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EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-311_033116.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-312_033116.htm
EX-10.1 - EMPLOYMENT AGREEMENT BETWEEN RACKSPACE US, INC. AND ALEX PINCHEV - RACKSPACE HOSTING, INC.raxex-101_033116.htm
EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-322_033116.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-321_033116.htm

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

 FORM 10-Q
(Mark one)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2016.
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from ______ to ______.
 
Commission file number 001-34143
RACKSPACE HOSTING, INC.
(Exact name of registrant as specified in its charter)

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

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

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   R    No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer R
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No R  
 
On May 5, 2016, 125,738,364 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:
 
 
 
 
 
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, 2015. 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 per share data)
 
December 31,
2015
 
March 31,
2016
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
484.7

 
$
534.2

Accounts receivable, net of allowance for doubtful accounts and customer credits of $7.3 as of December 31, 2015 and $8.1 as of March 31, 2016
 
174.4

 
170.9

Prepaid expenses
 
46.6

 
49.3

Other current assets
 
12.7

 
10.9

Total current assets
 
718.4

 
765.3

 
 
 
 
 
Property and equipment, net
 
1,148.0

 
1,115.2

Goodwill
 
81.1

 
80.4

Intangible assets, net
 
9.1

 
6.8

Other non-current assets
 
57.6

 
57.7

Total assets
 
$
2,014.2

 
$
2,025.4

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
136.3

 
$
145.1

Accrued compensation and benefits
 
57.3

 
58.2

Income and other taxes payable
 
12.0

 
9.7

Deferred revenue
 
29.6

 
27.5

Capital lease obligations
 
1.7

 
0.9

Total current liabilities
 
236.9

 
241.4

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Debt
 
492.4

 
492.6

Finance lease obligations for build-to-suit leases
 
164.3

 
161.5

Deferred income taxes
 
54.8

 
57.5

Deferred rent
 
49.5

 
49.5

Deferred revenue
 
1.6

 
1.5

Capital lease obligations
 
0.2

 
0.4

Other liabilities
 
46.4

 
45.1

Total liabilities
 
1,046.1

 
1,049.5

 
 
 
 
 
Commitments and Contingencies
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300.0 shares authorized; 130.9 shares issued and outstanding as of December 31, 2015; 128.1 shares issued and outstanding as of March 31, 2016
 
0.1

 
0.1

Additional paid-in capital
 
834.5

 
846.8

Accumulated other comprehensive loss
 
(36.2
)
 
(43.2
)
Retained earnings
 
169.7

 
172.2

Total stockholders’ equity
 
968.1

 
975.9

Total liabilities and stockholders’ equity
 
$
2,014.2

 
$
2,025.4


See accompanying notes to the unaudited consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended March 31,
(In millions, except per share data)
 
2015
 
2016
Net revenue
 
$
480.2

 
$
518.1

Costs and expenses:
 
 
 
 
Cost of revenue
 
162.8

 
180.4

Research and development
 
32.0

 
27.6

Sales and marketing
 
59.0

 
63.7

General and administrative
 
86.6

 
85.7

Depreciation and amortization
 
96.9

 
104.0

Total costs and expenses
 
437.3

 
461.4

Gain on sale
 

 
24.5

Income from operations
 
42.9

 
81.2

Other income (expense):
 
 
 
 
Interest expense
 
(0.4
)
 
(10.5
)
Interest and other income (expense)
 
(2.0
)
 
1.1

Total other income (expense)
 
(2.4
)
 
(9.4
)
Income before income taxes
 
40.5

 
71.8

Income taxes
 
13.0

 
23.0

Net income
 
$
27.5

 
$
48.8

 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
Foreign currency translation adjustments
 
$
(11.2
)
 
$
(7.0
)
Other comprehensive income (loss)
 
(11.2
)
 
(7.0
)
Comprehensive income
 
$
16.3

 
$
41.8

 
 
 
 
 
Net income per share
 
 
 
