Attached files

file filename
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-321_033115.htm
EX-10.4 - NON-EMPLOYEE DIRECTOR COMPENSATION SCHEDULE - RACKSPACE HOSTING, INC.raxex-104_033115.htm
EX-10.2 - EMPLOYMENT AGREEMENT BETWEEN RACKSPACE US, INC. AND SCOTT CRENSHAW - RACKSPACE HOSTING, INC.raxex-102_031315.htm
EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-322_033115.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-311_033115.htm
EX-10.1 - EMPLOYMENT AGREEMENT BETWEEN RACKSPACE MANAGED HOSTING LIMITED AND TIFFANY LATHE - RACKSPACE HOSTING, INC.raxex-101_033115.htm
EX-10.3 - EMPLOYMENT AGREEMENT BETWEEN RACKSPACE US, INC. AND JOE SAPORITO - RACKSPACE HOSTING, INC.raxex-103_033115.htm
EXCEL - IDEA: XBRL DOCUMENT - RACKSPACE HOSTING, INC.Financial_Report.xls
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-312_033115.htm

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

 FORM 10-Q
(Mark one)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2015.
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from ______ to ______.
 
Commission file number 001-34143
RACKSPACE HOSTING, INC.
(Exact name of registrant as specified in its charter)

 
Delaware
 
74-3016523
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)

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

(210) 312-4000
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   R    No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer R
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No R  
 
On May 7, 2015, 142,818,367 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.



RACKSPACE HOSTING, INC.
 TABLE OF CONTENTS
 



SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, are subject to the “safe harbor” created by those sections. The forward-looking statements in this report are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “aspires,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss in greater detail many of these risks, uncertainties and other factors in Part I, Item 1A "Risk Factors," contained in our Annual Report on Form 10-K for the year ended December 31, 2014. 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,” within our Annual 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” within our Annual Report 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® and Fanatical Support® are service marks of Rackspace US, Inc. registered in the United States and other countries. 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.




PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED BALANCE SHEETS
(In millions, except share and per share data)
 
December 31,
2014
 
March 31,
2015
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
213.5

 
$
275.7

Accounts receivable, net of allowance for doubtful accounts and customer credits of $5.3 as of December 31, 2014 and $6.5 as of March 31, 2015
 
156.5

 
154.0

Deferred income taxes
 
9.3

 
8.0

Prepaid expenses
 
33.6

 
32.3

Other current assets
 
8.8

 
9.1

Total current assets
 
421.7

 
479.1

 
 
 
 
 
Property and equipment, net
 
1,057.7

 
1,068.8

Goodwill
 
81.1

 
81.1

Intangible assets, net
 
16.6

 
14.6

Other non-current assets
 
47.2

 
48.7

Total assets
 
$
1,624.3

 
$
1,692.3

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
137.3

 
$
135.1

Accrued compensation and benefits
 
66.7

 
68.8

Income and other taxes payable
 
11.8

 
10.9

Deferred revenue
 
20.9

 
24.6

Capital lease obligations
 
15.0

 
9.9

Debt
 
25.1

 
0.1

Total current liabilities
 
276.8

 
249.4

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Deferred revenue
 
1.4

 
1.5

Capital lease obligations
 
1.5

 
0.8

Finance lease obligations for build-to-suit leases
 
117.4

 
146.6

Deferred income taxes
 
71.2

 
60.8

Deferred rent
 
49.9

 
50.0

Other liabilities
 
32.3

 
30.3

Total liabilities
 
550.5

 
539.4

 
 
 
 
 
Commitments and Contingencies
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 140,945,171 shares issued and outstanding as of December 31, 2014; 142,694,732 shares issued and outstanding as of March 31, 2015
 
0.1

 
0.1

Additional paid-in capital
 
696.0

 
757.9

Accumulated other comprehensive loss
 
(20.7
)
 
(31.9
)
Retained earnings
 
398.4

 
426.8

Total stockholders’ equity
 
1,073.8

 
1,152.9

Total liabilities and stockholders’ equity
 
$
1,624.3

 
$
1,692.3


See accompanying notes to the unaudited consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended March 31,
(In millions, except per share data)
 
2014
 
2015
 
 
 
 
 
Net revenue
 
$
421.0

 
$
480.2

Costs and expenses:
 
 
 
 
Cost of revenue
 
140.4

 
161.3

Research and development
 
25.2

 
32.0

Sales and marketing
 
57.4

 
59.0

General and administrative
 
71.1

 
86.6

Depreciation and amortization
 
87.8

 
96.9

Total costs and expenses
 
381.9

 
435.8

Income from operations
 
39.1

 
44.4

Other income (expense):
 
 
 
 
Interest expense
 
(0.5
)
 
(0.4
)
Interest and other income (expense)
 
0.3

 
(2.0
)
Total other income (expense)
 
(0.2
)
 
(2.4
)
Income before income taxes
 
38.9

 
42.0

Income taxes
 
13.5

 
13.6

Net income
 
$
25.4

 
$
28.4

 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
Foreign currency translation adjustments
 
$
2.9

 
$
(11.2
)
Other comprehensive income (loss)
 
2.9

 
(11.2
)
Comprehensive income
 
$
28.3

 
$
17.2

 
 
 
 
 
Net income per share
 
 
 
 
Basic
 
$
0.18

 
$
0.20

Diluted
 
$
0.18

 
$
0.20

 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
Basic
 
141.0

 
141.4

Diluted
 
143.8

 
144.2

 
See accompanying notes to the unaudited consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Three Months Ended March 31,
(In millions)
 
2014
 
2015
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
25.4

 
$
28.4

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
87.8

 
96.9

Deferred income taxes
 
(10.1
)
 
