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EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-322_093015.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-311_093015.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-321_093015.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-312_093015.htm

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

 FORM 10-Q
(Mark one)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 November 5, 2015, 134,695,396 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.



RACKSPACE HOSTING, INC.
 TABLE OF CONTENTS
 
Part I - Financial Information
 
Item 1.
Financial Statements:
 
 
 
Unaudited Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2015
 
Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2015
 
Item 2.
Item 3.
Item 4.
 
 
 
Part II - Other Information
 
Item 1.
Item 1A.
Item 2.
Item 6.
 
 
 
 



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, including our expectation of deceleration of the year-over-year growth rate. 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
 
September 30,
2015
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
213.5

 
$
189.0

Accounts receivable, net of allowance for doubtful accounts and customer credits of $5.3 as of December 31, 2014 and $6.8 as of September 30, 2015
 
156.5

 
174.9

Deferred income taxes
 
9.3

 
5.8

Prepaid expenses
 
33.6

 
55.5

Other current assets
 
8.8

 
15.5

Total current assets
 
421.7

 
440.7

 
 
 
 
 
Property and equipment, net
 
1,057.7

 
1,161.3

Goodwill
 
81.1

 
81.1

Intangible assets, net
 
16.6

 
10.3

Other non-current assets
 
47.2

 
60.4

Total assets
 
$
1,624.3

 
$
1,753.8

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

 
$
173.6

Accrued compensation and benefits
 
66.7

 
56.2

Income and other taxes payable
 
11.8

 
7.1

Deferred revenue
 
20.9

 
29.9

Capital lease obligations
 
15.0

 
3.1

Debt
 
25.1

 
140.0

Total current liabilities
 
276.8

 
409.9

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Deferred revenue
 
1.4

 
1.9

Capital lease obligations
 
1.5

 
0.5

Finance lease obligations for build-to-suit leases
 
117.4

 
165.4

Deferred income taxes
 
71.2

 
46.6

Deferred rent
 
49.9

 
49.4

Other liabilities
 
32.3

 
30.7

Total liabilities
 
550.5

 
704.4

 
 
 
 
 
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; 134,685,554 shares issued and outstanding as of September 30, 2015
 
0.1

 
0.1

Additional paid-in capital
 
696.0

 
841.8

Accumulated other comprehensive loss
 
(20.7
)
 
(29.7
)
Retained earnings
 
398.4

 
237.2

Total stockholders’ equity
 
1,073.8

 
1,049.4

Total liabilities and stockholders’ equity
 
$
1,624.3

 
$
1,753.8


See accompanying notes to the unaudited consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In millions, except per share data)
 
2014
 
2015
 
2014
 
2015
 
 
 
 
 
 
 
 
 
Net revenue
 
$
459.7

 
$
508.9

 
$
1,321.9

 
$
1,478.5

Costs and expenses:
 
 
 
 
 
 
 
 
Cost of revenue
 
142.9

 
171.2

 
428.4

 
496.4

Research and development
 
30.7

 
29.9

 
85.6

 
95.1

Sales and marketing
 
60.6

 
61.8

 
178.4

 
185.2

General and administrative
 
86.7

 
88.2

 
239.3

 
261.3

Depreciation and amortization
 
98.3

 
101.3

 
276.7

 
295.9

Total costs and expenses
 
419.2

 
452.4

 
1,208.4

 
1,333.9

Income from operations
 
40.5

 
56.5

 
113.5

 
144.6

Other income (expense):
 
 
 
 
 
 
 
 
Interest expense
 
(0.5
)
 
(2.8
)
 
(1.5
)
 
(5.1
)
Interest and other income (expense)
 
(2.1
)
 
(1.1
)
 
(1.7
)
 
(1.7
)
Total other income (expense)
 
(2.6
)
 
(3.9
)
 
(3.2
)
 
(6.8
)
Income before income taxes
 
37.9

 
52.6

 
110.3

 
137.8

Income taxes
 
12.2

 
16.1

 
36.7

 
43.7

Net income
 
$
25.7

 
$
36.5

 
$
73.6

 
$
94.1

 
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
$
(13.2
)
 
$
(10.2
)
 
$
(4.8
)
 
$
(9.0
)
Other comprehensive income (loss)
 
(13.2
)
 
(10.2
)
 
(4.8
)
 
(9.0
)
Comprehensive income
 
$
12.5

 
$
26.3

 
$
68.8

 
$
85.1

 
 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
 
Basic
 
$
0.18

 
$
0.26

 
$
0.52

 
$
0.67

Diluted
 
$
0.18

 
$
0.26

 
$
0.51

 
$
0.66

 
 
 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
 
 
Basic
 
143.0

 
139.0

 
142.0

 
140.9

Diluted
 
144.9

 
140.6

 
144.3

 
143.3

 
See accompanying notes to the unaudited consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Nine Months Ended September 30,
(In millions)
 
2014
 
2015
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
73.6

 
$
94.1

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
276.7

 
295.9

Deferred income taxes
 
(30.1
)
 
(34.1
)
Share-based compensation expense
 
49.8

 
60.0

Excess tax benefits from share-based compensation arrangements
 
(45.3
)
 
(51.5
)
Other operating activities
 
5.8

 
7.1

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable
 
(15.7
)
 
(26.3
)
Prepaid expenses and other current assets
 
(17.2
)
 
(25.1
)
Accounts payable, accrued expenses, and other current liabilities
 
93.9

 
45.7

Deferred revenue
 
(5.0
)
 
9.5

Deferred rent
 
6.3

 

Other non-current assets and liabilities
 
(1.2
)
 
4.3

Net cash provided by operating activities
 
391.6

 
379.6

Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(323.1
)
 
(331.9
)
All other investing activities
 
1.9

 
(4.6
)
Net cash used in investing activities
 
(321.2
)
 
(336.5
)
Cash Flows From Financing Activities
 
 
 
 
Proceeds from debt
 

 
140.0

Repayments of debt
 
(1.8
)
 
(25.1
)
Proceeds from finance lease obligations for build-to-suit leases
 

 
2.5

Principal payments of capital and build-to-suit leases
 
(32.5
)
 
(13.3
)
Payments for deferred acquisition obligations
 
(0.2
)
 
(0.2
)
Receipt of Texas Enterprise Fund grant
 
5.5

 