 
Basic
 
$
0.19

 
$
0.37

Diluted
 
$
0.19

 
$
0.37

 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
Basic
 
141.4

 
130.3

Diluted
 
144.2

 
131.0

 
See accompanying notes to the unaudited consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Three Months Ended March 31,
(In millions)
 
2015
 
2016
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
27.5

 
$
48.8

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
96.9

 
104.0

Deferred income taxes
 
(15.3
)
 
2.4

Share-based compensation expense
 
20.0

 
17.8

Excess tax benefits from share-based compensation arrangements
 
(20.2
)
 
(15.8
)
Gain on sale
 

 
(24.5
)
Other operating activities
 
2.8

 
4.0

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable
 
(1.8
)
 
(0.5
)
Prepaid expenses and other current assets
 
0.8

 
(1.0
)
Accounts payable, accrued expenses, and other current liabilities
 
26.9

 
20.8

Deferred revenue
 
4.3

 
(2.0
)
Deferred rent
 
0.4

 
(0.3
)
Other non-current assets and liabilities
 
3.0

 
2.5

Net cash provided by operating activities
 
145.3

 
156.2

Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(92.5
)
 
(82.9
)
Proceeds from sale
 

 
27.0

All other investing activities
 
0.7

 
(3.0
)
Net cash used in investing activities
 
(91.8
)
 
(58.9
)
Cash Flows From Financing Activities
 
 
 
 
Repayments of debt
 
(25.1
)
 

Payments for debt issuance costs
 

 
(0.4
)
Principal payments of capital and build-to-suit leases
 
(5.6
)
 
(0.8
)
Payments for deferred acquisition obligations
 
(0.1
)
 

Repurchase of common stock
 

 
(60.8
)
Shares of common stock withheld for employee taxes
 

 
(0.3
)
Proceeds from employee stock plans
 
21.8

 
0.2

Excess tax benefits from share-based compensation arrangements
 
20.2

 
15.8

Net cash provided by (used in) financing activities
 
11.2

 
(46.3
)
Effect of exchange rate changes on cash and cash equivalents
 
(2.5
)
 
(1.5
)
Increase in cash and cash equivalents
 
62.2

 
49.5

Cash and cash equivalents, beginning of period
 
213.5

 
484.7

Cash and cash equivalents, end of period
 
$
275.7

 
$
534.2

 
 
 
 
 
Supplemental Cash Flow Information
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
0.3

 
$
1.9

Cash payments for income taxes, net of refunds
 
$
3.8

 
$
3.6

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

 
$
0.2

Decrease in property and equipment in accounts payable and accrued expenses
 
(2.3
)
 
(4.3
)
Non-cash purchases of property and equipment
 
$
(2.3
)
 
$
(4.1
)
 
 
 
 
 
Accrual for repurchases of common stock not yet settled
 
$

 
$
6.8

Additional finance lease obligations for build-to-suit leases and other
 
$
35.1

 
$
1.0


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 managed cloud services in the business information technology ("IT") market. We serve our customers from our data centers on four continents. We help customers tap the power of cloud computing by delivering world-class service on the world's leading technology platforms. We are experts in IT, so our customers do not have to be.

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). The income tax expense allocated to foreign currency translation adjustments during the three months ended March 31, 2016 was $0.1 million. There were no income taxes allocated during the three months ended March 31, 2015.

Unaudited Interim Financial Information
 
The accompanying consolidated financial statements as of March 31, 2016, and for the three months ended March 31, 2015 and 2016, 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, 2015 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 26, 2016 (the "2015 Annual Consolidated Financial Statements"). The unaudited interim consolidated financial statements have been prepared on the same basis as the 2015 Annual Consolidated Financial Statements and, in the opinion of management, reflect all adjustments, which include normal recurring adjustments, necessary for a fair statement of our financial position as of March 31, 2016, our results of operations for the three months ended March 31, 2015 and 2016, and our cash flows for the three months ended March 31, 2015 and 2016.
 