(14.7
)
Share-based compensation expense
 
12.7

 
20.0

Excess tax benefits from share-based compensation arrangements
 
(15.1
)
 
(20.2
)
Other operating activities
 
2.0

 
2.8

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable
 
3.9

 
(1.8
)
Prepaid expenses and other current assets
 
3.3

 
0.8

Accounts payable, accrued expenses, and other current liabilities
 
30.3

 
26.9

Deferred revenue
 
(2.1
)
 
4.3

Deferred rent
 
2.3

 
0.4

Other non-current assets and liabilities
 
1.3

 
1.5

Net cash provided by operating activities
 
141.7

 
145.3

 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(85.0
)
 
(92.5
)
All other investing activities
 
0.5

 
0.7

Net cash used in investing activities
 
(84.5
)
 
(91.8
)
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
Principal payments of capital and build-to-suit leases
 
(12.5
)
 
(5.6
)
Repayments of debt
 
(0.1
)
 
(25.1
)
Payments for deferred acquisition obligations
 
(0.1
)
 
(0.1
)
Receipt of Texas Enterprise Fund grant
 
5.5

 

Shares of common stock withheld for employee taxes
 
(13.6
)
 

Proceeds from employee stock plans
 
2.1

 
21.8

Excess tax benefits from share-based compensation arrangements
 
15.1

 
20.2

Net cash provided by (used in) financing activities
 
(3.6
)
 
11.2

 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
0.5

 
(2.5
)
 
 
 
 
 
Increase in cash and cash equivalents
 
54.1

 
62.2

 
 
 
 
 
Cash and cash equivalents, beginning of period
 
259.7

 
213.5

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
313.8

 
$
275.7

 
 
 
 
 
Supplemental Cash Flow Information
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
0.5

 
$
0.3

Cash payments for income taxes, net of refunds
 
$
0.9

 
$
3.8

 
 
 
 
 
Non-cash Investing and Financing Activities
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
0.9

 
$

Increase (decrease) in property and equipment in accounts payable and accrued expenses
 
14.8

 
(2.3
)
Non-cash purchases of property and equipment
 
$
15.7

 
$
(2.3
)
 
 
 
 
 
Additional finance lease obligations for build-to-suit leases and other
 
$
17.6

 
$
35.1


See accompanying notes to the unaudited consolidated financial statements.

- 5 -


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

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

Nature of Operations

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

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

Basis of Consolidation

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

Foreign currency translation adjustments arising from differences in exchange rates from period to period are included in the foreign currency translation adjustment account in accumulated other comprehensive income (loss). There were no income taxes allocated to foreign currency translation adjustments during the three months ended March 31, 2014 or 2015

Unaudited Interim Financial Information
 
The accompanying consolidated financial statements as of March 31, 2015, and for the three months ended March 31, 2014 and 2015, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all financial information and disclosures required by GAAP for complete financial statements, and certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2014 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 2, 2015 (the "2014 Annual Consolidated Financial Statements"). The unaudited interim consolidated financial statements have been prepared on the same basis as the 2014 Annual Consolidated Financial Statements and, in the opinion of management, reflect all adjustments, which include normal recurring adjustments, necessary for a fair statement of our financial position as of March 31, 2015, our results of operations for the three months ended March 31, 2014 and 2015, and our cash flows for the three months ended March 31, 2014 and 2015.
 
The results of operations for the three months ended March 31, 2015 are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2015, or for any other interim period, or for any other future year.

Use of Estimates
 
The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and customer credits, property and equipment, fair values of intangible assets and goodwill, useful lives of intangible assets, fair value of share-based compensation, contingencies, and income taxes, among others. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from our estimates.

- 6 -



Significant Accounting Policies and Estimates

Our 2014 Annual Consolidated Financial Statements include an additional discussion of the significant accounting policies and estimates used in the preparation of our consolidated financial statements. There were no material changes to our significant accounting policies and estimates during the three months ended March 31, 2015.

Recent Accounting Pronouncements Not Yet Adopted

In May 2014, the Financial Accounting Standards Board ("FASB") issued guidance to clarify principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the standard requires capitalization of incremental costs to obtain a contract and significantly expanded quantitative and qualitative disclosures. The standard is effective for annual reporting periods beginning after December 15, 2016, however, the FASB has proposed a one year deferral of the effective date. If this proposal is approved, early adoption would be permitted as of the original effective date. Upon adoption, the new guidance will be applied retrospectively using one of two methods. One method is to apply the guidance retrospectively to each prior period presented with practical expedients available. The second method is to apply the guidance retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application. We are evaluating the impact on our consolidated financial statements of adopting this new accounting standard.

2. Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share: 
 
 
Three Months Ended March 31,
(In millions, except per share data)
 
2014
 
2015
Basic net income per share:
 
 
 
 
Net income
 
$
25.4

 
$
28.4

Weighted average shares outstanding:
 
 
 
 
Common stock
 
141.0

 
141.4

Number of shares used in per share computations
 
141.0

 
141.4

Net income per share
 
$
0.18

 
$
0.20

 
 
 
 
 
Diluted net income per share:
 
 
 
 
Net income
 
$
25.4

 
$
28.4

Weighted average shares outstanding:
 
 
 
 
Common stock
 
141.0

 
141.4

Stock options, awards and employee share purchase plans
 
2.8

 
2.8

Number of shares used in per share computations
 
143.8

 
144.2

Net income per share
 
$
0.18

 
$
0.20


We excluded 6.9 million and 2.5 million potential common shares from the computation of dilutive net income per share for the three months ended March 31, 2014 and 2015, respectively, because the effect would have been anti-dilutive.


