate capacity for new and existing customers while minimizing unnecessary excess capacity costs, we continuously evaluate our short and long-term data center capacity requirements. If we overestimate the demand for our services and therefore secure excess data center capacity, our operating margins could be materially reduced. If we underestimate our data center capacity requirements, we may not be able to service the expanding needs of our existing customers and may be required to limit new customer acquisition, which may materially impair our revenue growth.

In the past, we have leased data center facilities and built or maintained the facilities ourselves. Due to the lead time in expanding existing data centers or building new data centers, if we build or expand data centers ourselves, we are required to estimate demand for our services as far as two years into the future. This requirement to make customer demand estimates so far in advance makes it difficult to accurately estimate our data center space needs. Building and maintaining data center facilities is also quite expensive.

More recently, we have leased data centers from data center operators who have built or maintained the facilities for us. If there are facilities available for lease that suit our needs, our lead time to make capacity decisions is decreased. However, there is still substantial lead time necessary in making sure that available space is adequate for our needs and maximizes our investment return. If we inaccurately forecast our space needs, we may be forced to enter into a lease that is not ideal for our needs and may potentially be required to pay more to secure the space if the current customer demand were to require immediate space expansion.

We currently intend to continue to lease from data center operators, but we could be forced to re-evaluate those plans depending on the availability and cost of data center facilities, the ability to impact and control certain design aspects of the data center and economic conditions affecting the data center operator's ability to add additional facilities.
 
We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.
 
We do not own the facilities occupied by our current data centers but occupy them pursuant to commercial leasing arrangements. The initial terms of our main existing data center leases expire over the next 20 years. Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required or choose to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.
 
Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.

We rely on a number of third-party providers for data center space, equipment, maintenance and other services, and the loss of, or problems with, one or more of these providers may impede our growth or cause us to lose customers.
 
We rely on third-party providers to supply data center space, equipment and maintenance. For example, we lease data center space from third-party landlords, lease or purchase equipment from equipment providers, and source equipment maintenance through third parties. While we have entered into various agreements for the lease of data center space, equipment, maintenance and other services, the third party could fail to live up to the contractual obligations under those agreements. For example, a data center landlord may fail to adequately maintain its facilities or provide an appropriate data center infrastructure for which it is responsible. If that were to happen, we would not likely be able to deliver the services to our customers that we have agreed to provide according to our standards or at all. Additionally, if the third parties that we rely on do fail to deliver on their obligations, our customers may lose confidence in our company, which would make it likely that we would not able to retain those customers, and therefore negatively impede our growth and financial results.
 

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We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.
 
We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software or inadequate or delayed support by the third party could result in errors or a failure of our service, which could harm our operating results by adversely affecting our revenue or operating costs.
 
We engage and rely on third-party consultants who may fail to provide effective guidance or solutions, which could result in increased costs and loss of business opportunity.
 
We engage third-party consultants who provide us with guidance and solutions relating to everything from overall corporate strategy to data center operations to employee engagement. We engage these parties based on our perception of their expertise and ability to provide valuable insight or solutions in the areas that we believe need to be addressed in our business. However, these consultants may provide us with ineffective or even harmful guidance or solutions, which, if followed or implemented, could result in a loss of resources, operational failures or a loss of critical business opportunities.
 
Increased energy costs, power outages, and limited availability of electrical resources may adversely affect our operating results.
 
Our data centers are susceptible to increased regional, national or international costs of power and to electrical power outages. Our customer contracts do not allow us to pass on any increased costs of energy to our customers, which could affect our operating margins. Increases in our power costs could impact our operating results and financial condition. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Increased Internet bandwidth costs and network failures may adversely affect our operating results.
 
Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.
 
As our customer base grows and their usage of telecommunications capacity increases, we will be required to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.


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We could be required to repay substantial amounts of money to certain state and local governments if we lose tax exemptions or grants previously awarded to us, which could adversely affect our operating results.
 
In August 2007, we entered into an agreement with the State of Texas (Texas Enterprise Fund Grant) under which we could receive up to a total of $22 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest. As of February 1, 2015, we had met the requirements to receive a total of $14 million of the available funds. We can draw an additional $8 million if we have created a total of 4,000 new jobs in Texas as of December 31, 2015. We are responsible for maintaining all of the jobs used in calculating these disbursements through January 2022. If we eliminate jobs for which we have drawn funds, we are subject to a clawback on the amounts we have drawn plus 3.4% interest on such amounts per year. 

On August 3, 2007, we entered into a lease for approximately 67 acres of land and a 1.2 million square foot facility in Windcrest, Texas, which is in the San Antonio, Texas area, to house our corporate headquarters. In connection with this lease, we also entered into a Master Economic Incentives Agreement (“MEIA”) with the Cities of Windcrest and San Antonio, Texas; Bexar County; and certain other parties, pursuant to which we agreed to locate existing and future employees at the new facility location. The agreement requires that we meet certain employment levels each year. On July 24, 2012, the parties to the MEIA entered into an amendment which acknowledged Rackspace's achievement of the required employment commitment levels. In addition to requiring a set number of employees to be hired, the MEIA requires that the median compensation of those employees be no less than $51,000 per year. In exchange for meeting these employment obligations, the parties agreed to enter into the lease structure, pursuant to which, as a lessee of the Windcrest Economic Development Corporation, we will not be subject to most of the property taxes associated with the property for a 14-year period. If we fail to maintain these job creation requirements, we could lose a portion or all of the tax benefit being provided during the 14-year period by having to make payments in lieu of taxes ("PILOT") to the City of Windcrest. The amount of the PILOT payment would be calculated based on the amount of taxes that would have been owed for that period if the property were not exempt, and then such amount would be adjusted pursuant to certain factors, such as the percentage of employment achieved compared to the stated requirements.

We have debt obligations that include restrictive covenants limiting our flexibility to manage our business; failure to comply with these covenants could trigger an acceleration of our outstanding indebtedness and adversely affect our financial position and operating results.
 
Our credit facility requires compliance with a set of financial and non-financial covenants. Those covenants include financial leverage limitations and interest rate coverage requirements, as well as limitations on our ability to incur additional debt or liens, make restricted payments, sell assets, enter into affiliate transactions, merge or consolidate with other companies, make certain acquisitions and take other actions. If we default on our credit agreement due to non-compliance with such covenants or any other contractual requirement of the agreement, we may be required to repay all amounts owed under this credit facility and, if those amounts owed at the time of the default are substantial, the repayment could materially and adversely affect our liquidity and business. As of December 31, 2014, there was $25 million outstanding indebtedness under our credit facility in addition to immaterial outstanding letters of credit.
 
We also have equipment and other lease obligations. The principal balance of these capital lease obligations totaled approximately $23.9 million as of December 31, 2014. The payment obligations under the equipment leases are generally secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

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

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

We are exposed to commodity and market price risks that have the potential to substantially influence our profitability and liquidity.
 
We are a large consumer of power. During 2014, we expensed approximately $31.5 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations and changes in energy prices. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically tracked the general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. We periodically evaluate the advisability of entering into fixed-price utilities contracts and have entered into certain fixed-price utilities contracts for some of our power consumption. If we choose not to enter into a fixed-price contract, we expose our cost structure to this commodity price risk. If we do choose to enter into a fixed-price contract, we lose the opportunity to reduce our power costs if the price for power falls below the fixed cost.  

Our main credit facility is a revolving line of credit with a base rate determined by variable market rates, including the Prime Rate and the London Interbank Offered Rate ("LIBOR"). These market rates of interest are fluctuating and expose our interest expense to risk. At this point, our credit agreement does not obligate us to hedge any interest rate risk with any instruments, such as interest rate swaps or interest rate options, and we do not have any such instruments in place. As we borrow, we may enter into swaps to continuously control our interest rate risk. As a result, we are exposed to interest rate risk on our borrowings. As an example of the impact of this interest rate risk, a 100 basis point increase in LIBOR would increase the interest expense on $10 million of borrowings that are not hedged by $0.1 million annually. As of December 31, 2014, we had limited exposure to interest rate risk as there was $25 million amount outstanding on our revolving credit facility.

The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. However, some of our customers are currently invoiced in currencies other than the applicable functional currency. As a result, we may incur foreign currency losses based on changes in exchange rates between the date of the invoice and the date of collection. In addition, large changes in foreign exchange rates relative to our functional currencies could increase the costs of our services to non-U.S. customers relative to local competitors, thereby causing us to lose existing or potential customers to these local competitors. Thus, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Further, as we grow our international operations, our exposure to foreign currency risk could become more significant. To date, we have not entered into any foreign currency hedging contracts, although we may do so in the future.

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

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Government regulation is continuously evolving and, depending on its evolution, may adversely affect our operating results.
 