The results of operations for the three months ended March 31, 2016 are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2016, or for any other interim period, or for any other future year.

Use of Estimates
 
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. 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 2015 Annual Consolidated Financial Statements include an additional discussion of the significant accounting policies and estimates used in the preparation of our consolidated financial statements. There were no material changes to our significant accounting policies and estimates during the three months ended March 31, 2016.

Revision to Prior Period Financial Statements

During the first quarter of 2016, we discovered an error in the reporting of certain software licenses for the period from July 2013 through December 2015, resulting in an immaterial understatement of license expense and the related liability for these periods. The cumulative decrease to December 31, 2015 retained earnings as a result of this error was $8.4 million, representing the understatement of license expense of $13.6 million, net of the related impact on income taxes of $5.2 million. We have evaluated the materiality of this error and determined that the impact is not material to our results of operations, financial position, or cash flows in previously issued financial statements. We have retrospectively revised our financial statements for all periods presented to reflect the correction of this error and the related income tax effect. The impact of this revision on the consolidated balance sheet as of December 31, 2015 and the consolidated statements of comprehensive income and cash flows for the three months ended March 31, 2015 is as follows:
 
 
As of December 31, 2015
(In millions)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Balance Sheet:
 
 
 
 
 
 
Deferred income taxes
 
$
60.0

 
$
(5.2
)
 
$
54.8

Other liabilities
 
32.8

 
13.6

 
46.4

Total liabilities
 
1,037.7

 
8.4

 
1,046.1

Retained earnings
 
178.1

 
(8.4
)
 
169.7

Total stockholders' equity
 
976.5

 
(8.4
)
 
968.1

 
 
Three Months Ended March 31, 2015
(In millions, except per share data)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Statement of Comprehensive Income:
 
 
 
 
 
 
Cost of revenue
 
$
161.3

 
$
1.5

 
$
162.8

Income from operations
 
44.4

 
(1.5
)
 
42.9

Income before income taxes
 
42.0

 
(1.5
)
 
40.5

Income taxes
 
13.6

 
(0.6
)
 
13.0

Net income
 
28.4

 
(0.9
)
 
27.5

Comprehensive income
 
17.2

 
(0.9
)
 
16.3

Net income per share
 
 
 
 
 
 
Basic
 
$
0.20

 
$
(0.01
)
 
$
0.19

Diluted
 
$
0.20

 
$
(0.01
)
 
$
0.19

 
 
Three Months Ended March 31, 2015
(In millions)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Statement of Cash Flows:
 
 
 
 
 
 
Net income
 
$
28.4

 
$
(0.9
)
 
$
27.5

Deferred income taxes
 
(14.7
)
 
(0.6
)
 
(15.3
)
Other non-current assets and liabilities
 
1.5

 
1.5

 
3.0



- 7 -


Recent Accounting Pronouncements Not Yet Adopted

In May 2014, the FASB issued a new standard on revenue recognition. The core principle of the new 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. In August 2015, the FASB issued guidance which deferred the effective date by one year. The standard is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period, with early adoption permitted for annual periods beginning after December 15, 2016. We intend to adopt the standard on January 1, 2018. 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 continuing to evaluate our method of adoption and the impact this new accounting standard will have on our consolidated financial statements.

In January 2016, the FASB issued a new standard on the recognition and measurement of financial assets and financial liabilities that requires entities to measure most equity investments, except those accounted for under the equity method, at fair value and recognize changes in fair value in net income. The standard will become effective for Rackspace on January 1, 2018 and will be applied using a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. We are currently evaluating the impact this new accounting standard will have on our consolidated financial statements.

In February 2016, the FASB issued a new standard on lease accounting that will require lessees to recognize all leases with a term greater than 12 months on the balance sheet, as a lease liability and right-of-use asset. Lease classification will determine whether a lease is reported as a financing transaction in the income statement and statement of cash flows. Additionally, the new standard substantially changes sale-leaseback accounting and replaces current build-to-suit lease accounting guidance. The standard will become effective for Rackspace on January 1, 2019, with early adoption permitted. We anticipate this standard will have a material impact on our consolidated balance sheets, and we are currently evaluating its impact.