- 7 -


3. Property and Equipment, net
 
Property and equipment consisted of: 
(Dollar amounts in millions)
 
Estimated Useful Lives
 
December 31,
2014
 
March 31,
2015
Computers and equipment
 
3
-
5
years
 
$
1,495.2

 
$
1,538.4

Computer software
 
1
-
5
years
 
318.9

 
338.2

Furniture and fixtures
 
7
years
 
56.7

 
58.3

Buildings and leasehold improvements
 
2
-
30
years
 
253.6

 
301.7

Land
 
 
 
 
 
 
27.9

 
27.4

Property and equipment, at cost
 
 
 
 
 
 
2,152.3

 
2,264.0

Less accumulated depreciation and amortization
 
 
 
 
 
 
(1,249.5
)
 
(1,317.1
)
Work in process
 
 
 
 
 
 
154.9

 
121.9

Property and equipment, net
 
 
 
 
 
 
$
1,057.7

 
$
1,068.8

 
At December 31, 2014, the work in process balance consisted of build outs of $51.3 million for office facilities, $80.5 million for data centers, and $23.1 million for capitalized software and other projects. At March 31, 2015, the work in process balance consisted of build outs of $59.7 million for office facilities, $46.2 million for data centers, and $16.0 million for capitalized software and other projects. During the first quarter of 2015, we placed into service and began depreciating $51.4 million of construction costs related to the completed portion of a data center in the U.K., for which we are deemed the owner for accounting purposes. See Note 4. "Build-to-Suit Leases" for more information.

For the three months ended March 31, 2015, we capitalized non-cash interest of $1.8 million related to finance lease obligations for build-to-suit leases. There was no interest capitalized during the three months ended March 31, 2014.


- 8 -


4. Build-to-Suit Leases

We have entered into multiple complex real estate development and build-to-suit lease arrangements with independent real estate developers to design, construct and lease certain real estate projects. While the independent developers legally own the real estate projects and must finance the overall construction, we agreed to fund certain structural improvements and/or retain obligations related to certain potential construction cost overruns. As a result of our involvement during the construction period, we are considered the owner of the construction project, for accounting purposes only. We have recorded construction costs for these projects as an asset and a corresponding long-term liability within "Property and equipment, net" and "Finance lease obligations for build-to-suit leases," respectively, on our consolidated balance sheets.

When construction of a project is complete, we evaluate whether the build-to-suit lease arrangement qualifies for sales recognition under sale-leaseback accounting guidance. If the lease meets the criteria to qualify as a sale-leaseback, the asset and liability can be derecognized and the lease is accounted for as an operating lease with rent expense recognized over the lease term. If the sale-leaseback criteria are not met, the asset and liability remain on our consolidated balance sheets. The asset is then depreciated over the term of the lease and rental payments under the lease are recorded as a reduction of the liability and interest expense.

During the first quarter of 2015, we changed our non-current liability account title for finance lease obligations for assets under construction to finance lease obligations for build-to-suit leases. This non-current liability account now includes all build-to-suit finance lease obligations, including those for assets under construction as well as projects that did not qualify as a sale-leaseback at the completion of construction. As a result, finance obligations of $7.4 million as of December 31, 2014 and March 31, 2015, respectively, associated with build-to-suit construction projects that have failed sale leaseback, have been reclassified from capital lease obligations to finance lease obligations for build-to-suit leases in the consolidated balance sheets. Such amount as of December 31, 2014 was reclassified to conform to the current period presentation.

During the first quarter of 2015, construction of one of these real estate projects, a data center in the U.K., was partially completed. However, since the project is considered one unit of accounting, we will not perform a sale-leaseback analysis until the entire project is complete. As a result, we placed into service and began depreciating $51.4 million of construction costs related to the completed portion of the project as building and leasehold improvements within "Property and equipment, net" on our consolidated balance sheets. The lease on a portion of the project commenced during the first quarter of 2015 and rental payments are recorded as a reduction of the corresponding liability and as interest expense. At the end of the lease term, we will derecognize the remaining asset and liability balances.

As of December 31, 2014 and March 31, 2015 we had $117.4 million and $146.6 million, respectively, of finance lease obligations for build-to-suit leases related to real estate projects either completed or under construction for which we are deemed the accounting owner.

5. Contingencies

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

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

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


- 9 -


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

The composition of the equity awards outstanding as of December 31, 2014 and March 31, 2015 was as follows: 
(in millions)
 
December 31,
2014
 
March 31,
2015
Restricted stock
 
4.3
 
4.1
Stock options
 
6.8
 
5.2
     Total outstanding awards
 
11.1
 
9.3
 
We also have an Employee Stock Purchase Plan (the "ESPP"). Under the ESPP, eligible employees may purchase a limited number of shares of our common stock at the lesser of 85% of the market value on the enrollment date or 85% of the market value on the purchase date. The ESPP is made up of a series of offering periods. Each offering period has a maximum term of 24 months and is divided into semi-annual purchase intervals. Eligible employees may enroll at the beginning of any semi-annual purchase interval.

Share-Based Compensation Expense

Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended March 31,
(in millions)
 
2014
 
2015
Cost of revenue
 
$
3.8

 
$
4.0

Research and development
 
2.8

 
3.2

Sales and marketing
 
2.1

 
2.7

General and administrative
 
4.0

 
10.1

Pre-tax share-based compensation
 
12.7

 
20.0

Less: Income tax benefit
 
(4.4
)
 
(6.5
)
Total share-based compensation expense, net of tax
 
$
8.3

 
$
13.5


As of March 31, 2015, there was $163.1 million of total unrecognized compensation cost related to restricted stock, stock options and the ESPP, which will be recognized using the straight-line method over a weighted average period of 2.4 years.