Repurchase of common stock
 

 
(250.1
)
Shares of common stock withheld for employee taxes
 
(13.6
)
 

Proceeds from employee stock plans
 
18.0

 
29.2

Excess tax benefits from share-based compensation arrangements
 
45.3

 
51.5

Net cash provided by (used in) financing activities
 
20.7

 
(65.5
)
Effect of exchange rate changes on cash and cash equivalents
 
(1.3
)
 
(2.1
)
Increase (decrease) in cash and cash equivalents
 
89.8

 
(24.5
)
Cash and cash equivalents, beginning of period
 
259.7

 
213.5

Cash and cash equivalents, end of period
 
$
349.5

 
$
189.0

 
 
 
 
 
Supplemental Cash Flow Information
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
1.4

 
$
2.2

Cash payments for income taxes, net of refunds
 
$
6.8

 
$
17.0

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

 
$
0.4

Increase in property and equipment in accounts payable and accrued expenses
 
6.5

 
37.2

Non-cash purchases of property and equipment
 
$
7.4

 
$
37.6

 
 
 
 
 
Additional finance lease obligations for build-to-suit leases and other
 
$
70.8

 
$
48.6


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 or nine months ended September 30, 2014 or 2015

Unaudited Interim Financial Information
 
The accompanying consolidated financial statements as of September 30, 2015, and for the three and nine months ended September 30, 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 September 30, 2015, our results of operations for the three and nine months ended September 30, 2014 and 2015, and our cash flows for the nine months ended September 30, 2014 and 2015.
 
The results of operations for the three and nine months ended September 30, 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 or nine months ended September 30, 2015; however, we have updated our Revenue and Deferred Revenue policy description to reflect our existing accounting practices for multiple-element arrangements, as follows:

Revenue and Deferred Revenue

We provide cloud computing to customers, which is broadly defined as the delivery of computing, storage and applications over the Internet. Cloud computing is a service transaction for which revenue is recognized when persuasive evidence of an arrangement exists, usually either a signed, written contract or customer acknowledgment of online terms of service; services have been delivered to the customer; the amounts to be received for the services delivered are fixed or determinable; and collection of such amounts is reasonably assured.

Customers primarily consume our principal service offerings in one of two ways: (i) via dedicated computing resources committed to a single customer or (ii) via multi-tenant pools of computing resources provided on demand over the Internet. We also offer customers the flexibility to select the best combination of the two in order to meet the requirements of their unique applications and provide the technology to operate and manage multiple cloud computing environments seamlessly.

Each service offering is priced according to the terms of our committed resources and services. Contracts for dedicated computing resources are generally fixed term agreements with a 12-36 month term with a monthly recurring fee based on the computing resources reserved and provided to the customer, the complexity of the underlying infrastructure and the level of support we provide. 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. In certain instances we may charge a non-refundable installation fee. Beginning on the date the service is made available to customers, the monthly recurring fee is recognized monthly as services are provided and installation fees are recognized ratably over the estimated average life of a customer relationship. 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. Setup and other direct implementation activities performed at the inception of a customer contract are expensed as incurred.

Contracts for services utilizing pooled resources on demand are typically initiated online and can be canceled at any time without penalty. Customers are billed according to usage for only the resources consumed, and revenue is recognized in the month in which the customer uses the services.

Revenue recognition for multiple-element arrangements requires judgment to determine whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements using a hierarchy for allocating revenue to the elements: (i) vendor-specific objective evidence of fair value, (ii) third-party evidence, and (iii) best estimate of selling price. Revenue arrangements with multiple deliverables are divided into separate units of accounting when the delivered item(s) has value to the customer on a standalone basis, which is normally the situation for our services contracts. In this circumstance, revenue is recognized for each unit of accounting based on its relative estimated selling price. Estimated selling prices are management’s best estimates of the prices that we would charge our customers if we were to sell the standalone elements separately and include considerations of customer demand, prices charged by us and others for similar deliverables, and the cost of providing the service. When elements are delivered in different periods of time, revenue is recognized as each element is delivered.

Revenue is reported net of customer credits and sales and use tax. Invoiced amounts and accrued unbilled usage is recorded in accounts receivable and either deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of amounts that have been prepaid or deferred installation fees. As of September 30, 2015, of the total $31.8 million in deferred revenue recorded on our balance sheet (the majority of which related to prepaid amounts), $21.9 million, $8.7 million and $1.2 million will be amortized to revenue in 2015, 2016 and 2017, respectively.


- 7 -


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, 2017, with early adoption permitted for annual periods beginning after December 15, 2016. 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 September 30,
 
Nine Months Ended September 30,
(In millions, except per share data)
 
2014
 
2015
 
2014
 
2015
Basic net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
25.7

 
$
36.5

 
$
73.6

 
$
94.1

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
143.0

 
139.0

 
142.0

 
140.9

Number of shares used in per share computations
 
143.0

 
139.0

 
142.0

 
140.9

Net income per share
 
$
0.18

 
$
0.26

 
$
0.52

 
$
0.67

 
 
 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
25.7

 
$
36.5

 
$
73.6

 
$
94.1

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
143.0

 
139.0

 
142.0

 
140.9

Stock options, awards and employee share purchase plans
 
1.9

 
1.6

 
2.3

 
2.4

Number of shares used in per share computations
 
144.9

 
140.6

 
144.3

 
143.3

Net income per share
 
$
0.18

 
$
0.26

 
$
0.51

 
$
0.66


We excluded 5.8 million and 5.2 million potential common shares from the computation of dilutive net income per share for the three months ended September 30, 2014 and 2015, respectively, and 5.6 million and 3.8 million potential shares for the nine months ended September 30, 2014 and 2015, respectively, because the effect would have been anti-dilutive.