In March 2016, the FASB issued guidance that simplifies several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This new guidance will become effective for Rackspace on January 1, 2017, with early adoption permitted. We are currently evaluating the early adoption option and the impact this guidance will have on our consolidated financial statements.


- 8 -


2. Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share: 
 
 
Three Months Ended March 31,
(In millions, except per share data)
 
2015
 
2016
Basic net income per share:
 
 
 
 
Net income
 
$
27.5

 
$
48.8

Weighted average shares outstanding:
 
 
 
 
Common stock
 
141.4

 
130.3

Number of shares used in per share computations
 
141.4

 
130.3

Net income per share
 
$
0.19

 
$
0.37

 
 
 
 
 
Diluted net income per share:
 
 
 
 
Net income
 
$
27.5

 
$
48.8

Weighted average shares outstanding:
 
 
 
 
Common stock
 
141.4

 
130.3

Stock options, awards and employee share purchase plans
 
2.8

 
0.7

Number of shares used in per share computations
 
144.2

 
131.0

Net income per share
 
$
0.19

 
$
0.37


We excluded 2.5 million and 7.6 million potential common shares from the computation of dilutive net income per share for the three months ended March 31, 2015 and 2016, respectively, because the effect would have been anti-dilutive.

3. Property and Equipment, net
 
Property and equipment, net, at December 31, 2015 and March 31, 2016 consisted of the following: 
(In millions)
 
December 31,
2015
 
March 31,
2016
Computers and equipment
 
$
1,787.2

 
$
1,797.6

Computer software
 
370.6

 
376.3

Furniture and fixtures
 
63.5

 
63.3

Buildings and leasehold improvements
 
355.7

 
350.0

Land
 
28.1

 
27.8

Property and equipment, at cost
 
2,605.1

 
2,615.0

Less: Accumulated depreciation and amortization
 
(1,539.7
)
 
(1,589.7
)
Work in process
 
82.6

 
89.9

Property and equipment, net
 
$
1,148.0

 
$
1,115.2


The composition of the work in process balance was as follows:
(In millions)
 
December 31,
2015
 
March 31,
2016
Office facility build outs
 
$
11.5

 
$
11.6

Data center build outs
 
49.0

 
50.7

Capitalized software
 
22.1

 
27.6

Work in process
 
$
82.6

 
$
89.9



- 9 -


4. Goodwill

As described in Note 12. Segment Information, beginning in the first quarter of 2016, we changed our presentation of segment information to reflect changes in the way our business is managed. This resulted in a change to our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach.

During the first quarter of 2016, we reduced goodwill by $0.7 million in connection with the sale of certain assets of a non-strategic product line as described in Note 11. Gain on Sale.

As of March 31, 2016, the balance of goodwill by operating segment was as follows:
(In millions)
 
March 31,
2016
Americas
 
$
58.1

International
 
22.3

Total goodwill
 
$
80.4


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" in the consolidated balance sheets, as of December 31, 2015 and March 31, 2016 was $11.6 million. We have determined that it is not practicable to estimate the fair value of these investments. If we identify events or changes in circumstances that may have a significant adverse effect on the fair value of these investments, we will then estimate their fair values and determine if any decline in the fair value of the investments below carrying value is other-than-temporary. No events or circumstances indicating a potential impairment were identified as of March 31, 2016.