7. Taxes
 
We are subject to U.S. federal income tax and various state, local, and international income taxes in numerous jurisdictions. Our domestic and international tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions and the timing of recognizing revenue and expenses. As such, our effective tax rate is impacted by the geographical distribution of income and mix of profits in the various jurisdictions. Additionally, the amount of income taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we file.
  
We expect a taxable profit in the U.S. and U.K. for the full year 2015 before consideration of excess tax benefits, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2015. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the current period.


- 10 -


ITEM 2 - 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 consolidated financial statements and the related notes included elsewhere in this document and with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2014.

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 three months ended March 31, 2015 and March 31, 2014.
Liquidity and Capital Resources - Discussion of our financial condition, sources of liquidity, changes in cash flows and capital expenditure requirements.
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. For the first three months of 2015, 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. In a March 2015 industry report, 451 Research named Rackspace the segment leader in the "managed hosting" market segment, where managed services are wrapped around cloud infrastructure.

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.


- 11 -


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 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. These unmanaged cloud providers have 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.

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 and 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.

Growth
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except average monthly revenue per server)
 
March 31, 2014
 
December 31, 2014
 
March 31, 2015
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
421.0

 
$
472.5

 
$
480.2

 
Revenue growth (year over year)
 
16.2
%
 
15.8
%
 
14.1
%
 
 
 
 
 
 
 
 
 
Number of servers deployed at period end
 
106,229

 
112,628

 
114,105

 
Average monthly revenue per server
 
$
1,336

 
$
1,412

 
$
1,412

 
 
 
 
 
 
 
 
 
Number of employees (Rackers) at period end
 
5,743

 
5,936

 
5,964


Total net revenue for the three months ended March 31, 2015 increased $8 million, or 1.6%, from the three months ended December 31, 2014. Our net revenue was negatively impacted by a stronger U.S. dollar relative to other foreign currencies on a sequential quarter basis. Net revenue for the three months ended March 31, 2015 would have been approximately $5 million higher had foreign exchange rates remained constant from the three months ended December 31, 2014.

On a year-over-year basis, net revenue grew $59 million, or 14.1%, during the three months ended March 31, 2015, which includes the negative impact of approximately $11 million due to changes in foreign exchange rates.

- 12 -



Profitability
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except per share amounts)
 
March 31, 2014
 
December 31, 2014
 
March 31, 2015
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA
 
$
139.6

 
$
165.4

 
$
161.3

 
Adjusted EBITDA margin
 
33.2
%
 
35.0
%
 
33.6
%
 
 
 
 
 
 
 
 
 
Income from operations
 
$
39.1

 
$
50.0

 
$
44.4

 
Operating income margin
 
9.3
%
 
10.6
%
 
9.3
%
 
 
 
 
 
 
 
 
 
Net income
 
$
25.4

 
$
37.0

 
$
28.4

 
Net income margin
 
6.0
%
 
7.8
%
 
5.9
%
 
Diluted net income per share
 
$
0.18

 
$
0.26

 
$
0.20


On a sequential quarter basis, Adjusted EBITDA, income from operations and net income declined 2%, 11%, and 23%, respectively, for the three months ended March 31, 2015 compared to the three months ended December 31, 2014. Our profitability was impacted by higher employee-related expenses and license expense. The increase in employee-related expenses was driven by seasonally higher payroll tax expense in the first three months of 2015 and increased non-equity incentive compensation expense due to a higher bonus payout percentage. Higher license expense was due to price increases from some of our largest vendors coupled with higher volume to support the growth of our business. In addition to these factors, net income was negatively impacted on a sequential quarter basis by an increase in our effective tax rate from 25.1% for the three months ended December 31, 2014 to 32.4% for the three months ended March 31, 2015.

On a year-over-year basis, Adjusted EBITDA, income from operations, and net income grew 16%, 14%, and 12%, respectively. Adjusted EBITDA margin increased to 33.6% in the first three months of 2015 from 33.2% in the same period of 2014, as revenue growth of 14.1% outpaced growth in expenses. Operating income margin was flat at 9.3% for both periods, while net income margin declined slightly, from 6.0% to 5.9%.


- 13 -


Capital Efficiency, Infrastructure Capacity and Utilization
 
 
 
Three Months Ended
 
(Dollar amounts in millions)
 
March 31, 2014
 
December 31, 2014
 
March 31, 2015
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
 
 
 
 
 
 
Customer gear
 
$
60.7

 
$
72.5

 
$
58.7

 
Data center build outs
 
$
11.0

 
$
11.1

 
$
13.4

 
Office build outs
 
$
9.2

 
$
1.6

 
$
2.3

 
Capitalized software and other projects
 
$
19.8

 
$
19.4

 
$
15.8

 
Total capital expenditures
 
$
100.7

 
$
104.6

 
$
90.2

 
 
 
 
 
 
 
 
 
Capital efficiency and returns
 
 
 
 
 
 
 
Average capital base (1)
 
$
892.6

 
$
956.0

 
$
952.1

 
Capital turnover (annualized) (1)
 
1.89

 
1.98

 
2.02

 
Return on capital (annualized) (1)
 
11.5
%
 
15.7
%
 
12.6
%
 
 
 
 
 
 
 
 
 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
Megawatts under contract at period end (2)
 
58.1

 
58.1

 
63.2

 
Megawatts available for customer use at period end (3)
 
45.3

 
49.7

 
52.0

 
Megawatts utilized at period end
 
28.1

 
30.5

 
31.0

 
Annualized net revenue per average Megawatt of power utilized
 
$
60.7

 
$
62.6

 
$
62.5


(1)
Prior period amounts have been revised to reflect the impact of a reclassification of certain finance obligations associated with build-to-suit leases in the consolidated balance sheets. See “Notes to the Unaudited Consolidated Financial Statements - Note 4. Build-to-Suit Leases” for further discussion.
(2)
Megawatts under contract at period end represents data center capacity for which we have a contract enabling us to take control of the space. For our newest data center in London, as of March 31, 2015, we have included four megawatts.
(3)
Megawatts available for customer use at period end represents data center capacity that is built-out and is being used to provide service to customers.