- 8 -


3. Property and Equipment, net
 
Property and equipment consisted of: 
(Dollar amounts in millions)
 
Estimated Useful Lives
 
December 31,
2014
 
September 30,
2015
Computers and equipment
 
3
-
5
years
 
$
1,495.2

 
$
1,739.6

Computer software
 
1
-
5
years
 
318.9

 
362.0

Furniture and fixtures
 
7
years
 
56.7

 
60.6

Buildings and leasehold improvements
 
2
-
30
years
 
253.6

 
353.8

Land
 
 
 
 
 
 
27.9

 
28.4

Property and equipment, at cost
 
 
 
 
 
 
2,152.3

 
2,544.4

Less accumulated depreciation and amortization
 
 
 
 
 
 
(1,249.5
)
 
(1,465.2
)
Work in process
 
 
 
 
 
 
154.9

 
82.1

Property and equipment, net
 
 
 
 
 
 
$
1,057.7

 
$
1,161.3

 
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 September 30, 2015, the work in process balance consisted of build outs of $14.0 million for office facilities, $50.2 million for data centers, and $17.9 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. In addition, during the third quarter of 2015 we placed into service and began depreciating $47.7 million of construction costs related to the completion of our new U.K. office. We are deemed the owner of both buildings for accounting purposes. See Note 4. "Build-to-Suit Leases" for more information.

For the three and nine months ended September 30, 2015, we capitalized interest of $1.2 million and $5.9 million, respectively, related to finance lease obligations for build-to-suit leases. There was no interest capitalized during the three and nine months ended September 30, 2014.


- 9 -


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 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 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 completed. 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. Rental payments are recorded as a reduction of the corresponding liability and as interest expense, and at the end of the lease term, we will derecognize the remaining asset and liability balances.

During the third quarter of 2015, construction of an office building in the U.K was completed. We performed a sale-leaseback analysis, and, due to our continuing involvement in the project, we were precluded from derecognizing the asset and liability. As a result, we placed into service and began depreciating $47.7 million of construction costs as building and leasehold improvements within "Property and equipment, net" on our consolidated balance sheets. The assets will be depreciated throughout the lease term. Rental payments under the lease are recorded as a reduction of the liability and as interest expense, and at the end of the lease term, we will derecognize the remaining asset and liability balances.

As of December 31, 2014 and September 30, 2015 we had $117.4 million and $165.4 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. Cost Method Investments

We have several direct investments accounted for under the cost method. The aggregate carrying amount of our cost method investments, which are recorded as Other non-current assets, as of December 31, 2014 and September 30, 2015 was $1.1 million and $11.6 million, respectively. We have determined that it is not practicable to estimate the fair value of these investments. As such, if we identify events or changes in circumstances that may have a significant adverse effect on the fair value of the investment, we will then estimate the fair value of the investment and determine if any decline in the fair value of the investment below its carrying value is other-than-temporary. No events or circumstances indicating a potential impairment were identified as of September 30, 2015.


- 10 -


6. Debt

We are party to a revolving credit facility that has a total commitment of $200 million. As of December 31, 2014, we had outstanding borrowings of $25 million under this facility at an interest rate of 1.42%. These outstanding borrowings were fully repaid in January 2015.

During the three months ended September 30, 2015, we borrowed $140 million under the credit facility. The weighted average interest rate of these borrowings was 1.47%. Additionally there were insignificant letters of credit outstanding as of September 30, 2015, and therefore, we had $60 million available for future borrowings. As of the same date, we were in compliance with all of the covenants under our facility.

7. 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.


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8. 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. We also have made restricted stock grants to employees 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 September 30, 2015 was as follows: 
(in millions)
 
December 31,
2014
 
September 30,
2015
Restricted stock
 
4.3
 
4.4
Stock options
 
6.8
 
4.8
     Total outstanding awards
 
11.1
 
9.2
 
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 September 30,
 
Nine Months Ended September 30,
(in millions)
 
2014
 
2015
 
2014
 
2015
Cost of revenue
 
$
4.2

 
$
4.2

 
$
12.1

 
$
12.3

Research and development
 
3.3

 
2.4

 
9.4

 
11.3

Sales and marketing
 
2.7

 
2.7

 
6.8

 
8.2

General and administrative
 
9.6

 
10.3

 
21.5

 
28.2

Pre-tax share-based compensation
 
19.8

 
19.6

 
49.8

 
60.0

Less: Income tax benefit
 
(6.3
)
 
(5.9
)
 
(16.5
)
 
(19.0
)
Total share-based compensation expense, net of tax
 
$
13.5

 
$
13.7

 
$
33.3

 
$
41.0


As of September 30, 2015, there was $156.9 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.


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9. 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 share-based compensation in 2015. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the three and nine months ended September 30, 2015.

On July 27, 2015, in Altera Corp. v. Commissioner, the U.S. Tax Court issued an opinion related to the treatment of share-based compensation expense in an intercompany cost-sharing arrangement. A final decision has yet to be issued by the Tax Court. At this time, the U.S. Department of the Treasury has not withdrawn the requirement to include share-based compensation from its regulations and the Internal Revenue Service may appeal. We will continue to monitor developments related to the regulation and the potential impact of those developments on the consolidated financial statements.

10. Share Repurchase Program

On November 6, 2014, our board of directors authorized a share repurchase program. 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 and paid $200 million to repurchase our common stock. The payment was accounted for as a reduction to stockholders' equity in our consolidated balance sheet in 2014. We received an initial delivery of 3.3 million shares of common stock in November 2014, and we received an additional 0.9 million shares of common stock in May 2015 as final settlement of the ASR. All shares received were subsequently retired.

On August 5, 2015, our board of directors increased the authorization under the existing share repurchase program to a total of up to $1 billion, in addition to the $200 million already purchased under the ASR. The program will remain in effect for a period not to exceed 24 months from authorization.

During the three months ended September 30, 2015, we repurchased $250 million, or 8.2 million shares, of our common stock on the open market; these shares were subsequently retired. Therefore, as of September 30, 2015, approximately $750 million remained available for additional purchases under the current program.


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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“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 and nine months ended September 30, 2015 and September 30, 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 nine 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. For the second year in a row, Rackspace has been ranked as a leader in the Gartner Magic Quadrant for Cloud-Enabled Managed Hosting, 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.


- 14 -


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.

While we believe our managed cloud strategy uniquely positions us in the long-term to dominate this significant multi-billion-dollar, high-growth market, quarterly revenue growth (on a year-over-year basis) has decelerated for four quarters in a row, declining from 18.3% in the third quarter of 2014 to 10.7% in the third quarter of 2015. There are a number of factors that have contributed to the overall decline, including sales and marketing issues and product challenges in our public cloud. We believe that these issues were exacerbated by talent gaps that lingered into the first half of this year, following a period of elevated turnover connected to the publicly announced strategic evaluation that we went through in 2014. We believe we have identified our key challenges and have moved aggressively to address each of them.