- 10 -


6. Debt

Debt consisted of:
 
December 31, 2015
(In millions)
Revolving Credit Facility
 
Senior Notes due 2024
 
Total
Principal balance
$

 
$
500.0

 
$
500.0

Unamortized debt issuance costs

 
(7.6
)
 
(7.6
)
Total debt

 
492.4

 
492.4

Less: current portion of debt

 

 

Debt, excluding current portion
$

 
$
492.4

 
$
492.4


 
March 31, 2016
(In millions)
Revolving Credit Facility
 
Senior Notes due 2024
 
Total
Principal balance
$

 
$
500.0

 
$
500.0

Unamortized debt issuance costs

 
(7.4
)
 
(7.4
)
Total debt

 
492.6

 
492.6

Less: current portion of debt

 

 

Debt, excluding current portion
$

 
$
492.6

 
$
492.6


Revolving Credit Facility

We are party to a $200 million unsecured revolving credit facility (the "Revolving Credit Facility"). As of March 31, 2016, we had no outstanding borrowings under the Revolving Credit Facility and $0.4 million of undrawn letters of credit. As of the same date, we were in compliance with all of the covenants under this facility.

Senior Notes due 2024

As of March 31, 2016, the outstanding principal amount of the Senior Notes due 2024 (the "Senior Notes") was $500 million. The Senior Notes will mature on January 15, 2024 and bear interest at a rate of 6.5% per year, payable semi-annually on January 15 and July 15 of each year. The first interest payment date is July 15, 2016. As of March 31, 2016, we were in compliance with all covenants under the Senior Notes indenture.

The fair value of the Senior Notes as of March 31, 2016 was $490.0 million, based on quoted market prices for identical assets that are traded in over-the-counter secondary markets that are not considered active. The fair value of the Senior Notes is classified as Level 2 in the fair value hierarchy.

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 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.


- 11 -


8. Share-Based Compensation
 
Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended March 31,
(In millions)
 
2015
 
2016
Cost of revenue
 
$
4.0

 
$
4.1

Research and development
 
3.2

 
2.2

Sales and marketing
 
2.7

 
2.6

General and administrative
 
10.1

 
8.9

Pre-tax share-based compensation
 
20.0

 
17.8

Less: Income tax benefit
 
(6.5
)
 
(5.7
)
Total share-based compensation expense, net of tax
 
$
13.5

 
$
12.1


As of March 31, 2016, there was $166.7 million of unrecognized compensation cost, which will be recognized using the straight-line method over a weighted average period of 2.6 years.

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 2016 before consideration of excess tax benefits, and therefore we anticipate utilizing benefits of tax deductions related to share-based compensation in 2016. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the three months ended March 31, 2016.

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. 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 filed a notice of appeal to the Ninth Circuit of Appeals on February 19, 2016. Until a final decision has been reached, we will continue to monitor developments related to the regulation and the possible impact, if any, of those developments on the consolidated financial statements.

10. Share Repurchase Program

Our board of directors has authorized a share repurchase program under which shares may be repurchased from time to time through both open market and privately negotiated transactions.

During the three months ended March 31, 2016, we repurchased $68 million, or 3.2 million shares, of our common stock on the open market under our authorized share repurchase program; these shares were subsequently retired. Of these repurchases, $61 million had been settled as of March 31, 2016, and the remaining $7 million, representing 0.3 million shares, was recorded as a liability in "Accounts payable and accrued expenses" on the Consolidated Balance Sheet.

As of March 31, 2016, approximately $566 million of the amount authorized by the board under the current program remained available for additional purchases.

11. Gain on Sale

On January 5, 2016, we completed the sale of certain assets of a non-strategic product line, consisting primarily of intellectual property with an immaterial remaining net book value, for total consideration of $27.0 million. We recorded a pre-tax gain of $24.5 million on the sale of these assets, reported within “Gain on sale” in the consolidated statement of comprehensive income for the three months ended March 31, 2016.


- 12 -


12. Segment Information

Rackspace operates solely as a provider of managed cloud services in the business information technology market. Beginning in the first quarter of 2016, we have revised our reportable segments to present Americas and International. These reportable segments are the result of changes in our organization effective January 1, 2016 and represent the way we report both Net revenue and Income before income taxes, which are the primary financial measures our chief operating decision maker ("CODM") uses to manage our business, including the allocation of resources and performance assessment. In addition, they are inputs for measuring achievement in our non-equity incentive compensation plan and certain performance-vesting equity awards.