On a sequential quarter basis, Return on Capital ("ROC") decreased from 15.7% for the three months ended December 31, 2014 to 12.6% for the three months ended March 31, 2015. The decrease is primarily due to the 11% decrease in sequential quarter income from operations, coupled with the negative impact of a higher effective tax rate of 32.4% for the first three months of 2015 compared to 25.1% for the last three months of 2014. Our average capital base decreased slightly and capital turnover increased to 2.02 from 1.98, partially driven by the decrease in capital expenditures from $104.6 million for the three months ended December 31, 2014 to $90.2 million for the three months ended March 31, 2015.

On a year-over-year basis, ROC increased from 11.5% to 12.6%, primarily due to the 14% increase in income from operations between periods and the positive impact of a lower effective tax rate of 32.4% compared to 34.6% in the prior year period. While our average capital base increased 6.7% between periods, our capital turnover also increased to 2.02 for the three months ended March 31, 2015, compared to 1.89 for the same period of 2014.



- 14 -


Results of Operations

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

Consolidated Statements of Income:
 
 
Three Months Ended
(In millions)
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
Net revenue
 
$
421.0

 
$
441.2

 
$
459.7

 
$
472.5

 
$
480.2

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
140.4

 
145.1

 
142.9

 
153.9

 
161.3

Research and development
 
25.2

 
29.7

 
30.7

 
31.4

 
32.0

Sales and marketing
 
57.4

 
60.4

 
60.6

 
59.2

 
59.0

General and administrative
 
71.1

 
81.5

 
86.7

 
82.8

 
86.6

Depreciation and amortization
 
87.8

 
90.6

 
98.3

 
95.2

 
96.9

Total costs and expenses
 
381.9

 
407.3

 
419.2

 
422.5

 
435.8

Income from operations
 
39.1

 
33.9

 
40.5

 
50.0

 
44.4

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.5
)
 
(0.5
)
 
(0.5
)
 
(0.4
)
 
(0.4
)
Interest and other income (expense)
 
0.3

 
0.1

 
(2.1
)
 
(0.3
)
 
(2.0
)
Total other income (expense)
 
(0.2
)
 
(0.4
)
 
(2.6
)
 
(0.7
)
 
(2.4
)
Income before income taxes
 
38.9

 
33.5

 
37.9

 
49.3

 
42.0

Income taxes
 
13.5

 
11.0

 
12.2

 
12.3

 
13.6

Net income
 
$
25.4

 
$
22.5

 
$
25.7

 
$
37.0

 
$
28.4

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
 
Three Months Ended
(Percent of net revenue)
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
33.3
 %
 
32.9
 %
 
31.1
 %
 
32.6
 %
 
33.6
 %
Research and development
 
6.0
 %
 
6.7
 %
 
6.7
 %
 
6.6
 %
 
6.7
 %
Sales and marketing
 
13.6
 %
 
13.7
 %
 
13.2
 %
 
12.5
 %
 
12.3
 %
General and administrative
 
16.9
 %
 
18.5
 %
 
18.9
 %
 
17.5
 %
 
18.0
 %
Depreciation and amortization
 
20.9
 %
 
20.5
 %
 
21.4
 %
 
20.2
 %
 
20.2
 %
Total costs and expenses
 
90.7
 %
 
92.3
 %
 
91.2
 %
 
89.4
 %
 
90.7
 %
Income from operations
 
9.3
 %
 
7.7
 %
 
8.8
 %
 
10.6
 %
 
9.3
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
Interest and other income (expense)
 
0.1
 %
 
0.0
 %
 
(0.5
)%
 
(0.1
)%
 
(0.4
)%
Total other income (expense)
 
(0.1
)%
 
(0.1
)%
 
(0.6
)%
 
(0.1
)%
 
(0.5
)%
Income before income taxes
 
9.2
 %
 
7.6
 %
 
8.2
 %
 
10.4
 %
 
8.8
 %
Income taxes
 
3.2
 %
 
2.5
 %
 
2.6
 %
 
2.6
 %
 
2.8
 %
Net income
 
6.0
 %
 
5.1
 %
 
5.6
 %
 
7.8
 %
 
5.9
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 15 -


Three Months Ended March 31, 2015 Compared to Three Months Ended March 31, 2014
 
Net Revenue

Net revenue increased $59 million, or 14%, primarily due to both the acquisition of new customers and incremental services rendered to existing customers. 

Net revenue was negatively impacted by a stronger U.S. dollar relative to other foreign currencies in the three months ended March 31, 2015 compared to the three months ended March 31, 2014. Net revenue for the three months ended March 31, 2015 would have been approximately $11 million higher had foreign exchange rates remained constant from the prior year.

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 $21 million, or 15%. Of this increase, $10 million was attributable to employee-related expenses, such as salaries, benefits and incentive compensation, driven by a 6% increase in average headcount to support business growth and higher non-equity incentive compensation due to a higher payout percentage. License costs increased $10 million, reflecting price increases from some of our largest vendors in addition to higher volume to support our growth. Data center costs increased $2 million due to higher rent, maintenance, and bandwidth expenses. Partially offsetting these increases is the impact from a $3 million expense recorded during the three months ended March 31, 2014 related to an unresolved contractual issue with a vendor that did not repeat in the current year. As a percentage of net revenue, cost of revenue increased 30 basis points, from 33.3% in the three months ended March 31, 2014 to 33.6% in the three months ended March 31, 2015.