We are subject to varying degrees of regulation in each of the jurisdictions in which we provide services. Local laws and regulations, and their interpretation and enforcement, differ significantly among those jurisdictions. These regulations and laws may cover taxation, privacy, data protection, pricing, content, copyrights, distribution, mobile communications, electronic device certification, electronic waste, electronic contracts and other communications, consumer protection, web services, the provision of online payment services, unencumbered Internet access to our services, the design and operation of websites, and the characteristics and quality of products and services. These laws can be costly to comply with, can be a significant diversion to management’s time and effort, and can subject us to claims or other remedies, as well as negative publicity. Many of these laws were adopted prior to the advent of the Internet and related technologies and, as a result, do not contemplate or address the unique issues that the Internet and related technologies produce. Some of the laws that do reference the Internet and related technologies have been and continue to be interpreted by the courts, but their applicability and scope remain largely uncertain.
 
In addition, future regulatory, judicial, and legislative changes may have a material adverse effect on our ability to deliver services within various jurisdictions. National regulatory frameworks have only recently been, or are still being, put in place in many countries. Accordingly, many countries are still in the early stages of providing for and adapting to a liberalized telecommunications market. As a result, in these markets we may encounter more protracted and difficult procedures to obtain any necessary licenses or negotiate interconnection agreements, which could negatively impact our ability to expand in these markets or increase our operating costs in these markets.

Privacy concerns relating to our technology could damage our reputation and deter current and potential users from using our products and services.
 
Since our products and services are web-based, we store substantial amounts of data for our customers on our servers, including personal information. Any systems failure or compromise of our security that results in the release of our customers’ data could (i) subject us to substantial damage claims from our customers, (ii) expose us to costly regulatory remediation and (iii) harm our reputation and brand. We may also need to expend significant resources to protect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand our hosting footprint.
 
Regulatory authorities around the world are considering a number of legislative proposals concerning data protection. In addition, the interpretation and application of data protection laws in Europe and elsewhere are still uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines, this could result in an order requiring that we change our data practices, which could have an adverse effect on our business. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business.


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Our ability to operate and expand our business is susceptible to risks associated with international sales and operations.
 
We anticipate that, for the foreseeable future, a significant portion of our revenue will continue to be derived from sources outside of the U.S. A key element of our growth strategy is to further expand our customer base internationally and successfully operate data centers in foreign markets. We have limited experience operating in foreign jurisdictions other than the U.K. and Hong Kong and expect to continue to grow our international operations. Managing a global organization is difficult, time consuming, and expensive. Our inexperience in operating our business globally increases the risk that international expansion efforts that we may undertake will not be successful. In addition, conducting international operations subjects us to new risks that we have not generally faced. These risks include:
 
Localization of our services, including translation into foreign languages and adaptation for local practices and regulatory requirements;
Lack of familiarity with and unexpected changes in foreign regulatory requirements;
Longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
Difficulties in managing and staffing international operations;
Fluctuations in currency exchange rates;
Potentially adverse tax consequences, including the complexities of transfer pricing, foreign value added tax systems, and restrictions on the repatriation of earnings;
Dependence on certain third parties, including channel partners with whom we do not have extensive experience;
The burdens of complying with a wide variety of foreign laws and legal standards;
Increased financial accounting and reporting burdens and complexities;
Political, social, and economic instability abroad, terrorist attacks and security concerns in general; and
Reduced or varied protection for intellectual property rights in some countries.
Operating in international markets also requires significant management attention and financial resources. The investment and additional resources required to establish operations and manage growth in other countries may not produce desired levels of revenue or profitability.

Our referral and reseller partners provide revenue to our business, and we benefit from our association with them. The loss of these participants could adversely affect our business.
 
Our referral and reseller partners drive revenue to our business. Most of these partners offer services that are complementary to our services; however, some may actually compete with us in one or more of our product or service offerings. These network partners may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own services rather than ours, which could cause our revenue to decline.
 
Also, we derive tangible and intangible benefits from our association with some of our network partners, particularly high profile partners that reach a large number of companies through the Internet. If a substantial number of these partners terminate their relationship with us, our business could be adversely affected.
 

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Our acquisitions may divert our management’s attention, result in dilution to our stockholders and consume resources that are necessary to sustain our business.
 
We have made acquisitions, and, if appropriate opportunities present themselves, we may make additional acquisitions or investments or enter into joint ventures or strategic alliances with other companies. Risks commonly encountered in such transactions include:
 
The difficulty of assimilating the operations and personnel of the combined companies;
The potential post-acquisition loss of personnel acquired through an acquisition;
The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;
The potential disruption of our ongoing business;
The diversion of management attention from our existing business;
The inability of management to maximize our financial and strategic position through the successful integration of the acquired businesses;
Difficulty in maintaining controls, procedures, and policies;
The impairment of relationships with employees, suppliers, and customers as a result of any integration;
The loss of an acquired base of customers and accompanying revenue; and
The assumption of leased facilities, other long-term commitments or liabilities that could have a material adverse impact on our profitability and cash flow.
As a result of these potential problems and risks, businesses that we may acquire or invest in may not produce the revenue, earnings, or business synergies that we anticipated. In addition, there can be no assurance that any potential transaction will be successfully identified and completed or that, if completed, the acquired business or investment will generate sufficient revenue to offset the associated costs or other potential harmful effects on our business.

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

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Risks Related to the Ownership of Our Common Stock
 
The trading price of our common stock may be volatile.

The market price of our common stock has been highly volatile and could be subject to wide fluctuations in response to, among other things, the factors discussed in this Risk Factors section and elsewhere in this periodic report, operating results that do not meet market analyst expectations, and other factors beyond our control, such as stock market volatility and fluctuations in the valuation of companies perceived by investors to be comparable to us. For example, between December 31, 2013 and December 31, 2014, the closing trading price of our common stock was very volatile, ranging between $26.28 and $48.24 per share, including single-day increases of up to 17.7% and declines up to 19.1%.

Further, the stock markets have experienced price and volume fluctuations that have affected our stock price and the market prices of equity securities of many other companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies.

In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.
  
We do not intend to pay dividends on our common stock.

We have never declared or paid any cash dividend on our capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.
 
Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change of control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.
 
Our restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors deemed undesirable by our board of directors that our stockholders might consider favorable. Some of these provisions:
 
Authorize the issuance of blank check preferred stock, which can be created and issued by our board of directors without prior stockholder approval, with voting, liquidation, dividend, and other rights senior to those of our common stock;
Provide for a classified board of directors, with each director serving a staggered three-year term;
Prohibit our stockholders from filling board vacancies or increasing the size of our board, calling special stockholder meetings or taking action by written consent;
Provide for the removal of a director only with cause and by the affirmative vote of the holders of a majority of the shares then entitled to vote at an election of our directors; and
Require advance written notice of stockholder proposals and director nominations.
In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

ITEM 1B - UNRESOLVED STAFF COMMENTS

None.


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ITEM 2 - PROPERTIES

Office Space

Our corporate headquarters facility is located in San Antonio, Texas and consists of a 1.2 million square foot facility located on approximately 67 acres of land. We have remodeled and are currently using approximately 800 thousand square feet of office space and will continue to remodel the formerly vacant facility as needed to facilitate our future growth and office requirements. In addition to our corporate headquarters, we have office locations throughout the U.S., the U.K., the Netherlands, Hong Kong, Switzerland, Australia, and Mexico City. As of December 31, 2014, we utilized approximately 1.1 million square feet of leased office space for customer service, operations, sales, corporate and administrative functions.

Data Centers

As of December 31, 2014, we leased data centers located in the U.S. (in Texas, Virginia, and Illinois), the U.K., Hong Kong and Australia. At December 31, 2014, we were utilizing 31 Megawatts of power at our data centers and had 58 Megawatts of power under contract.

We are continuously looking for additional data center space to accommodate future growth or that would present an attractive business opportunity for us. However, we believe that our existing office space and data center facilities as well as those currently under construction in the U.K. are adequate for our current needs and that suitable additional or alternative space will be available in the future to meet our anticipated needs.