Revenue is attributed to each geographic segment based on the location of the Rackspace support team serving the customer. There are no internal revenue transactions between our segments. The Americas segment includes revenue from customers who are supported by Rackspace support teams located primarily in the U.S. and, to a lesser extent, in Latin America. The International segment includes revenue from customers who are supported by Rackspace support teams located in countries outside the U.S. and Latin America.

Direct costs, including employee-related costs of our customer support teams and data center employees, costs to lease and operate our data centers, and selling and marketing expenses are recorded by each segment. Certain expenses related to functions centrally managed by the Americas segment, such as research and development expenses, amortization of internally developed software, and many of our general and administrative expenses, are recorded by the Americas segment and are not allocated. In addition, the gain on the sale of certain assets of a non-strategic product line, as described in Note 11. Gain on Sale, has been reflected in the Americas segment in the three months ended March 31, 2016. Segment information for total assets and capital expenditures is not presented as this information is not used by our CODM in measuring segment performance or allocating resources between segments.

Information related to our segments is as follows:
 
 
Three Months Ended March 31,
(In millions)
 
2015
 
2016
Net Revenue:
 
 
 
 
Americas
 
$
349.2

 
$
383.6

International
 
131.0

 
134.5

Total net revenue
 
$
480.2

 
$
518.1

 
 
 
 
 
Income before income taxes:
 
 
 
 
Americas
 
$
5.1

 
$
40.9

International
 
35.4

 
30.9

Total income before income taxes
 
$
40.5

 
$
71.8

 
 
 
 
 
Depreciation and amortization:
 
 
 
 
Americas
 
$
76.9

 
$
79.2

International
 
20.0

 
24.8

Total depreciation and amortization
 
$
96.9

 
$
104.0



- 13 -


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, 2015.

The MD&A is organized as follows:
Overview - Discussion of the nature of our business and overall analysis of financial highlights and key metrics in order to provide context for the remainder of the MD&A.
Results of Operations - An analysis of our financial results comparing the three months ended March 31, 2016 and March 31, 2015.
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 our customers from 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.

We have two reportable segments: Americas and International. Revenue is attributed to each geographic segment based on the location of the Rackspace support team serving the customer. The Americas segment includes revenue from customers who are supported by Rackspace support teams located primarily in the U.S. and, to a lesser extent, in Latin America, and the International segment includes revenue from customers who are supported by Rackspace support teams located in countries outside the U.S. and Latin America.

Highlights from the first quarter of 2016 include:

Net revenue of $518 million on revenue growth of 7.9% from the first quarter of 2015

We purchased and retired $68 million of shares of our common stock through our authorized share repurchase program

We completed the sale of certain assets of a non-strategic product line for total consideration of $27 million, resulting in a pre-tax gain of $24.5 million.


- 14 -


Recent Developments

In April 2016 we announced a strategic relationship with Cloud Technology Partners ("CTP") to deliver professional and managed services for enterprises on the leading computing platforms, including AWS and Microsoft Azure. Many customers want the agility and cost efficiency of cloud but are slowed by a complex transformation. Together with CTP, we will provide a solution to help customers accelerate their realization of cloud benefits.

We also announced in April 2016 the launch of our OpenStack Everywhere offering that enables customers to run a fully managed OpenStack private cloud in their data center of choice, whether it's in their own, a third-party data center, a Rackspace-supported third-party colocation facility or a Rackspace data center. The offering will allow customers to run OpenStack private clouds without the high cost, risk and operational burden of doing it themselves and is backed by Fanatical Support.

Recently, we announced that we are working together with Google to co-develop an open server architecture design specification based on IBM's new POWER9 hardware for submission to Facebook's Open Compute project.