Another factor that impacts our revenue growth is that the timing of revenue materialization for certain large contracts may be more volatile. While this factor negatively affected our first half revenue growth rate, the revenue growth rate in the third quarter of 2015 was favorably impacted by a large, multi-year agreement that began to materialize during the quarter. Despite the fact that this agreement is expected to also favorably impact the fourth quarter, we expect the decline in the year-over-year revenue growth rate to continue.

Recent Developments

In July 2015 we launched Fanatical Support for Microsoft Azure, an expansion of our service offering for our Microsoft product portfolio. Microsoft Azure is a public cloud platform that's becoming increasingly popular with business enterprises. We will work with customers to help them speed their deployment of Azure, minimize costs and optimize performance. Our engineers will provide application and infrastructure architecture guidance, making it easy for customers to succeed with Azure.

We also announced in July 2015 a collaboration with Intel Corporation to form the OpenStack Innovation Center, to be located at our corporate headquarters in San Antonio. This project will bring together OpenStack engineers from Rackspace and Intel to advance the scalability, manageability and reliability of OpenStack by adding new features, functionality and eliminating bugs through upstream code contributions.

In September 2015 we launched our Managed Security and Compliance Assistance offering to assist customers in addressing data security, protecting critical business processes, and mitigating risks from potential cyberattacks and threats. The offering is designed to detect and respond to advanced persistent threats (APTs) and other types of cyberattacks. The offering is tailored to customers' business needs and backed by a 24/7/365 Customer Security Operations Center (CSOC) at Rackspace.


- 15 -


In October 2015 we launched Fanatical Support for AWS, under which we will offer tools, expertise, application management and operational support to customers on the Amazon Web Services (AWS) cloud. We will operate as a trusted partner to businesses that want to realize the power of the AWS Cloud by blending automation, technology and human expertise to deliver ongoing architecture, management, security services and 24x7x365 operations, all backed by AWS-certified engineers and architects.

These recent announcements support our strategy to differentiate ourselves and create value for our customers through our industry-leading Fanatical Support and choice of leading technologies and platforms.

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)
 
September 30, 2014
 
June 30, 2015
 
September 30, 2015
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
459.7

 
$
489.4

 
$
508.9

 
Revenue growth (year over year)
 
18.3
%
 
11.0
%
 
10.7
%
 
 
 
 
 
 
 
 
 
Number of servers deployed at period end
 
110,453

 
116,329

 
118,654

 
Average monthly revenue per server
 
$
1,405

 
$
1,416

 
$
1,444

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

 
6,115

 
6,177


Total net revenue for the three months ended September 30, 2015 increased $20 million, or 4.0%, from the three months ended June 30, 2015. Net revenue for the three months ended September 30, 2015 was favorably impacted by a large, multi-year agreement that began to materialize during the period and by a weaker U.S. dollar relative to other foreign currencies on a sequential quarter basis. Net revenue for the three months ended September 30, 2015 would have been approximately $1 million lower had foreign exchange rates remained constant from the three months ended June 30, 2015, resulting in a constant currency growth rate of 3.8%.

On a year-over-year basis, net revenue grew $49 million, or 10.7%, during the three months ended September 30, 2015, which includes the negative impact of approximately $10 million due to changes in foreign exchange rates. On a constant currency basis, net revenue grew 12.9% during the three months ended September 30, 2015 compared to the same period of the prior year.


- 16 -


Profitability
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except per share amounts)
 
September 30, 2014
 
June 30, 2015
 
September 30, 2015
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA
 
$
158.6

 
$
161.8

 
$
177.4

 
Adjusted EBITDA margin
 
34.5
%
 
33.1
%
 
34.9
%
 
 
 
 
 
 
 
 
 
Income from operations
 
$
40.5

 
$
43.7

 
$
56.5

 
Operating income margin
 
8.8
%
 
8.9
%
 
11.1
%
 
 
 
 
 
 
 
 
 
Net income
 
$
25.7

 
$
29.2

 
$
36.5

 
Net income margin
 
5.6
%
 
6.0
%
 
7.2
%
 
Diluted net income per share
 
$
0.18

 
$
0.20

 
$
0.26


On a sequential quarter basis our margins improved, as Adjusted EBITDA increased 180 basis points to 34.9% of net revenue, income from operations increased 220 basis points to 11.1% of net revenue and net income increased 120 basis points to 7.2% of net revenue for the three months ended September 30, 2015 compared to the three months ended June 30, 2015. Our margins were positively impacted by lower employee-related expenses as a percentage of net revenue and a decrease in marketing expense. Employee-related expenses reflected the impact of decreased non-equity incentive bonus expense due to a lower bonus payout percentage. Lower marketing expense resulted from fewer Rackspace::Solve events held during the third quarter of 2015 as well as reduced spending on online advertising. In addition, there was a general decrease in professional and consulting fees. The positive impact from these expenses and a decrease in the effective tax rate on our net income margin was partially offset by an unfavorable impact of foreign exchange rate movements from June 30, 2015 to September 30, 2015.

On a year-over-year basis, Adjusted EBITDA margin increased to 34.9% in the three months ended September 30, 2015 from 34.5% in the same period of 2014, as revenue growth of 10.7% outpaced growth in expenses. Operating income margin improved to 11.1% from 8.8% and net income margin increased to 7.2% from 5.6%.


- 17 -


Capital Efficiency, Infrastructure Capacity and Utilization
 
 
 
Three Months Ended
 
(Dollar amounts in millions)
 
September 30, 2014
 
June 30, 2015
 
September 30, 2015
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
 
 
 
 
 
 
Customer gear
 
$
78.7

 
$
117.3

 
$
87.1

 
Data center build outs
 
$
14.8

 
$
15.8

 
$
18.8

 
Office build outs
 
$
3.5

 
$
3.3

 
$
6.1

 
Capitalized software and other projects
 
$
20.4

 
$
15.2

 
$
15.7

 
Total capital expenditures
 
$
117.4

 
$
151.6

 
$
127.7

 
 
 
 
 
 
 
 
 
Capital efficiency and returns
 
 
 
 
 
 
 
Average capital base (1)
 
$
935.8

 
$
967.2

 
$
1,027.0

 
Capital turnover (annualized) (1)
 
1.97

 
2.02

 
1.98

 
Return on capital (annualized) (1)
 
11.8
%
 
12.1
%
 
15.0
%
 
 
 
 
 
 
 
 
 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
Megawatts under contract at period end (2)
 
58.1

 
63.6

 
63.6

 
Megawatts available for customer use at period end (3)
 
45.4

 
54.1

 
55.3

 
Megawatts utilized at period end
 
29.9

 
31.6

 
32.7

 
Annualized net revenue per average Megawatt of power utilized
 
$
62.4

 
$
62.5

 
$
63.3


(1)
September 30, 2014 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") increased from 12.1% for the three months ended June 30, 2015 to 15.0% for the three months ended September 30, 2015. The increase is primarily due to the increase in sequential quarter income from operations described above, partially offset by a 6% increase in our average capital base.