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ITEM 3 – LEGAL PROCEEDINGS
 
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, we were involved in the following legal proceedings:

On May 29, 2012, Clouding IP, LLC filed a complaint against us in the United States District Court for the District of Delaware. The complaint alleged, among other things, infringement of the following nine patents: U.S. Patent No. 7,596,784 purporting to cover a “Method System and Apparatus for Providing Pay-Per-Use Distributed Computing Resources;” U.S. Patent No. 7,065,637 purporting to cover a “System for Configuration of Dynamic Computing Environments Using a Visual Interface;” U.S. Patent No. 6,738,799 purporting to cover a “Methods and Apparatuses for File Synchronization and Updating Using a Signature List;” U.S. Patent No. 5,495,607 purporting to cover a “Network Management System Having Virtual Catalog Overview of Files Disruptively Stored Across Network Domain;” U.S. Patent No. 6,925,481 purporting to cover a “Technique for Enabling Remote Data Access and Manipulation from a Pervasive Device;” U.S. Patent No. 7,254,621 purporting to cover a “Technique for Enabling Remote Data Access and Manipulation from a Pervasive Device;” U.S. Patent No. 6,963,908 purporting to cover a “System for Transferring Customized Hardware and Software Settings from One Computer to Another Computer to Provide Personalized Operating Environments;" U.S. Patent No. 6,631,449 purporting to cover a “Dynamic Distributed Data System and Method;” and U.S. Patent No. 6,918,014 purporting to cover a “Dynamic Distributed Data System and Method.” The plaintiff sought monetary damages and costs. The parties reached a settlement of the case, and on November 3, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

On September 17, 2012, PersonalWeb Technologies LLC and Level 3 Communications, LLC filed a complaint against us in the United States District Court for the Eastern District of Texas. The complaint alleged, among other things, infringement of the following nine patents: U.S. Patent No. 5,978,791 purporting to cover “Data Processing System Using Substantially Unique Identifiers to Identify Data Items, Whereby Data Items Have the Same Identifiers;” U.S Patent No. 6,415,280 purporting to cover “Identifying and Requesting Data in Network Using Identifiers Which Are Based On Contents of Data;” U.S. Patent No. 6,928,442 purporting to cover “Enforcement and Policing of Licensed Content Using Content-based Identifiers;” U.S. Patent No. 7,802,310 purporting to cover “Controlling Access to Data in a Data Processing System;” U.S. Patent No. 7,945,539 purporting to cover “Distributing and Accessing Data in a Data Processing System;” U.S. Patent No. 7,945,544 purporting to cover “Similarity-Based Access Control of Data in a Data Processing System;” U.S. Patent No. 7,949,662 purporting to cover “De-duplication of Data in a Data Processing System;” U.S. Patent No. 8,001,096 purporting to cover “Computer File System Using Content-Dependent File Identifiers;” and U.S. Patent No. 8,099,420 purporting to cover “Accessing Data in a Data Processing System.” Plaintiff PersonalWeb Technologies sought injunctive relief, monetary damages, costs, and attorney's fees. The parties reached a settlement of the case, and on October 20, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

On February 25, 2013, Rotatable Technologies LLC filed a complaint against us in the United States District Court for the Eastern District of Texas. The complaint alleged, among other things, infringement of U.S. Patent No. 6,326,978 purporting to cover “Display Method for Selectively Rotating Windows on a Computer Display.” The plaintiff sought injunctive relief, monetary damages, costs, and attorney's fees. The parties reached a settlement of the case, and on November 6, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

On March 18, 2014, Selene Communications Technologies, LLC filed a complaint against us in the United States District Court for the District of Delaware. The complaint alleges, among other things, infringement of the following two patents: U.S. Patent No. 6,363,377 purporting to cover a “Search Data Processor” and U.S. Patent No. 7,143,444 purporting to cover an “Application-Layer Anomaly and Misuse Detection.” The plaintiff sought injunctive relief, monetary damages and costs. The parties reached a settlement of the case, and on December 2, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

ITEM 4 – MINE SAFETY DISCLOSURES
 
Not applicable.

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PART II

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

Market Information for Common Stock

Our common stock began trading on the New York Stock Exchange under the symbol "RAX" beginning on August 8, 2008. The following table sets forth the high and low closing prices for our common stock for the periods indicated, as reported by the New York Stock Exchange.

Fiscal Year 2013 Quarters:
 
High
 
Low
First Quarter
 
$
79.24

 
$
49.74

Second Quarter
 
$
52.24

 
$
34.46

Third Quarter
 
$
53.85

 
$
38.08

Fourth Quarter
 
$
53.50

 
$
33.19


Fiscal Year 2014 Quarters:
 
High
 
Low
First Quarter
 
$
40.36

 
$
31.26

Second Quarter
 
$
38.28

 
$
26.28

Third Quarter
 
$
39.79

 
$
29.50

Fourth Quarter
 
$
48.24

 
$
32.80


The last reported sale price for our common stock on the New York Stock Exchange was $39.13, $46.81 and $49.24 per share on December 31, 2013, December 31, 2014, and February 23, 2015, respectively.

Dividend Policy

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

Stockholders

As of February 23, 2015, there were 314 registered stockholders of record of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these stockholders of record.

Securities Authorized for Issuance Under Equity Compensation Plans

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

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Stock Performance Graph

The graph set forth below compares the five-year cumulative total stockholder return on our common stock between December 31, 2009 and December 31, 2014 with the cumulative total return of (i) the Russell 1000 Index and (ii) the Nasdaq Internet Total Return Index over the same period. This graph assumes the investment of $100 on December 31, 2009 in our common stock, the Russell 1000 Index and the Nasdaq Internet Total Return Index and assumes the reinvestment of dividends, if any. The Russell 1000 Index, of which Rackspace is a member, measures the performance of the large-cap segment of U.S. equities. The Nasdaq Internet Total Return Index consists of U.S. listed companies engaged in Internet-related businesses.

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




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Issuer Purchases of Equity Securities

The table below sets forth information regarding the company’s purchases of its common stock during its fourth fiscal quarter ended December 31, 2014:

Period
 
Total Number of Shares Purchased
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Programs (1)
 
Maximum Dollar Value of Shares that May Yet Be Purchased Under the Programs
November 1, 2014-November 30, 2014
 
3,286,385

 
$
42.60

 
3,286,385

 
$
360,000,000

December 1, 2014- December 31, 2014
 

 
$

 

 
$
360,000,000

Total
 
3,286,385

 
 
 
3,286,385

 



(1)
On November 6, 2014, our board of directors authorized a program to repurchase up to $500 million of our common stock over the next two years. Under this program, shares may be repurchased from time to time through both open market and privately negotiated transactions. On November 12, 2014, we entered into an accelerated share repurchase ("ASR") agreement to repurchase $200 million of our common stock. During the fourth quarter of 2014, we received an initial delivery of approximately 3.3 million shares of common stock under the ASR agreement. For further discussion of the ASR agreement, see Item 8 of Part II, "Financial Statements and Supplementary Data - Note 8 - Stockholders' Equity.

- 31 -


ITEM 6 - SELECTED FINANCIAL DATA

The following selected financial data should be read in conjunction with our audited consolidated financial statements and the notes thereto, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this document. Historical results are not necessarily indicative of future results.

The selected financial data as of December 31, 2013 and 2014 and for the years ended December 31, 2012, 2013 and 2014 have been derived from our audited consolidated financial statements, which are included elsewhere in this document. The selected financial data as of December 31, 2010, 2011 and 2012 and for the years ended December 31, 2010 and 2011 have been derived from our audited consolidated financial statements as of and for those periods, which are not included in this document.
 
Year Ended December 31,
(In thousands, except per share data)
2010
 
2011
 
2012
 
2013
 
2014
Statement of comprehensive income data
 
 
 
 
 
 
 
 
 
Net revenue
$
780,555

 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

 
$
1,794,357

Income from operations
$
79,602

 
$
123,471

 
$
172,741

 
$
133,136

 
$
163,529

Net income
$
46,358

 
$
76,411

 
$
105,418

 
$
86,737

 
$
110,553

 
 
 
 
 
 
 
 
 
 
Net income per share (1)
 
 
 
 
 
 
 
 
 
Basic
$
0.37

 
$
0.59

 
$
0.78

 
$
0.63

 
$
0.78

Diluted
$
0.35

 
$
0.55

 
$
0.75

 
$
0.61

 
$
0.77

 
 
 
 
 
 
 
 
 
 
Balance sheet data
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
104,941

 
$
159,856

 
$
292,061

 
$
259,733

 
$
213,505

Total assets
$
761,577

 
$
1,026,482

 
$
1,295,551

 
$
1,491,797

 
$
1,624,284

Non-current liabilities
$
133,572

 
$
189,310

 
$
196,465

 
$
177,877

 
$
273,772


(1)
See Note 2 to the consolidated financial statements for an explanation of the method used to determine the number of shares used in computing basic and diluted net income per common share.

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ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis (“MD&A”) is intended to help readers understand our results of operations, financial condition and cash flows and should be read in conjunction with the audited consolidated financial statements and the related notes included elsewhere in this document. References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries.