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 $7 million, or 27%, due to increased employee-related expenses, such as salaries, benefits and incentive compensation, driven by higher non-equity incentive compensation due to a higher payout percentage. We continue to invest in research and development activities to enhance our existing offerings and develop new products and services to complement and leverage Fanatical Support.

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 $2 million, or 3%, primarily due to higher non-equity incentive compensation due to a higher payout percentage.


- 16 -


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.

General and administrative expenses increased $16 million, or 22%. Employee-related expenses increased $11 million, mainly due to an 8% increase in average headcount and higher non-equity incentive compensation due to a higher payout percentage. In addition, share-based compensation expense increased, reflecting the impact of the forfeiture of certain executive stock grants during the three months ended March 31, 2014 that did not repeat in the current period. Internal software support and maintenance expenses increased $3 million to support the growth of our business. As a percentage of net revenue, general and administrative expenses increased 110 basis points, from 16.9% in the three months ended March 31, 2014 to 18.0% in the three months ended March 31, 2015 primarily due to the impact of the executive stock grant forfeitures in the prior year.

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 $9 million, or 10%. The 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 decreased as a percentage of net revenue, from 20.9% in the three months ended March 31, 2014 to 20.2% in the three months ended March 31, 2015.

Other Income (Expense)

Other expense was $2.4 million and $0.2 million for the three months ended March 31, 2015 and 2014, respectively. The increase in other expense of $2.2 million between periods was driven by the unfavorable impact of foreign exchange rate movements.

Income Taxes

Our effective tax rate decreased from 34.6% for the three months ended March 31, 2014 to 32.4% for the three months ended March 31, 2015. 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 for the three months ended March 31, 2015 primarily as a result of a decrease in the effective tax rate on our profits earned outside of the U.S. compared to the three months ended March 31, 2014. Our foreign earnings are generally taxed at lower rates than in the United States.

Net Income

Net income increased $3 million, or 12%, driven by higher net revenue and the positive impact of a lower effective tax rate, partially offset by higher expenses as we continue to make investments to support future growth. Net income per diluted share was $0.20 in the three months ended March 31, 2015, an increase of $0.02 from the same period of 2014.


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.


- 17 -


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 March 31, 2015, we held $276 million in cash and cash equivalents, of which $131 million is associated with indefinitely reinvested foreign earnings. We consider the undistributed earnings of our foreign subsidiaries as of March 31, 2015 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 earnings 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 finance lease obligations. As of December 31, 2014 and March 31, 2015, we had $134 million and $157 million outstanding with respect to these arrangements, respectively.  
    
As of March 31, 2015, there were no outstanding borrowings under the revolving credit facility. The $25 million outstanding balance as of December 31, 2014 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 March 31, 2015, 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. 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 in the second quarter of 2015.
 

- 18 -


Cash Flows

The following table sets forth a summary of certain cash flow information for the periods indicated: 
 
 
Three Months Ended March 31,
(In millions)
 
2014
 
2015
Cash provided by operating activities
 
$
141.7

 
$
145.3

Cash used in investing activities
 
$
(84.5
)
 
$
(91.8
)
Cash provided by (used in) financing activities
 
$
(3.6
)
 
$
11.2


Cash Provided by Operating Activities

Net cash provided by operating activities is primarily generated 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.
 
Net cash provided by operating activities increased $4 million, or 3%, from the first three months of 2014 compared to the first three months of 2015. Net income adjusted for non-cash items such as depreciation and amortization expense, share-based compensation expense and excess tax benefits from share-based compensation arrangements increased $10 million in the three months ended March 31, 2015 from the same period of 2014. This increase was partially offset by a reduction of $7 million in cash contributed by net changes in assets and liabilities between periods.

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.

Net cash used in investing activities increased $7 million from the first three months of 2014 compared to the first three months of 2015 due to an increase in cash purchases for property and equipment.
 
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.

Net cash used in financing activities was $4 million during the first three months of 2014 compared to net cash provided by financing activities of $11 million during the first three months of 2015, an increase of $15 million. Net repayments of debt and capital leases increased by $18 million between periods, driven by the January 2015 repayment of $25 million borrowed under our revolving credit facility partially offset by a $7 million decrease in principal payments of capital leases in the first three months of 2015 compared to the same period of the prior year. This was offset by an increase in proceeds from employee stock plans of $20 million and an increase in excess tax benefits from share-based compensation arrangements of $5 million. Further, the prior year period included a $14 million cash outflow for the withholding of shares related to the vesting of certain restricted stock in satisfaction of employee tax obligations and a $6 million cash receipt from the Texas Enterprise Fund grant.

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.
 

- 19 -


Critical Accounting Policies and Estimates
  
Our critical accounting policies and estimates have not changed from those described in our Annual Report on Form 10-K filed with the SEC on March 2, 2015 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates.” 

Recent Accounting Pronouncements Not Yet Adopted

For a description of accounting pronouncements recently issued but not yet adopted, see "Notes to the Unaudited Consolidated Financial Statements - Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies."


- 20 -


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 table presents 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.