On a year-over-year basis, ROC increased from 11.8% to 15.0%, primarily due to the increase in income from operations between periods, partially offset by a 10% increase in our average capital base. Our capital turnover for the three months ended September 30, 2015 of 1.98 did not change significantly from the same period of 2014.

- 18 -


Results of Operations

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

Consolidated Statements of Income:
 
 
Three Months Ended
(In millions)
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
Net revenue
 
$
459.7

 
$
472.5

 
$
480.2

 
$
489.4

 
$
508.9

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
142.9

 
153.9

 
161.3

 
163.9

 
171.2

Research and development
 
30.7

 
31.4

 
32.0

 
33.2

 
29.9

Sales and marketing
 
60.6

 
59.2

 
59.0

 
64.4

 
61.8

General and administrative
 
86.7

 
82.8

 
86.6

 
86.5

 
88.2

Depreciation and amortization
 
98.3

 
95.2

 
96.9

 
97.7

 
101.3

Total costs and expenses
 
419.2

 
422.5

 
435.8

 
445.7

 
452.4

Income from operations
 
40.5

 
50.0

 
44.4

 
43.7

 
56.5

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.5
)
 
(0.4
)
 
(0.4
)
 
(1.9
)
 
(2.8
)
Interest and other income (expense)
 
(2.1
)
 
(0.3
)
 
(2.0
)
 
1.4

 
(1.1
)
Total other income (expense)
 
(2.6
)
 
(0.7
)
 
(2.4
)
 
(0.5
)
 
(3.9
)
Income before income taxes
 
37.9

 
49.3

 
42.0

 
43.2

 
52.6

Income taxes
 
12.2

 
12.3

 
13.6

 
14.0

 
16.1

Net income
 
$
25.7

 
$
37.0

 
$
28.4

 
$
29.2

 
$
36.5

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Three Months Ended
(Percent of net revenue)
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
31.1
 %
 
32.6
 %
 
33.6
 %
 
33.5
 %
 
33.7
 %
Research and development
 
6.7
 %
 
6.6
 %
 
6.7
 %
 
6.8
 %
 
5.9
 %
Sales and marketing
 
13.2
 %
 
12.5
 %
 
12.3
 %
 
13.2
 %
 
12.1
 %
General and administrative
 
18.9
 %
 
17.5
 %
 
18.0
 %
 
17.7
 %
 
17.3
 %
Depreciation and amortization
 
21.4
 %
 
20.2
 %
 
20.2
 %
 
20.0
 %
 
19.9
 %
Total costs and expenses
 
91.2
 %
 
89.4
 %
 
90.7
 %
 
91.1
 %
 
88.9
 %
Income from operations
 
8.8
 %
 
10.6
 %
 
9.3
 %
 
8.9
 %
 
11.1
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.4
)%
 
(0.5
)%
Interest and other income (expense)
 
(0.5
)%
 
(0.1
)%
 
(0.4
)%
 
0.3
 %
 
(0.2
)%
Total other income (expense)
 
(0.6
)%
 
(0.1
)%
 
(0.5
)%
 
(0.1
)%
 
(0.8
)%
Income before income taxes
 
8.2
 %
 
10.4
 %
 
8.8
 %
 
8.8
 %
 
10.3
 %
Income taxes
 
2.6
 %
 
2.6
 %
 
2.8
 %
 
2.9
 %
 
3.2
 %
Net income
 
5.6
 %
 
7.8
 %
 
5.9
 %
 
6.0
 %
 
7.2
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 19 -


Three Months Ended September 30, 2015 Compared to Three Months Ended September 30, 2014
 
Net Revenue

Net revenue increased $49 million, or 11%, primarily due to both the acquisition of new customers and incremental services rendered to existing customers. In particular, net revenue for the three months ended September 30, 2015 was favorably impacted by a large, multi-year agreement that began to materialize during the period.

Net revenue was negatively impacted by a stronger U.S. dollar relative to other foreign currencies in the three months ended September 30, 2015 compared to the three months ended September 30, 2014. Net revenue for the three months ended September 30, 2015 would have been approximately $10 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 $28 million, or 20%. Of this increase, $15 million was attributable to license expense, resulting from the combination of higher costs of $8 million and the impact of a $7 million benefit recorded in the prior year for a refund of sales tax paid on previous license purchases. The $8 million increase in expense reflected price increases from some of our largest vendors in addition to higher volume to support our growth. Employee-related expenses, including salaries, benefits and incentive compensation, increased $6 million, primarily driven by an 8% increase in average headcount to support business growth, partially offset by a decrease in non-equity incentive bonus expense due to a lower bonus payout percentage. Data center costs increased $5 million due to higher rent and maintenance. As a percentage of net revenue, cost of revenue increased 260 basis points, from 31.1% in the three months ended September 30, 2014 to 33.7% in the three months ended September 30, 2015. Higher license expense represented 230 basis points of the increase, including an impact of 150 basis points for the prior year sales tax refund that did not repeat in the current year period.

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 decreased $1 million, or 3%, primarily due to a $2 million decrease in employee-related expenses, such as salaries, benefits, and incentive compensation. Decreases in non-equity incentive bonus expense due to a lower payout bonus percentage and share-based compensation expense were partially offset by a decrease in costs capitalized for the development of software for internal use.

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 $1 million, or 2%, primarily attributable to employee-related expenses due to increased headcount.