The MD&A is organized as follows:
Overview - Discussion of the nature and key trends of our business and overall analysis of financial highlights and key metrics in order to provide context for the remainder of the MD&A.
Results of Operations - An analysis of our financial results comparing the year 2014 to 2013 and 2013 to 2012.
Liquidity and Capital Resources - Discussion of our financial condition, sources of liquidity, changes in cash flows and capital expenditure requirements.
Critical Accounting Estimates - Discussion of accounting estimates that we believe are most important to understanding the assumptions and judgments incorporated in our consolidated financial statements.
Supplemental Information - Description and reconciliation of Non-GAAP Financial Measures used throughout this MD&A and financial information and key metrics for the most recent five quarters.

This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contained in any forward-looking statements. See “Special Note Regarding Forward-Looking Statements” contained elsewhere in this document.

Overview

Description of our Business

Rackspace is the world leader in the managed cloud segment of the business IT market. We serve more than 300,000 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. We deliver our services with our unique approach to the customer experience, called Fanatical Support.

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, Australia, and Mexico. Our growth strategy includes targeting additional international customers as we continue our expansion in continental Europe, the Asia-Pacific region and Latin America. During 2014, 31% of our net revenue was from non-U.S. customers, and no individual customer accounted for more than 2% of our net revenue.

Trends in our Business

The fast-growing and crowded cloud computing industry is bifurcating into two segments: unmanaged cloud and managed cloud. As a reflection of this trend, in 2014, Gartner Inc. distinguished for the first time between unmanaged, or “infrastructure as a service,” cloud providers, and those who deliver managed cloud. Its new report on the latter market segment, the Gartner Magic Quadrant for Cloud-Enabled Managed Hosting, ranked Rackspace as a leader, in both North America and Europe.

We believe that the managed cloud segment of the cloud computing market 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 and they want specialized expertise in running the ever-expanding set of technologies that are at the heart of cloud scale applications.

We believe demand for managed cloud will continue to grow for four reasons:

1.
Lack of In-House IT Expertise. As business IT applications grow in number and complexity, most companies do not have the IT staff needed to deliver a robust, reliable online presence, and to leverage their data for insights about customer behavior and internal operations.


- 33 -


2.
Strategic Resource Utilization. Larger companies that do have specialized, dedicated IT engineers would rather focus these expensive resources on strategic areas that differentiate their business rather than managing servers or databases or running a website.

3.
Market Acceptance. As companies have experienced the benefits of using managed cloud providers to handle some of their IT workloads, they have become more comfortable having those providers manage additional IT services. This trend will accelerate as various barriers to adoption are broken down, through developments such as the expansion of open and standard technologies and advances in the security of cloud computing.

4.
Accelerated Business Creation. Cloud computing has removed many of the traditional barriers to new business formation through the low cost nimbleness, and capital efficiency that it brings to IT infrastructure. Managed cloud does the same thing for the costs associated with infrastructure management and application expertise. Managed cloud is driving innovation and new business formation at a rapid rate. The rising supply of powerful, easy-to-use cloud computing is creating new demand.

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 complex tools and applications that run on top of it. During 2014, several of these unmanaged cloud providers sharply reduced the prices that they charge business customers for access to raw cloud infrastructure. This decline in cloud infrastructure prices has encouraged a proliferation of complex cloud tools and applications, requiring specialized expertise to adopt and manage. Many companies have difficulty finding and hiring the specialized engineers that they need and as a result, more businesses are turning to managed cloud providers such as Rackspace. During the last three quarters of 2014, while unmanaged cloud providers were significantly dropping their prices, we continued to gain new customers and grow revenue with year-over-year quarterly revenue growth of 17.4%, 18.3%, and 15.8% in the second, third and fourth quarters of 2014, respectively.

In order to take advantage of the long-term continued growth opportunities in the market, we have been making infrastructure investments to complement and leverage Fanatical Support, our principal differentiation from our competitors across our multiple service offerings. Our 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.

In 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.

Financial Highlights and 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 discussion includes the presentation of Adjusted EBITDA and Return on Capital which are non-GAAP financial measures. Generally, a non-GAAP financial measure is a numerical measure of a company’s performance, financial position, or cash flows that either excludes or includes amounts that are not normally included or excluded in the most directly comparable measure calculated and presented in accordance with GAAP. Other companies may calculate non-GAAP measures differently, limiting their usefulness as a comparative measure. We believe Adjusted EBITDA and Return on Capital provide helpful information with respect to evaluating our performance. We have reconciled each of these non-GAAP measures to the applicable most comparable GAAP measure in the “Supplemental Information” section of this MD&A.


- 34 -


Growth
 
 
 
Three Months Ended
 
Year Ended
 
(Dollar amounts in thousands, except average monthly revenue per server)
 
September 30, 2014
 
December 31, 2014
 
December 31, 2013
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Dedicated cloud, net revenue
 
$
319,601

 
$
324,729

 
$
1,119,636

 
$
1,254,666

 
Public cloud, net revenue
 
$
140,175

 
$
147,693

 
$
415,150

 
$
539,691

 
Net revenue
 
$
459,776

 
$
472,422

 
$
1,534,786

 
$
1,794,357

 
Revenue growth (year over year)
 
18.3
 %
 
15.8
 %
 
17.2
 %
 
16.9
 %
 
 
 
 
 
 
 
 
 
 
 
Net upgrades (monthly average)
 
1.4
 %
 
1.2
 %
 
1.3
 %
 
1.3
 %
 
Churn (monthly average)
 
-0.6
 %
 
-0.5
 %
 
-0.8
 %
 
-0.6
 %
 
Growth in installed base (monthly average) (1)
 
0.8
 %
 
0.7
 %
 
0.5
 %
 
0.7
 %
 
 
 
 
 
 
 
 
 
 
 
Number of servers deployed at period end
 
110,453

 
112,628

 
103,886

 
112,628

 
Average monthly revenue per server
 
$
1,405

 
$
1,412

 
$
1,307

 
$
1,382

 
 
 
 
 
 
 
 
 
 
 
Number of employees (Rackers) at period end
 
5,939

 
5,936

 
5,651

 
5,936

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

All of our service offerings fall under the umbrella of cloud computing, broadly defined as the delivery of computing, storage, and applications over the Internet. We present our revenue in two categories: dedicated cloud and public cloud.

Dedicated cloud, also known as "managed hosting," refers to IT services that we provide on a server or servers reserved for a specific customer. Dedicated cloud is largely a recurring, subscription-based business and generates the majority of our revenue. Our customers pay us a recurring fee based on the capacity and complexity of the IT systems we manage and the level of service intensity we provide, pursuant to service agreements that typically provide for fixed monthly payments. This category also includes revenue for private cloud services, which refers to a pool of computing resources that is virtualized for greater efficiency and nimbleness but that is dedicated to one particular customer rather than being used by multiple customers. In 2014, dedicated cloud revenue of $1.3 billion represented 70% of our total net revenue and grew 12% from 2013.

Public cloud refers to multi-tenant pools of computing resources delivered on-demand over the Internet. Virtualization and other cloud technologies allow us to effectively provision and manage pools of computing resources across a larger base of customers and deliver more resources to businesses when they need them. At the same time, pooled cloud computing substantially lowers the cost of IT services for some applications. There are multiple varieties of public cloud services that can be quickly and easily scaled up or down on-demand. Public cloud services are priced on a pay-per-use basis that we recognize as recurring revenue as the services are provided. In 2014, public cloud revenue of $540 million represented 30% of our total net revenue and grew 30% from 2013.

Because of rapid changes in technology and customer behavior, these categories have become less and less clear-cut and meaningful. More business customers are consuming both single-tenant dedicated computing and multi-tenant private cloud computing, in their data centers and ours, in ways that are increasingly seamless and difficult to separate in any meaningful way. As a result of these developments, beginning with our announcement of our financial results for the first quarter of 2015, we will stop disclosing net revenue as public cloud or dedicated cloud, and will only disclose consolidated net revenue.

Total net revenue increased 17% from 2013, to $1.8 billion. Contributing to this increase was the positive impact of a weaker U.S. dollar relative to the functional currencies of our foreign operations in 2014 compared to 2013. Net revenue for 2014 would have been approximately $22 million lower had foreign exchange rates remained constant from the prior year.

Our year-over-year revenue growth rate accelerated during the first three quarters of 2014 while slightly decelerating during the fourth quarter. Changes in foreign exchange rates negatively impacted our fourth quarter results, which was a reversal from the positive impact experienced during the first three quarters of 2014. On a sequential quarter basis, fourth quarter net revenue of $472 million increased 2.8%, which includes the negative impact of approximately $6 million due to changes in foreign exchange rates.