 
 
Three Months Ended
(In millions)
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
Income from operations
 
$
39.1

 
$
33.9

 
$
40.5

 
$
50.0

 
$
44.4

Effective tax rate
 
34.6
%
 
33.0
%
 
32.0
%
 
25.1
%
 
32.4
%
Net operating profit after tax (NOPAT)
 
$
25.6

 
$
22.7

 
$
27.5

 
$
37.5

 
$
30.0

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
25.4

 
$
22.5

 
$
25.7

 
$
37.0

 
$
28.4

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,566.9

 
$
1,648.0

 
$
1,724.5

 
$
1,624.3

 
$
1,692.3

Less: Excess cash (1)
 
(263.3
)
 
(287.4
)
 
(294.3
)
 
(156.8
)
 
(218.1
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(224.4
)
 
(231.6
)
 
(244.4
)
 
(215.8
)
 
(214.8
)
Less: Deferred revenue (current and non-current)
 
(24.5
)
 
(23.2
)
 
(21.5
)
 
(22.3
)
 
(26.1
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for build-to-suit leases (2)
 
(172.1
)
 
(187.8
)
 
(210.9
)
 
(270.8
)
 
(287.7
)
Capital base (2)
 
$
882.6

 
$
918.0

 
$
953.4

 
$
958.6

 
$
945.6

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,529.4

 
$
1,607.5

 
$
1,686.3

 
$
1,674.4

 
$
1,658.3

Average capital base (2)
 
$
892.6

 
$
900.3

 
$
935.8

 
$
956.0

 
$
952.1

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
6.7
%
 
5.6
%
 
6.1
%
 
8.8
%
 
6.9
%
Return on capital (annualized) (2)
 
11.5
%
 
10.1
%
 
11.8
%
 
15.7
%
 
12.6
%

(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)
Prior period amounts have been revised to reflect the impact of a reclassification of certain finance obligations associated with build-to-suit leases in the consolidated balance sheets. See “Notes to the Unaudited Consolidated Financial Statements - Note 4. Build-to-Suit Leases” for further discussion.
    

- 21 -


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 table presents a reconciliation of Adjusted EBITDA to net income.

 
 
Three Months Ended
(Dollars in millions)
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
421.0

 
$
441.2

 
$
459.7

 
$
472.5

 
$
480.2

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
39.1

 
$
33.9

 
$
40.5

 
$
50.0

 
$
44.4

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
25.4

 
$
22.5

 
$
25.7

 
$
37.0

 
$
28.4

   Plus: Income taxes
 
13.5

 
11.0

 
12.2

 
12.3

 
13.6

   Plus: Total other (income) expense
 
0.2

 
0.4

 
2.6

 
0.7

 
2.4

   Plus: Depreciation and amortization
 
87.8

 
90.6

 
98.3

 
95.2

 
96.9

   Plus: Share-based compensation expense
 
12.7

 
17.3

 
19.8

 
20.2

 
20.0

Adjusted EBITDA
 
$
139.6

 
$
141.8

 
$
158.6

 
$
165.4

 
$
161.3

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
9.3
%
 
7.7
%
 
8.8
%
 
10.6
%
 
9.3
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
33.2
%
 
32.1
%
 
34.5
%
 
35.0
%
 
33.6
%

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.

 
Three Months Ended
(In millions)
March 31,
2014
 
March 31,
2015
Adjusted EBITDA
$
139.6

 
$
161.3

Non-cash deferred rent
2.3

 
0.4

Total capital expenditures
(100.7
)
 
(90.2
)
Cash payments for interest, net of interest received
(0.4
)
 
(0.3
)
Cash payments for income taxes, net of refunds
(0.9
)
 
(3.8
)
Adjusted free cash flow
$
39.9

 
$
67.4



- 22 -


Quarterly Key Metrics

The following table sets forth our quarterly key metrics for each of our most recent five quarters as of the period ended March 31, 2015. The quarterly data presented below has been prepared on a basis consistent with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2014 and, in the opinion of management, reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information. You should read this information in conjunction with the consolidated financial statements and the related notes included elsewhere in this document and with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2014. Our results for these quarterly periods are not necessarily indicative of the results of operations for a full year or any period.
 
 
 
Three Months Ended
(Dollar amounts in millions, except average monthly revenue per server)
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
 
 
 
 
Growth
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
421.0

 
$
441.2

 
$
459.7

 
$
472.5

 
$
480.2

Revenue growth (year over year)
 
16.2
%
 
17.4
%
 
18.3
%
 
15.8
%
 
14.1
%
Number of employees (Rackers) at period end
 
5,743

 
5,798

 
5,939

 
5,936

 
5,964

Number of servers deployed at period end
 
106,229

 
107,657

 
110,453

 
112,628

 
114,105

Average monthly revenue per server
 
$
1,336

 
$
1,375

 
$
1,405

 
$
1,412

 
$
1,412

Profitability
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
39.1

 
$
33.9

 
$
40.5

 
$
50.0

 
$
44.4

Depreciation and amortization
 
$
87.8

 
$
90.6

 
$
98.3

 
$
95.2

 
$
96.9

Share-based compensation expense
 
$
12.7

 
$
17.3

 
$
19.8

 
$
20.2

 
$
20.0

Adjusted EBITDA (1)
 
$
139.6

 
$
141.8

 
$
158.6

 
$
165.4

 
$
161.3

Adjusted EBITDA margin
 
33.2
%
 
32.1
%
 
34.5
%
 
35.0
%
 
33.6
%
Operating income margin
 
9.3
%
 
7.7
%
 
8.8
%
 
10.6
%
 
9.3
%
Income from operations
 
$
39.1

 
$
33.9

 
$
40.5

 
$
50.0

 
$
44.4

Effective tax rate
 
34.6
%
 
33.0
%
 
32.0
%
 
25.1
%
 
32.4
%
Net operating profit after tax (NOPAT) (1)
 