- 20 -


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 $2 million, or 2%. Employee-related expenses increased $2 million mainly due to an increase in salaries and an 8% increase in headcount, partially offset by a decrease in non-equity incentive bonus expense due to a lower bonus payout percentage. Internal software support and maintenance expenses increased $1 million to support the growth of our business, while professional and consulting fees decreased $2 million. The prior year period was impacted by $3 million of expenses, primarily legal and other professional fees, incurred in connection with a formal evaluation by our board of directors of the Company's long-term strategic alternatives during the three months ended September 30, 2014, partially offset by a benefit from the reversal of a previously recorded sales and use tax accrual. As a percentage of net revenue, general and administrative expenses decreased 160 basis points, from 18.9% in the three months ended September 30, 2014 to 17.3% in the three months ended September 30, 2015. This decrease was primarily driven by a 70 basis point decrease in employee-related expenses, a 70 basis point decrease related to the expenses incurred for the formal evaluation in 2014 that did not repeat in the current year, and a 50 basis point decrease in professional and consulting fees.

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 $3 million, or 3%. 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. Partially offsetting the impact of these additions was a $4 million abandonment charge recorded in the prior year period related to an unimproved portion of our corporate headquarters building that we intend to demolish and redevelop. As a percentage of net revenue, depreciation and amortization expense decreased 150 basis points, from 21.4% in the three months ended September 30, 2014 to 19.9% in the three months ended September 30, 2015. The headquarters building abandonment charge represented 90 basis points of change between periods.

Other Income (Expense)

Other expense was $3.9 million and $2.6 million for the three months ended September 30, 2015 and 2014, respectively. This increase was primarily due to the recognition of interest expense on our finance lease obligations for build-to-suit leases.

Income Taxes

Our effective tax rate decreased from 32.0% for the three months ended September 30, 2014 to 30.6% for the three months ended September 30, 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 September 30, 2015 primarily due to the benefit of discrete items recorded during the period, largely related to the impact of the Altera Corp. v. Commissioner decision. This decision, issued on July 27, 2015 by the U.S. Tax Court, is related to the treatment of share-based compensation expense in an intercompany cost-sharing arrangement. Partially offsetting the benefit of discrete items recorded in the three months ended September 30, 2015 was the negative impact of a higher proportion of our profits earned in the U.S. compared to the three months ended September 30, 2014 and the federal R&D credit legislation that expired on December 31, 2014. Our U.S. earnings are generally taxed at higher rates than our foreign earnings.

Net Income

Net income increased $11 million, or 42%, 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 $0.26 in the three months ended September 30, 2015, an increase of $0.08 from the same period of 2014.

- 21 -



Nine Months Ended September 30, 2015 Compared to Nine Months Ended September 30, 2014

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

Consolidated Statements of Income:
 
 
Nine Months Ended
(In millions)
 
September 30,
2014
 
September 30,
2015
Net revenue
 
$
1,321.9

 
$
1,478.5

Costs and expenses:
 
 
 
 
Cost of revenue
 
428.4

 
496.4

Research and development
 
85.6

 
95.1

Sales and marketing
 
178.4

 
185.2

General and administrative
 
239.3

 
261.3

Depreciation and amortization
 
276.7

 
295.9

Total costs and expenses
 
1,208.4

 
1,333.9

Income from operations
 
113.5

 
144.6

Other income (expense):
 
 
 
 
Interest expense
 
(1.5
)
 
(5.1
)
Interest and other income (expense)
 
(1.7
)
 
(1.7
)
Total other income (expense)
 
(3.2
)
 
(6.8
)
Income before income taxes
 
110.3

 
137.8

Income taxes
 
36.7

 
43.7

Net income
 
$
73.6

 
$
94.1


 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Nine Months Ended
(Percent of net revenue)
 
September 30,
2014
 
September 30,
2015
Net revenue
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
Cost of revenue
 
32.4
 %
 
33.6
 %
Research and development
 
6.5
 %
 
6.4
 %
Sales and marketing
 
13.5
 %
 
12.5
 %
General and administrative
 
18.1
 %
 
17.7
 %
Depreciation and amortization
 
20.9
 %
 
20.0
 %
Total costs and expenses
 
91.4
 %
 
90.2
 %
Income from operations
 
8.6
 %
 
9.8
 %
Other income (expense):
 
 
 
 
Interest expense
 
(0.1
)%
 
(0.3
)%
Interest and other income (expense)
 
(0.1
)%
 
(0.1
)%
Total other income (expense)
 
(0.2
)%
 
(0.5
)%
Income before income taxes
 
8.3
 %
 
9.3
 %
Income taxes
 
2.8
 %
 
3.0
 %
Net income
 
5.6
 %
 
6.4
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 22 -


Net Revenue

Net revenue increased $157 million, or 12%, 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 nine months ended September 30, 2015 compared to the nine months ended September 30, 2014. Net revenue for the nine months ended September 30, 2015 would have been approximately $33 million higher had foreign exchange rates remained constant from the prior year.

Cost of Revenue

Cost of revenue increased $68 million, or 16%. Of this increase, $33 million was attributable to license expense, resulting from the combination of higher costs of $26 million and the impact of a $7 million benefit recorded in the prior year for a refund of sales tax paid on previous license purchases. The $26 million increase in expense reflected price increases from some of our largest vendors in addition to higher volume to support our growth. Employee-related expenses increased $21 million driven by a 7% increase in average headcount to support business growth, a 5% increase in average salaries, an increase in non-equity incentive bonus expense due to increasing headcount and a higher bonus payout percentage, partially offset by lower employee paid time off expense due to a modification of our paid time off benefit policy. Data center costs increased $10 million due to higher maintenance, rent and utilities expenses. As a percentage of net revenue, cost of revenue increased 120 basis points, from 32.4% in the nine months ended September 30, 2014 to 33.6% in the nine months ended September 30, 2015. This change was primarily driven by an increase of 150 basis points for higher license expense, of which 50 basis points related to the prior year sales tax refund that did not repeat, partially offset by a 30 basis point decrease for employee-related expenses.

Research and Development Expenses

Research and development expenses increased $10 million, or 11%, primarily due to increased employee-related expenses. Higher employee-related expenses reflect a decrease in costs capitalized for the development of software for internal use and $3 million of share-based compensation expense recorded during the nine months ended September 30, 2015 related to the acceleration of vesting of certain awards, partially offset by lower contract labor and lower employee paid time off expense due to a modification of our paid time off benefit policy.