- 35 -


Profitability
 
 
 
Three Months Ended
 
Year Ended
 
(Dollar amounts in thousands, except per share amounts)
 
September 30, 2014
 
December 31, 2014
 
December 31, 2013
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA
 
$
158,662

 
$
165,384

 
$
505,788

 
$
605,418

 
Adjusted EBITDA margin
 
34.5
%
 
35.0
%
 
33.0
%
 
33.7
%
 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
40,513

 
$
50,005

 
$
133,136

 
$
163,529

 
Operating income margin
 
8.8
%
 
10.6
%
 
8.7
%
 
9.1
%
 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
25,740

 
$
36,916

 
$
86,737

 
$
110,553

 
Net income margin
 
5.6
%
 
7.8
%
 
5.7
%
 
6.2
%
 
Diluted net income per share
 
$
0.18

 
$
0.26

 
$
0.61

 
$
0.77


Adjusted EBITDA, income from operations, and net income all grew at a faster pace than revenue, at 20%, 23%, and 27%, respectively. This is reflected in the expansion of our margins, as Adjusted EBITDA increased 70 basis points to 33.7% of net revenue, income from operations increased 40 basis points to 9.1% of net revenue, and net income increased 50 basis points to 6.2% of net revenue.

Capital Efficiency, Infrastructure Capacity and Utilization
 
 
 
Three Months Ended
 
Year Ended
 
(Dollar amounts in thousands)
 
September 30, 2014
 
December 31, 2014
 
December 31, 2013
 
December 31, 2014
 
 
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
 
 
 
 
 
 
 
 
Customer gear
 
$
78,677

 
$
72,488

 
$
297,787

 
$
276,620

 
Data center build outs
 
$
14,825

 
$
11,079

 
$
58,278

 
$
50,634

 
Office build outs
 
$
3,464

 
$
1,633

 
$
31,103

 
$
21,166

 
Capitalized software and other projects
 
$
20,457

 
$
19,429

 
$
84,921

 
$
86,719

 
Total capital expenditures
 
$
117,423

 
$
104,629

 
$
472,089

 
$
435,139

 
 
 
 
 
 
 
 
 
 
 
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
Average capital base
 
$
943,235

 
$
963,478

 
$
804,173

 
$
930,417

 
Capital turnover (1)
 
1.95

 
1.96

 
1.91

 
1.93

 
Return on capital (1)
 
11.7
%
 
15.5
%
 
11.0
%
 
12.2
%
 
 
 
 
 
 
 
 
 
 
 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end
 
58.1

 
58.1

 
60.0

 
58.1

 
Megawatts available for use at period end
 
45.4

 
49.7

 
46.9

 
49.7

 
Megawatts utilized at period end
 
29.9

 
30.5

 
27.4

 
30.5

 
Net revenue per average Megawatt of power utilized (1)
 
$
62,448

 
$
62,572

 
$
59,442

 
$
61,917

(1) Metrics for the three months ended September 30, 2014 and December 31, 2014 are annualized.     

Return on Capital ("ROC") increased from 11.0% in 2013 to 12.2% in 2014. The increase in 2014 was primarily due to the 23% increase in income from operations between periods reflecting improved results and the positive impact of a lower effective tax rate of 31% compared to 34% in the prior year. While our average capital base increased 16% between periods, our capital turnover also increased to 1.93 for 2014, compared to 1.91 for 2013 partially driven by the decrease in capital expenditures in 2014 compared to 2013.

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

Customer gear - Includes servers, firewalls, load balancers, cabinets, backup libraries, storage arrays and drives, and network cabling used in customers' infrastructure environments.

Data center build-outs - Includes generators, uninterruptible power supplies ("UPS"), power distribution units, mechanical and electrical plants, chillers, raised floor, data center gear and other data center building improvements.

- 36 -


Office build-outs - Includes building improvements, raised floor, furniture and equipment.

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

Capital expenditures were $435 million in 2014, compared to $472 million in 2013. Higher capital expenditures in 2013 reflected equipment and data center costs associated with the global launch of our Performance Cloud Servers and the purchase of land for future expansion of our London U.K. data center.

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

Disciplined Use of Capital and Management of Profitability

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

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

We have achieved a critical mass that generates long-term cost advantages. Like any service that moves from distributed to centralized production, scale is a factor in ensuring costs are low enough to drive mass adoption. We are able to generate significant cost advantages based on our large installed customer base and growth profile. We purchase large quantities of computing and data center assets, which allows us to negotiate higher volume pricing savings.



- 37 -


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:
 
 
Year Ended December 31,
(In thousands)
 
2012
 
2013
 
2014
Net revenue
 
$
1,309,239

 
$
1,534,786

 
$
1,794,357

Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
419,013

 
492,493

 
582,334

Research and development
 
56,736

 
90,213

 
117,006

Sales and marketing
 
166,172

 
208,417

 
237,548

General and administrative
 
244,732

 
297,520

 
322,056

Depreciation and amortization
 
249,845

 
313,007

 
371,884

Total costs and expenses
 
1,136,498

 
1,401,650

 
1,630,828

Income from operations
 
172,741

 
133,136

 
163,529

Other income (expense):
 
 
 
 
 
 
Interest expense
 
(4,749
)
 
(3,118
)
 
(1,913
)
Interest and other income (expense)
 
15

 
741

 
(2,012
)
Total other income (expense)
 
(4,734
)
 
(2,377
)
 
(3,925
)
Income before income taxes
 
168,007

 
130,759

 
159,604

Income taxes
 
62,589

 
44,022

 
49,051

Net income
 
$
105,418

 
$
86,737

 
$
110,553

 
Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Year Ended December 31,
(Percent of net revenue)
 
2012
 
2013
 
2014
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
32.0
 %
 
32.1
 %
 
32.5
 %
Research and development
 
4.3
 %
 
5.9
 %
 
6.5
 %
Sales and marketing
 
12.7
 %
 
13.6
 %
 
13.2
 %
General and administrative
 
18.7
 %
 
19.4
 %
 
17.9
 %
Depreciation and amortization
 
19.1
 %
 
20.4
 %
 
20.7
 %
Total costs and expenses
 
86.8
 %
 
91.3
 %
 
90.9
 %
Income from operations
 
13.2
 %
 
8.7
 %
 
9.1
 %
Other income (expense):
 
 
 
 
 
 
Interest expense
 
(0.4
)%
 
(0.2
)%
 
(0.1
)%
Interest and other income (expense)
 
0.0
 %
 
0.0
 %
 
(0.1
)%
Total other income (expense)
 
(0.4
)%
 
(0.2
)%
 
(0.2
)%
Income before income taxes
 
12.8
 %
 
8.5
 %
 
8.9
 %
Income taxes
 
4.8
 %
 
2.9
 %
 
2.7
 %
Net income
 
8.1
 %
 
5.7
 %
 
6.2
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

- 38 -


Year ended December 31, 2014 Compared to Year ended December 31, 2013

Net Revenue

Net revenue increased $260 million, or 17%, primarily due to both the acquisition of new customers and incremental services rendered to existing customers. Year-over-year revenue increases were 12% for dedicated cloud and 30% for public cloud.

Also contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the functional currencies of our foreign operations in 2014 compared to 2013. Net revenue for 2014 would have been approximately $22 million lower had foreign exchange rates remained constant from the prior year. The U.S. dollar impact of foreign exchange rate movements on net income is minimal, as the majority of our foreign customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively.

We use a metric called “installed base growth” to measure revenue growth derived only from our existing customer base. During 2014, our monthly average churn rate was 0.6%, compared to 0.8% in 2013. Overall, our installed base grew at a monthly average rate of 0.7% in 2014, compared to 0.5% in 2013.

Cost of Revenue

Cost of revenue primarily consists of employee-related costs of our customer support teams and data center employees, as well as the costs to lease and operate our data centers. Many of our data center costs vary with the volume of services sold, including power, bandwidth, software licenses and costs related to maintenance and the replacement of IT equipment components.

Cost of revenue increased $90 million, or 18%. Of this increase, $45 million was attributable to employee-related expenses, such as salaries, benefits and incentive compensation, driven by an 11% increase in average headcount to support business growth. License costs increased $27 million, as higher expenses of $34 million related to our growth were partially offset by a $7 million benefit recorded in the third quarter of 2014 related to a refund of sales tax paid on previous license purchases. Data center costs increased $22 million, mostly related to rent, maintenance and utilities. As a percentage of net revenue, cost of revenue increased 40 basis points, from 32.1% in 2013 to 32.5% in 2014, primarily driven by higher license expense.

Research and Development Expenses

Research and development expenses are mainly costs for employees and consultants who are focused on the deployment of new technologies to address emerging trends and the development and enhancement of proprietary tools.

Research and development expenses increased $27 million, or 30% due to increased employee-related expenses, such as salaries, benefits and incentive compensation. During 2014, we 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 consist of employee-related costs of our sales and marketing employees, including sales commissions, compensation paid to certain channel partners, and costs for advertising and promoting our services and to generate customer demand.