$
25.6

 
$
22.7

 
$
27.5

 
$
37.5

 
$
30.0

NOPAT margin
 
6.1
%
 
5.1
%
 
6.0
%
 
7.9
%
 
6.3
%
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
Interest bearing debt (2)
 
$
45.9

 
$
34.2

 
$
24.0

 
$
41.6

 
$
10.8

Stockholders' equity
 
$
1,100.0

 
$
1,171.2

 
$
1,223.7

 
$
1,073.8

 
$
1,152.9

Less: Excess cash
 
$
(263.3
)
 
$
(287.4
)
 
$
(294.3
)
 
$
(156.8
)
 
$
(218.1
)
Capital base (2)
 
$
882.6

 
$
918.0

 
$
953.4

 
$
958.6

 
$
945.6

Average capital base (2)
 
$
892.6

 
$
900.3

 
$
935.8

 
$
956.0

 
$
952.1

Capital turnover (annualized) (2)
 
1.89

 
1.96

 
1.97

 
1.98

 
2.02

Return on capital (annualized) (1) (2)
 
11.5
%
 
10.1
%
 
11.8
%
 
15.7
%
 
12.6
%
Capital expenditures
 
 
 
 
 
 
 
 
 
 
Cash purchases of property and equipment
 
$
85.0

 
$
114.0

 
$
124.1

 
$
107.2

 
$
92.5

Non-cash purchases of property and equipment (3)
 
$
15.7

 
$
(1.6
)
 
$
(6.7
)
 
$
(2.6
)
 
$
(2.3
)
Total capital expenditures
 
$
100.7

 
$
112.4

 
$
117.4

 
$
104.6

 
$
90.2

Customer gear
 
$
60.7

 
$
64.8

 
$
78.7

 
$
72.5

 
$
58.7

Data center build outs
 
$
11.0

 
$
13.8

 
$
14.8

 
$
11.1

 
$
13.4

Office build outs
 
$
9.2

 
$
6.8

 
$
3.5

 
$
1.6

 
$
2.3

Capitalized software and other projects
 
$
19.8

 
$
27.0

 
$
20.4

 
$
19.4

 
$
15.8

Total capital expenditures
 
$
100.7

 
$
112.4

 
$
117.4

 
$
104.6

 
$
90.2

Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end (4)
 
58.1

 
58.1

 
58.1

 
58.1

 
63.2

Megawatts available for customer use at period end (5)
 
45.3

 
45.4

 
45.4

 
49.7

 
52.0

Megawatts utilized at period end
 
28.1

 
29.0

 
29.9

 
30.5

 
31.0

Annualized net revenue per average Megawatt of power utilized
 
$
60.7

 
$
61.8

 
$
62.4

 
$
62.6

 
$
62.5


- 23 -


(1)
See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.
(2)
Prior period amounts have been revised to reflect the impact of a reclassification of certain finance obligations associated with build-to-suit leases in the consolidated balance sheets. See “Notes to the Unaudited Consolidated Financial Statements - Note 4. Build-to-Suit Leases” for further discussion.
(3)
Non-cash purchases of property and equipment represents changes in amounts accrued for purchases under vendor financing and other deferred payment arrangements.
(4)
Megawatts under contract at period end represents data center capacity for which we have a contract enabling us to take control of the space. For our newest data center in London, as of March 31, 2015, we have included four megawatts.
(5)
Megawatts available for customer use at period end represents data center capacity that is built-out and is being used to provide service to customers.


- 24 -


ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
There have been no significant changes to our market risks since December 31, 2014. For a discussion of our exposure to market risk, refer to Part II, Item 7A "Quantitative and Qualitative Disclosures about Market Risk," contained in our Annual Report on Form 10-K for the year-ended December 31, 2014.

ITEM 4  CONTROLS AND PROCEDURES
 
Evaluation of disclosure controls and procedures

Under the supervision and with the participation of our senior management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), as amended, as of the end of the period covered by this quarterly report (the “Evaluation Date”). Based on this evaluation, our chief executive officer and chief financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our SEC reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting

There were no changes in our internal controls over financial reporting during our most recent fiscal quarter reporting period identified in connection with management’s evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



- 25 -


PART II – OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS
 
For a discussion of legal proceedings, see "Notes to the Unaudited Consolidated Financial Statements - Note 5. Contingencies."

ITEM 1A – RISK FACTORS

For a discussion of our risk factors, refer to Part I, Item 1A "Risk Factors," contained in our Annual Report on Form 10-K for the year-ended December 31, 2014. As of March 31, 2015, there had been no material change in this information.


- 26 -


ITEM 6 – EXHIBITS
 
Exhibit Number
 
 Description
10.1*
 
Employment Agreement between Rackspace Managed Hosting Limited and Tiffany Lathe, dated September 11, 2007
10.2*
 
Employment Agreement between Rackspace US, Inc. and Scott Crenshaw, dated April 1, 2015
10.3*
 
Employment Agreement between Rackspace US, Inc. and Joe Saporito, dated March 11, 2015
10.4*
 
Non-Employee Director Compensation Schedule
31.1*
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
 
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**
 
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**
 
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS*
 
XBRL Instance Document
101.SCH*
 
XBRL Taxonomy Extension Schema
101.CAL*
 
XBRL Taxonomy Extension Calculation Linkbase
101.DEF*
 
XBRL Taxonomy Extension Definition Linkbase
101.LAB*
 
XBRL Taxonomy Extension Label Linkbase
101.PRE*
 
XBRL Taxonomy Extension Presentation Linkbase

*
Filed herewith.
**
Furnished herewith.


- 27 -


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on May 11, 2015.


Rackspace Hosting, Inc.