Sales and Marketing Expenses

Sales and marketing expenses increased $7 million, or 4%. Higher employee-related expenses reflected increases in salaries, sales commissions and share-based compensation expense, partially offset by lower employee paid time off expense due to a modification of our paid time off benefit policy. Spending on marketing activities and advertising increased, and included nine Rackspace::Solve events held during the nine months ended September 30, 2015 compared to two similar events held during the same period of the prior year. As a percentage of net revenue, sales and marketing expenses decreased 100 basis points, from 13.5% in the nine months ended September 30, 2014 to 12.5% in the nine months ended September 30, 2015, primarily driven by a decrease of 60 basis points for employee-related expenses.

General and Administrative Expenses

General and administrative expenses increased $22 million, or 9%. Employee-related expenses increased $16 million, primarily due to a 7% increase in average headcount, higher share-based compensation expense resulting from certain executive forfeitures during the nine months ended September 30, 2014 that did not repeat in the current period, higher non-equity incentive bonus expense, and higher contract labor, partially offset by lower employee paid time off expense due to a modification of our paid time off benefit policy. Internal software support and maintenance expenses increased $5 million to support the growth of our business. Bad debt expense increased $3 million due to increases in write-offs and specific reserves during the nine months ended September 30, 2015. Offsetting these increases was $3 million of expenses, primarily legal and other professional fees, incurred in connection with a formal evaluation by our board of directors of our long-term strategic alternatives during the nine months ended September 30, 2014.


- 23 -


Depreciation and Amortization Expense

Depreciation and amortization expense increased $19 million, or 7%. 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. Partially offsetting the impact of these additions was a $4 million abandonment charge recorded in the prior year period related to an unimproved portion of our corporate headquarters building that we intend to demolish and redevelop. As a percentage of net revenue, depreciation and amortization expense decreased 90 basis points, from 20.9% in the nine months ended September 30, 2014 to 20.0% in the nine months ended September 30, 2015. The headquarters building abandonment charge represented 30 basis points of change between periods.

Other Income (Expense)

Other expense was $6.8 million and $3.2 million for the nine months ended September 30, 2015 and 2014, respectively. This increase was primarily due to the recognition of interest expense on our finance lease obligations for build-to-suit leases.

Income Taxes

Our effective tax rate decreased from 33.2% for the nine months ended September 30, 2014 to 31.7% for the nine months ended September 30, 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 nine months ended September 30, 2015 primarily due to the benefit of discrete items recorded during the period, largely related to the impact of the Altera Corp. v. Commissioner decision. This decision, issued on July 27, 2015 by the U.S. Tax Court, is related to the treatment of share-based compensation expense in an intercompany cost-sharing arrangement. Partially offsetting the benefit of discrete items recorded in the nine months ended September 30, 2015 was the negative impact of of a higher proportion of our profits earned in the U.S. compared to the nine months ended September 30, 2014. Our U.S. earnings are generally taxed at higher rates than our foreign earnings.

Net Income

Net income increased $21 million, or 28%, 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 $0.66 in the nine months ended September 30, 2015, an increase of $0.15 from the same period of 2014.

Liquidity and Capital Resources

We primarily finance our operations and capital expenditures with internally-generated cash from operations and, if necessary, borrowings under our 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 future ability to generate cash from operations will depend on our financial performance, general economic conditions, technology trends and developments, and other factors. We could 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), share repurchase plans, and our overall cost of capital. We have recently adopted a new capital structure policy under which we have established a target debt level of approximately 1.5X Adjusted EBITDA to be achieved over the next two years and maintained thereafter.

Cash and cash equivalents

At September 30, 2015, we held $189 million in cash and cash equivalents, of which $115 million is held by foreign entities. We consider the undistributed earnings of our foreign subsidiaries as of September 30, 2015 to be permanently reinvested and, accordingly, no U.S. income taxes have been provided thereon. We have not repatriated earnings to the U.S., and we do not anticipate the need to do so in the future as we believe sources of funds available in the U.S. are sufficient to meet our domestic liquidity needs arising in the ordinary course of business.


- 24 -


Capital and finance lease obligations

In prior years, we financed a portion of our purchases of data center equipment through capital leases with our major vendors. Although we have shifted our strategy in recent years and currently pay cash for our equipment purchases, we believe borrowings from vendor-financed arrangements will continue to be available if we choose this method of financing in the future. As of December 31, 2014 and September 30, 2015, we had $17 million and $4 million outstanding with respect to these arrangements, respectively.

Additionally, we have entered into multiple real estate development and build-to-suit lease arrangements with independent real estate developers to design, construct and finance certain real estate projects that result in finance lease obligations. As of December 31, 2014 and September 30, 2015, we had $117 million and $165 million outstanding with respect to these arrangements, respectively. See "Notes to the Unaudited Consolidated Financial Statements - Note 4. Build-to-Suit Leases" for more information on our finance lease obligations.

Revolving credit facility

We have a revolving credit facility with a total commitment of $200 million and an accordion feature, which allows for an increase in the commitment to a total of $400 million, subject to credit approval. During the first nine months of 2015, we fully repaid the $25 million balance that was outstanding as of December 31, 2014, and we borrowed an additional $140 million in order to partially fund our share repurchase program described below. As of September 30, 2015, this balance remained outstanding, and therefore we had $60 million available for future borrowings. As of September 30, 2015, we were in compliance with all of the covenants under our facility. Although our revolving credit facility matures in September 2016, we intend to replace our existing facility prior to maturity to ensure continued access to funding under a credit facility.

Share repurchase program

On November 6, 2014, our board of directors authorized a share repurchase program. 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 and paid $200 million to repurchase our common stock. We received an initial delivery of 3.3 million shares of common stock in November 2014, and we received an additional 0.9 million shares of common stock in May 2015 as final settlement of the ASR. All shares received were subsequently retired.

On August 5, 2015, our board of directors increased the authorization under the existing share repurchase program to a total of up to $1 billion, in addition to the $200 million already purchased under the ASR. The program will remain in effect for a period not to exceed 24 months from authorization.

During the three months ended September 30, 2015, we repurchased $250 million, or 8.2 million shares, of our common stock on the open market; these shares were subsequently retired. Therefore, as of September 30, 2015, approximately $750 million remained available for additional purchases under the current program. We intend to repurchase at least an additional $250 million of common stock within the next six months, subject to market conditions, cash needs to support our business, the terms of our debt agreements and arrangement of financing. We expect to fund our future share repurchases with proceeds from debt issuances and future free cash flow.
 