Sales and marketing expenses increased $29 million, or 14%. Employee-related expenses increased $22 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, partially offset by a decrease related to the 2013 open cloud branding campaign.

General and Administrative Expenses

General and administrative expenses include employee-related and facility costs for functions such as finance and accounting, human resources, information technology, and legal, as well as professional fees, general corporate costs and overhead.

- 39 -


General and administrative expenses increased $25 million, or 8%, but decreased as a percentage of net revenue from 19.4% in 2013 to 17.9% in 2014. 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 2014. Employee-related expenses increased $16 million, primarily due to increased headcount, salaries and contract labor, while share-based compensation was flat as expense from new grants was offset by certain executive forfeitures in early 2014. Internal software support and maintenance expenses increased $5 million, to support the growth of the business. Professional fees decreased $3 million, primarily due to higher spending in 2013 on strategic consulting projects.

Depreciation and Amortization Expense

Depreciation and amortization includes amortization of leasehold improvements associated with our data centers and corporate facilities, as well as depreciation of our data center infrastructure and equipment. Amortization expense is also comprised of the amortization of our customer-based intangible assets related to acquisitions, internally developed technology, and software licenses purchased from third-party vendors.

Depreciation and amortization expense increased $59 million, or 19%. During 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 purchases of property and equipment to support the growth of our business, with depreciable customer gear assets representing the majority of additions. Depreciation and amortization expense increased as a percentage of net revenue, from 20.4% in 2013 to 20.7% in 2014. The headquarters building abandonment charge represented 20 basis points of the increase between years.

Other Income (Expense)

Other expense was $3.9 million and $2.4 million for 2014 and 2013, respectively. The increase in other expense of $1.5 million between years was mostly driven by the unfavorable impact of foreign exchange rate movements, partially offset by lower interest expense related to a reduction in the average balance of outstanding interest-bearing debt.

Income Taxes

Our effective tax rate decreased from 33.7% in 2013 to 30.7% in 2014. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, tax credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. The effective tax rate decreased in 2014 primarily as a result of a larger portion of our profits earned outside of the U.S. compared to 2013. Our foreign earnings are generally taxed at lower rates than in the United States.

For a full reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Item 8 of Part II, “Financial Statements and Supplementary Data – Note 10Taxes.”

Year ended December 31, 2013 Compared to Year ended December 31, 2012

Net Revenue

Net revenue increased $226 million, or 17%, primarily due to both the acquisition of new customers and incremental services rendered to existing customers. Year-over-year revenue increases were 11% for our dedicated cloud service and 37% for our public cloud service.

Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the functional currencies of our foreign operations in 2013 compared to 2012. Net revenue for 2013 would have been approximately $5 million higher had foreign exchange rates remained constant from the prior year, with minimal impact to our margins as the majority of these customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively.

We use a metric called “installed base growth” to measure revenue growth derived only from our existing customer base. During 2013, our monthly average churn rate was 0.8%, compared to 0.8% in 2012. Overall, our installed base grew at a monthly average rate of 0.5% in 2013, compared to 0.8% in 2012.

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Cost of Revenue

Cost of revenue increased $73 million, or 18%. Of this increase, $32 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits, and to a lesser extent, increases in share-based compensation. These increases are primarily due to additional headcount and salary increases. The cost increase was further attributable to an increase in license costs of $10 million and an increase in data center costs of $36 million, mostly related to rent, maintenance and utilities, partially offset by a decrease in consulting fees of $3 million. The remaining variance was due to small changes in other cost of revenue expenses.

Research and Development Expenses

Research and development expenses increased $33 million, or 59%. Of this increase, $29 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits and, to a lesser extent, increases in non-equity incentive compensation and share-based compensation expense. These increases are primarily due to additional headcount and salary increases. The remaining increase of $4 million was primarily attributable to increases in professional fees, travel costs, and internal software support and maintenance. Research and development costs increased as a percentage of net revenue, from 4.3% in 2012 to 5.9% in 2013, primarily due to employee-related expenses increasing at a faster rate than revenue.

Sales and Marketing Expenses

Sales and marketing expenses increased $42 million, or 25%. Of this increase, $22 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits and, to a lesser extent, increases in commissions, non-equity incentive compensation and share-based compensation. Total compensation increased primarily as a result of salary increases and the hiring of additional sales and marketing personnel. Marketing program expenses increased $14 million partially related to our open cloud branding campaign during the first half of the year. The cost increase was further attributable to an increase in travel costs of $2 million. The remaining variance was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

General and administrative expenses increased $53 million, or 22%. Of this increase, $32 million was attributable to employee-related expenses primarily due to increases in salaries and benefits and share-based compensation expense. The increase in employee-related expenses is due to a 6% increase in average headcount, including strategic hires to support the growth of the business, as well as salary increases and new equity grants. Professional fees increased $11 million primarily as a result of legal expenses and strategic consulting. The remaining variance was due to small changes in other general and administrative expenses as we invest in the infrastructure to support the business.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $63 million, or 25%. This increase was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build-outs and internally developed and purchased software. Depreciation and amortization expenses increased as a percentage of net revenue, from 19.1% in 2012 to 20.4% in 2013, as a result of the increase in the balance of property and equipment.

Other Income (Expense)

Other expense was $2.4 million and $4.7 million for 2013 and 2012, respectively. The decrease was driven by lower interest expense related to a reduction in outstanding interest-bearing debt.

Income Taxes

Our effective tax rate decreased from 37.3% in 2012 to 33.7% in 2013. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, tax credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States.


- 41 -


For a full reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Item 8 of Part II, “Financial Statements and Supplementary Data – Note 10Taxes.”

Liquidity and Capital Resources

We finance our operations and capital expenditures through a combination of internally-generated cash from operations and borrowings under vendor-financed arrangements and our existing revolving credit facility. We believe that our current sources of funds will be sufficient to meet our operating and capital needs in the foreseeable future.

Our long-term future capital requirements will depend on many factors, most importantly our revenue growth and our investments in new technologies and services. Our ability to generate cash depends on our financial performance, general economic conditions, technology trends and developments, and other factors. As our business continues to grow, our need for data center capacity will also grow. Most recently we have financed data center growth through leasing activities, and we will continue to evaluate all opportunities to secure further data center capacity in the future. We could be required, or could elect, to seek additional funding in the form of debt or equity. We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), and our overall cost of capital.
 
At December 31, 2014, we held $214 million in cash and cash equivalents, of which $102 million is associated with indefinitely reinvested foreign earnings. We consider the undistributed earnings of our foreign subsidiaries as of December 31, 2014 to be permanently reinvested and, accordingly, no U.S. income taxes have been provided thereon. We have not, nor do we anticipate the need to, repatriate funds to the U.S. to satisfy domestic liquidity needs arising in the ordinary course of business.

Our available cash and cash equivalents are held in bank deposits, money market funds, and overnight sweep accounts. Our money market mutual funds comply with Rule 2a-7 and invest exclusively in high-quality, short-term obligations that include securities issued or guaranteed by the U.S. government or by U.S. government agencies and floating rate and variable rate demand notes of U.S. and foreign corporations. We actively monitor the third-party depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal, secondly on the liquidity of our investments, and finally on maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation, or “FDIC,” insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

Historically, we financed a portion of our purchases of data center equipment through vendor-financed arrangements in the form of leases with our major vendors. Additionally, we have entered into certain real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects that result in capital and finance lease obligations. As of December 31, 2013 and 2014, we had $65 million and $134 million outstanding with respect to these arrangements, respectively. 

As of December 31, 2014, we had $25 million in outstanding borrowings under our revolving credit facility. The $25 million outstanding balance was fully repaid on January 12, 2015. The revolving credit facility has a total commitment in the amount of $200 million and matures in September 2016. The facility further includes an accordion feature, which allows for an increase in the commitment to a total of $400 million under the same terms and conditions, subject to credit approval of the banking syndicate. The facility is unsecured and governed by customary financial and non-financial covenants, including a leverage ratio of not greater than 3.00 to 1.00, an interest coverage ratio of not less than 3.00 to 1.00 and a requirement to maintain a certain level of tangible assets in our U.S. entities. As of December 31, 2014, we were in compliance with all of the covenants under our facility. 

On November 6, 2014, our board of directors authorized a program to repurchase up to $500 million of our common stock over the next two years. Under this program, shares may be repurchased from time to time through both open market and privately negotiated transactions. On November 12, 2014, we entered into an accelerated share repurchase ("ASR") agreement with a financial institution to repurchase an aggregate $200 million of our common stock. Under the ASR agreement, we paid $200 million to the financial institution and received an initial delivery of approximately 3.3 million shares of common stock which were subsequently retired. The final number of shares repurchased under the ASR agreement will be based generally upon the average daily volume weighted-average price of our common stock during the repurchase period, less a discount and subject to adjustments pursuant to the terms and conditions of the ASR agreement.

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If the actual number of shares to be repurchased under the agreement exceeds the number of shares initially delivered, we will receive the excess shares at the end of the repurchase period. If the number of shares initially delivered exceeds the actual number of shares to be repurchased, we will either deliver shares of common stock or make a cash payment to the financial institution at our election. Final settlement is expected to occur within the first six months of 2015.

Cash Flows

The following table sets forth a summary of our cash flows for the periods indicated: 
 
 
Year Ended December 31,
(In thousands)
 
2012
 
2013
 
2014
Cash provided by operating activities
 
$
399,499

 
$
444,060

 
$
542,510

Cash used in investing activities
 
$
(276,221
)
 
$
(464,224
)
 
$
(428,105
)
Cash provided by (used in) financing activities
 
$
7,455

 
$
(11,772
)
 
$
(157,286
)

Cash Provided by Operating Activities
 
Net cash provided by operating activities results primarily from cash received from customers for our cloud computing service offerings, offset by cash payments made for employee and consultant compensation (less amounts capitalized related to internal-use software that are reflected as cash used in investing activities), data center costs, license costs, marketing programs, taxes, and other general corporate expenditures.

From 2013 to 2014, net cash provided by operating activities increased $98 million primarily due to the increase in net income adjusted for depreciation and amortization expense and share-based compensation expense. Changes in operating assets and liabilities did not have a material effect on the change in net cash provided by operating activities.

From 2012 to 2013, net cash provided by operating activities increased $45 million. This was driven by a $71 million increase in net income adjusted for non-cash items including depreciation and amortization expense, share-based compensation expense, and realized excess tax benefits from share-based compensation arrangements. This was partially offset by a $27 million decrease in operating cash flows due to changes in operating assets and liabilities, primarily due to the timing of payments made for trade payables and payroll-related expenses.

Cash Used in Investing Activities

Net cash used in investing activities primarily consists of capital expenditures to meet the demands of our growing customer base. The largest outlays of cash are for purchases of customer gear, data center and office build-outs, and capitalized payroll costs related to internal-use software development.

From 2013 to 2014, net cash used in investing activities decreased $36 million largely due to a $22 million decrease in cash purchases of property and equipment. Capital expenditures were higher in 2013 due to increased equipment and data center costs associated with the global launch of our Performance Cloud Servers, the purchase of land for future expansion of our London U.K. data center, and the tenant improvement build-out of several office facilities. Additionally, there was a $10 million decrease in net cash paid for acquisitions because we did not make any acquisitions in 2014.

From 2012 to 2013, net cash used in investing activities increased $188 million primarily due to a $183 million increase in the cash purchases of property and equipment. Capital expenditures increased $134 million from 2012 to 2013 due to increased equipment purchases and data center build-outs. Additionally, there was a $48 million increase in cash outflow as a result of our shift away from using capital leases for equipment purchases. Additionally, there was a $4 million increase in net cash paid for acquisitions from 2012 to 2013.

Cash Provided by or Used in Financing Activities

Cash provided by financing activities typically consists of proceeds from debt, proceeds from employee stock plans, and realized excess tax benefits from share-based compensation arrangements. Cash used in financing activities typically consists of principal payments of capital leases and repayments of debt.

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From 2013 to 2014, net cash used in financing activities increased $146 million, primarily due to $200 million paid for shares of our common stock under the ASR agreement described above, partially offset by $25 million borrowed under our revolving credit facility, which was fully repaid in January 2015. Furthermore, there was an additional $14 million cash outflow in 2014 for the withholding of shares related to the vesting of certain restricted stock in satisfaction of employee tax obligations. All shares purchased in 2014 were subsequently retired. These financing cash outflows were partially offset by a $26 million decrease in capital lease payments resulting from the shift discussed above, a $9 million increase in proceeds from employee stock plans, and $6 million received from the Texas Enterprise Fund grant.

In 2013 net cash used in financing activities was $12 million compared to net cash provided by financing activities of $7 million in 2012, a change of $19 million. The largest driver was a $17 million decrease in proceeds from employee stock plans as a result of lower employee stock option exercise activity. Additionally, the financing cash inflow from excess tax benefits from share-based compensation arrangements decreased $12 million, and there was a $4 million decrease in financing cash flows due to the receipt of Texas Enterprise Fund grant money in 2012. This was partially offset by a $10 million decrease in capital lease payments and a $5 million decrease in payments for deferred acquisition obligations.

Contractual Obligations

The following table summarizes our contractual obligations as of December 31, 2014
(In thousands)
 
Total
 
2015
 
2016-2017
 
2018-2019
 
2020 and Beyond
Debt
 
$
25,156

 
$
25,156

 
$

 
$

 
$

Capital leases
 
22,394

 
15,541

 
2,773

 
1,285

 
2,795

Operating leases
 
836,107

 
71,130

 
131,143

 
117,349

 
516,485

Purchase obligations
 
105,220

 
83,563

 
21,451

 
206

 

Asset retirement obligations
 
8,036

 
236

 
245

 

 
7,555

Total contractual obligations
 
$
996,913

 
$
195,626

 
$
155,612

 
$
118,840

 
$
526,835


Debt
 
Debt obligations consist of principal and interest related to borrowings under our revolving credit facility. The outstanding balance was fully repaid on January 12, 2015.

Leases
 
Our capital leases are primarily related to expenditures for customer gear and other IT equipment. The future obligation for capital leases includes principal and interest. Our operating leases are primarily for data center facilities and office space.

Purchase Obligations
 
Our non-cancelable purchase obligations primarily relate to minimum commitments for certain software licenses, hardware purchases, and costs associated with our data centers, including bandwidth and electricity.

Asset Retirement Obligations

Asset retirement obligations represent our best estimate of commitments to return leased property to original condition upon lease termination.

Other
 
We have excluded $110 million of finance lease obligations for assets under construction and $21 million of uncertain tax positions from the table above as we are unable to make a reasonably reliable estimate of the timing of payments.



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Off-Balance Sheet Arrangements
 
During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. These entities are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
 
We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us, our employees, agents or representatives. These indemnification obligations are considered off-balance sheet arrangements. To date, we have not encountered material costs as a result of such obligations and have not accrued any material liabilities related to such indemnification obligations in our consolidated financial statements.

See Item 8 of Part II, "Financial Statements and Supplementary Data – Note 7Commitments and Contingencies" for more information related to these indemnification arrangements.

Critical Accounting Policies and Estimates
 
Our consolidated financial statements are prepared in accordance with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, significant judgment is required in making estimates and selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. These judgments and estimates affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We consider these policies that require significant management judgment and estimates to be used in the preparation of our consolidated financial statements to be critical accounting policies.
 
We review our estimates and judgments on an ongoing basis, including those related to revenue recognition, service credits, allowance for doubtful accounts, property and equipment, goodwill and intangibles, contingencies, the fair valuation of stock related to share-based compensation, software development, and income taxes.

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

We recognize revenue when persuasive evidence of an arrangement exists, service has been provided to the customer, the amount of fees to be paid by the customer is fixed or determinable, and collectibility is reasonably assured. Because we provide our cloud computing and hosting services to our customers and do not sell individual hardware and software products, we generally recognize revenue, including implementation and set-up fees, on a monthly basis, as services are delivered. For services that are billed according to customer usage, revenue is recognized in the month in which the usage is provided. Implementation and set-up fees are amortized over the estimated average customer life. If a customer terminates its relationship with us before the expiration of the estimated average customer life, any unamortized installation fees are recognized as revenue at that time. Amounts that have been invoiced and accruals for unbilled usage are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of prepaid service fees and set-up fees. Professional services are recognized in the period services are provided.

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


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Valuation of Accounts Receivable and Service Credits

We record an allowance for doubtful accounts on trade accounts receivable for estimated losses resulting from the inability of our customers to make required payments. When evaluating the adequacy of the allowance, we analyze the overall quality of our accounts receivable portfolio, current economic conditions and trends, historical bad debt write-offs, customer creditworthiness, and specifically identified customer risks. If actual collections of customer receivables differ from our estimates, additional allowances may be required which could have an impact on our results of operations.

Our customer agreements provide that we will achieve certain service levels related primarily to network uptime, critical infrastructure availability, and hardware replacement. To the extent that such service levels are not achieved, we may be obligated to provide credits to our customers. We record a reserve for estimated customer credits on trade accounts receivable to recognize estimated adjustments to receivables and record a reduction to revenue. We base this reserve on historical experience and specific knowledge of factors impacting our delivery of services such as third-party power or service issues, unfavorable weather, or other interruptions or conditions. If actual service levels achieved vary from our estimates, we may be required to increase our reserve which could have an impact on our results of operations.