Cash Flows

The following table sets forth a summary of certain cash flow information for the periods indicated: 
 
 
Nine Months Ended September 30,
(In millions)
 
2014
 
2015
Cash provided by operating activities
 
$
391.6

 
$
379.6

Cash used in investing activities
 
$
(321.2
)
 
$
(336.5
)
Cash provided by (used in) financing activities
 
$
20.7

 
$
(65.5
)


- 25 -


Cash Provided by Operating Activities

Net cash provided by operating activities decreased $12 million, or 3%, from the first nine months of 2014 compared to the first nine months of 2015. Net income adjusted for non-cash items such as depreciation and amortization expense, share-based compensation expense, excess tax benefits from share-based compensation arrangements, and deferred income taxes increased $41 million between periods, reflecting our improved operating margins. This increase was more than offset by a $53 million decrease in cash provided by net changes in operating assets and liabilities, primarily driven by changes in accounts payable, accrued expenses and other current liabilities, accounts receivable and deferred revenue. Changes in accounts payable, accrued expenses and other current liabilities resulted in a net reduction of $48 million in cash inflows between periods, largely due to lower compensation accruals for bonuses and paid time off together with higher income tax payments. Cash outflows from accounts receivable increased $11 million between periods, as our accounts receivable balance increased mainly due to the growth in net revenue. Partially offsetting these changes is a $15 million increase in cash from deferred revenue, primarily due to prepayments from certain customers.

Cash Used in Investing Activities

Net cash used in investing activities increased $15 million, or 5%, from the first nine months of 2014 compared to the first nine months of 2015 primarily due to a $9 million increase in cash purchases of property and equipment.
 
Cash Provided by or Used in Financing Activities
 
Net cash provided by financing activities was $21 million during the first nine months of 2014 compared to net cash used in financing activities of $66 million during the first nine months of 2015, a change of $86 million. The largest driver of the change was $250 million paid for the repurchase of common stock in the first nine months of 2015, partially offset by $140 million borrowed under our revolving credit facility during this same period. In addition, during the first nine months of 2015 we repaid the $25 million balance that was outstanding on the credit facility at December 31, 2014. These outflows were partially offset by a decrease in principal payments of capital and build-to-suit leases and increases in proceeds from employee stock plans and excess tax benefits from share-based compensation arrangements. Further, the first nine months of 2014 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.

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.
 
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."


- 26 -


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)
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
Income from operations
 
$
40.5

 
$
50.0

 
$
44.4

 
$
43.7

 
$
56.5

Adjustment for build-to-suit lease impact (1)
 

 

 

 
(0.4
)
 
(1.1
)
Income from operations, adjusted
 
$
40.5

 
$
50.0

 
$
44.4

 
$
43.3

 
$
55.4

Effective tax rate
 
32.0
%
 
25.1
%
 
32.4
%
 
32.4
%
 
30.6
%
Net operating profit after tax (NOPAT)
 
$
27.5

 
$
37.5

 
$
30.0

 
$
29.3

 
$
38.4

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
25.7

 
$
37.0

 
$
28.4

 
$
29.2

 
$
36.5

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,724.5

 
$
1,624.3

 
$
1,692.3

 
$
1,832.6

 
$
1,753.8

Less: Excess cash (2)
 
(294.3
)
 
(156.8
)
 
(218.1
)
 
(258.4
)
 
(128.0
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(244.4
)
 
(215.8
)
 
(214.8
)
 
(256.4
)
 
(236.9
)
Less: Deferred revenue (current and non-current)
 
(21.5
)
 
(22.3
)
 
(26.1
)
 
(29.7
)
 
(31.8
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for build-to-suit leases (3)
 
(210.9
)
 
(270.8
)
 
(287.7
)
 
(299.3
)
 
(292.1
)
Capital base (3)
 
$
953.4

 
$
958.6

 
$
945.6

 
$
988.8

 
$
1,065.0

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,686.3

 
$
1,674.4

 
$
1,658.3

 
$
1,762.4

 
$
1,793.2

Average capital base (3)
 
$
935.8

 
$
956.0

 
$
952.1

 
$
967.2

 
$
1,027.0

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
6.1
%
 
8.8
%
 
6.9
%
 
6.6
%
 
8.1
%
Return on capital (annualized) (3)
 
11.8
%
 
15.7
%
 
12.6
%
 
12.1
%
 
15.0
%

(1)
Reflects additional expense we would have expected to record if our build-to-suit lease arrangements had been deemed operating leases instead of finance lease obligations for build-to-suit leases. Calculated as the excess of estimated straight-line rent expense over actual depreciation expense for completed real estate projects under build-to-suit lease arrangements.
(2)
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.
(3)
In the first quarter of 2015, we reclassified certain finance obligations associated with build-to-suit leases in the consolidated balance sheets. Prior period amounts have been revised to reflect the impact of this reclassification. See “Notes to the Unaudited Consolidated Financial Statements - Note 4. Build-to-Suit Leases” for further discussion.
    

- 27 -


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)
 
September 30,
2014
 
December 31,
2014
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
459.7

 
$
472.5

 
$
480.2

 
$
489.4

 
$
508.9

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
40.5

 
$
50.0

 
$
44.4

 
$
43.7

 
$
56.5

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
25.7

 
$
37.0

 
$
28.4

 
$
29.2

 
$
36.5

   Plus: Income taxes
 
12.2

 
12.3

 
13.6

 
14.0

 
16.1

   Plus: Total other (income) expense
 
2.6

 
0.7

 
2.4

 
0.5

 
3.9

   Plus: Depreciation and amortization
 
98.3

 
95.2

 
96.9

 
97.7

 
101.3

   Plus: Share-based compensation expense
 
19.8

 
20.2

 
20.0

 
20.4

 
19.6

Adjusted EBITDA
 
$
158.6

 
$
165.4

 
$
161.3

 
$
161.8

 
$
177.4

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
8.8
%
 
10.6
%
 
9.3
%
 
8.9
%
 
11.1
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
34.5
%
 
35.0
%
 
33.6
%
 
33.1
%
 
34.9
%

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
 
Nine Months Ended
(In millions)
September 30,
2014
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