Property, Equipment, and Other Long-Lived Assets

In providing services to our customers, we utilize significant amounts of property and equipment, which we depreciate on a straight-line basis over their estimated useful lives. Changes in technology or changes in the intended use of property and equipment may cause the estimated useful life or the value of these assets to change, so we periodically review the appropriateness of the estimated economic useful lives for each category of property and equipment.

Long-lived assets, including property and equipment and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset in conjunction with its asset group compared to the estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of the asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the assets. There were no impairment charges recorded in 2012, 2013 or 2014.

Goodwill

Goodwill is subject to periodic testing for impairment at the reporting unit level. We are required to perform an evaluation of goodwill on an annual basis or more frequently if events or circumstances indicate a potential impairment. The annual test for impairment is conducted as of October 1st. The evaluation of goodwill for impairment is judgmental in nature and requires the use of significant estimates and assumptions around the identification of reporting units and determination of the fair value of a reporting unit. Changes in these estimates and assumptions could produce materially different results.

We did not identify any triggering events in 2014 that required us to perform an interim impairment test. Additionally, upon conclusion of our 2014 annual test, we noted that the fair value of our reporting unit was substantially in excess of the carrying value of the reporting unit’s net assets.

Contingencies

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

Share-Based Compensation

Share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, share-based compensation expense and our results of operations could be impacted.


- 46 -


Software Development

We capitalize the salaries and related compensation costs of employees and consultants who devote time to the development of certain internal-use software projects. Judgment is required in determining whether an enhancement to previously developed software is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We generally amortize capitalized software development costs over periods from 12 to 60 months with most amortizing over 36 months.

Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments and estimates are required in evaluating our tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.

Historically, our effective tax rates have not differed significantly from the statutory rate, and any differences are primarily due to the tax impact of foreign operations, research and development tax credits, state taxes, contingency reserves for uncertain tax positions and certain benefits realized related to stock option activity. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses.

Recent Accounting Pronouncements Not Yet Adopted

For a description of accounting pronouncements recently issued but not yet adopted, see Item 8 of Part II, "Financial Statements and Supplementary Data - Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies."


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Supplemental Information

Non-GAAP Financial Measures

Throughout this MD&A, we have utilized certain non-GAAP financial measures in discussions and analysis of our financial performance. For each of these non-GAAP financial measures, we have described the reasons for their use and have provided reconciliations to the most directly comparable GAAP measure below.
 
Return on Capital ("ROC")
 
We believe that ROC is an important metric for investors in evaluating our company’s performance. ROC measures how effectively a company generates profits from the capital that is deployed. We calculate ROC by dividing net operating profit after tax by our average capital base. The following tables present a reconciliation of ROC to return on assets, which we calculate directly from amounts on the Consolidated Statements of Comprehensive Income and the Consolidated Balance Sheets.  
 
 
Year Ended December 31,
(In thousands)
 
2012
 
2013
 
2014
Income from operations
 
$
172,741

 
$
133,136

 
$
163,529

Effective tax rate
 
37.3
%
 
33.7
%
 
30.7
%
Net operating profit after tax (NOPAT)
 
$
108,309

 
$
88,269

 
$
113,326

 
 
 
 
 
 
 
Net income
 
$
105,418

 
$
86,737

 
$
110,553

 
 
 
 
 
 
 
Total assets at period end
 
$
1,295,551

 
$
1,491,797

 
$
1,624,284

Less: Excess cash (1)
 
(249,712
)
 
(210,761
)
 
(156,814
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(175,128
)
 
(195,894
)
 
(215,774
)
Less: Deferred revenue (current and non-current)
 
(20,960
)
 
(26,530
)
 
(22,276
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for assets under construction
 
(130,444
)
 
(149,043
)
 
(263,401
)
Capital base
 
$
719,307

 
$
909,569

 
$
966,019

 
 
 
 
 
 
 
Average total assets (2)
 
$
1,158,384

 
$
1,393,079

 
$
1,611,109

Average capital base (2)
 
$
679,125

 
$
804,173

 
$
930,417

 
 
 
 
 
 
 
Return on assets (Net income/Average total assets)
 
9.1
%
 
6.2
%
 
6.9
%
Return on capital (NOPAT/Average capital base)
 
15.9
%
 
11.0
%
 
12.2
%
(1)
Defined 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.
(2)
Average based on ending balances for the most recent five quarters.


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Three Months Ended
(In thousands)
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
Income from operations
 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

 
$
50,005

Effective tax rate
 
22.7
%
 
34.6
%
 
33.0
%
 
32.0
%
 
25.1
%
Net operating profit after tax (NOPAT)
 
$
20,992

 
$
25,587

 
$
22,704

 
$
27,549

 
$
37,454

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
$
36,916

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,491,797

 
$
1,566,949

 
$
1,647,975

 
$
1,724,542

 
$
1,624,284

Less: Excess cash (1)
 
(210,761
)
 
(263,309
)
 
(287,411
)
 
(294,307
)
 
(156,814
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(195,894
)
 
(224,423
)
 
(231,563
)
 
(244,397
)
 
(215,774
)
Less: Deferred revenue (current and non-current)
 
(26,530
)
 
(24,485
)
 
(23,248
)
 
(21,437
)
 
(22,276
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for assets under construction
 
(149,043
)
 
(164,703
)
 
(180,220
)
 
(203,464
)
 
(263,401
)
Capital base
 
$
909,569

 
$
890,029

 
$
925,533

 
$
960,937

 
$
966,019

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,471,783

 
$
1,529,373

 
$
1,607,462

 
$
1,686,259

 
$
1,674,413

Average capital base
 
$
873,749

 
$
899,799

 
$
907,781

 
$
943,235

 
$
963,478

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
5.7
%
 
6.7
%
 
5.6
%
 
6.1
%
 
8.8
%
Return on capital (annualized)
 
9.6
%
 
11.4
%
 
10.0
%
 
11.7
%
 
15.5
%
(1)
Defined 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.

Adjusted EBITDA
 
We use Adjusted EBITDA as a supplemental measure to review and assess our performance. Adjusted EBITDA is a metric that is used by analysts and investors for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.
 
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. The following tables present a reconciliation of Adjusted EBITDA to net income.
 

- 49 -


 
 
Year Ended December 31,
(Dollars in thousands)
 
2012
 
2013
 
2014
 
 
 
 
 
 
 
Net revenue
 
$
1,309,239

 
$
1,534,786

 
$
1,794,357

 
 
 
 
 
 
 
Income from operations
 
$
172,741

 
$
133,136

 
$
163,529

 
 
 
 
 
 
 
Net income
 
$
105,418

 
$
86,737

 
$
110,553

   Plus: Income taxes
 
62,589

 
44,022

 
49,051

   Plus: Total other (income) expense
 
4,734

 
2,377

 
3,925

   Plus: Depreciation and amortization
 
249,845

 
313,007

 
371,884

   Plus: Share-based compensation expense
 
41,546

 
59,645

 
70,005

Adjusted EBITDA
 
$
464,132

 
$
505,788

 
$
605,418

 
 
 
 
 
 
 
Operating income margin
 
13.2
%
 
8.7
%
 
9.1
%
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
35.5
%
 
33.0
%
 
33.7
%

 
 
Three Months Ended
(Dollars in thousands)
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

 
$
472,422

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

 
$
50,005

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
$
36,916

   Plus: Income taxes
 
6,108

 
13,448

 
11,078

 
12,137

 
12,388

   Plus: Total other (income) expense
 
251

 
230

 
358

 
2,636

 
701

   Plus: Depreciation and amortization
 
87,683

 
87,805

 
90,559

 
98,307

 
95,213

   Plus: Share-based compensation expense
 
17,188

 
12,732

 
17,265

 
19,842

 
20,166

Adjusted EBITDA
 
$
132,028

 
$
139,661

 
$
141,711

 
$
158,662

 
$
165,384

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
6.7
%
 
9.3
%
 
7.7
%
 
8.8
%
 
10.6
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
32.4
%
 
33.2
%
 
32.1
%
 
34.5
%
 
35.0
%


- 50 -


Adjusted Free Cash Flow
 
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. 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 and cash payments for income taxes. The following table presents a reconciliation of Adjusted Free Cash Flow to Adjusted EBITDA as a supplement to our reconciliation of Adjusted EBITDA to net income provided above. 

 
 
Year Ended December 31,
(In thousands)
 
2012
 
2013
 
2014
Adjusted EBITDA
 
$
464,132

 
$
505,788