Revision of Prior Period Financial Statements

During the first quarter of 2016, we discovered an error in the reporting of certain software licenses for the period from July 2013 through December 2015, resulting in an immaterial understatement of license expense and the related liability for these periods. The cumulative decrease to December 31, 2015 retained earnings as a result of this error was $8.4 million, representing the understatement of license expense of $13.6 million, net of the related impact on income taxes of $5.2 million. We have evaluated the materiality of this error and determined that the impact is not material to our results of operations, financial position, or cash flows in previously issued financial statements. We have retrospectively revised our financial statements for all periods presented to reflect the correction of this error and the related income tax effect. Refer to Item 1 of Part I, "Financial Statements - Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies" for more information.

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 constant currency revenue growth, 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 constant currency revenue growth, 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.


- 15 -


Growth
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except average monthly revenue per server)
 
March 31, 2015
 
December 31, 2015
 
March 31, 2016
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
480.2

 
$
522.8

 
$
518.1

 
Revenue growth (year over year)
 
14.1
%
 
10.7
%
 
7.9
%
 
Constant currency revenue growth (year over year)
 
16.6
%
 
12.0
%
 
9.2
%
 
 
 
 
 
 
 
 
 
Number of servers deployed at period end
 
114,105

 
118,177

 
116,507

 
Average monthly revenue per server
 
$
1,412

 
$
1,472

 
$
1,472

 
 
 
 
 
 
 
 
 
Number of employees (Rackers) at period end
 
5,964

 
6,189

 
6,203


Total net revenue for the three months ended March 31, 2016 decreased $5 million, or 0.9%, from the three months ended December 31, 2015. Net revenue growth was negatively impacted by a stronger U.S. dollar relative to other foreign currencies on a sequential quarter basis, our sale of a non-strategic product line in January 2016 and seasonality in our business. Net revenue for the three months ended March 31, 2016 would have been approximately $6 million higher had foreign exchange rates remained constant from the three months ended December 31, 2015, resulting in a constant currency growth rate of 0.2%. In addition, our sale of certain assets of a non-strategic product line had a negative impact on revenue of $3 million. Our sequential quarter revenue growth was also affected by seasonality, as utility consumption typically rises in the fourth quarter before trending down in the first quarter and because larger enterprises slow their buying activities in the fourth quarter due to the holidays and corporate budget cycles, which impacts revenue growth in the first quarter.

On a year-over-year basis, net revenue grew $38 million, or 7.9%, during the three months ended March 31, 2016, which includes the negative impact of approximately $6 million due to changes in foreign exchange rates. On a constant currency basis, net revenue grew 9.2% during the three months ended March 31, 2016 compared to the same period of the prior year. The negative impact from our sale of certain assets of a non-strategic product line in January 2016 was $3 million.

We had a total of 116,507 servers deployed as of March 31, 2016, an increase of 2,402 servers from March 31, 2015 and a decrease of 1,670 servers from December 31, 2015. During the first quarter of 2016, we decommissioned approximately 1,600 servers in order to replace older and less efficient gear. The decommissioned equipment was fully depreciated and retired as of March 31, 2016.


- 16 -


Profitability
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except per share amounts)
 
March 31, 2015
 
December 31, 2015
 
March 31, 2016
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA
 
$
159.8

 
$
182.0

 
$
178.5

 
Adjusted EBITDA margin
 
33.3
%
 
34.8
%
 
34.5
%
 
 
 
 
 
 
 
 
 
Income from operations
 
$
42.9

 
$
59.9

 
$
81.2

 
Operating income margin
 
8.9
%
 
11.5
%
 
15.7
%
 
 
 
 
 
 
 
 
 
Net income
 
$
27.5

 
$
31.1

 
$
48.8

 
Net income margin
 
5.7
%
 
6.0
%
 
9.4
%
 
Diluted net income per share
 
$
0.19

 
$
0.23

 
$
0.37


On a sequential quarter basis, Adjusted EBITDA margin declined 30 basis points to 34.5% for the three months ended March 31, 2016 compared to 34.8% for the three months ended December 31, 2015, reflecting the decrease in net revenue while expenses remained flat. Our income from operations margin and net income margin were positively impacted by 470 basis points and 320 basis points, respectively, from the gain on sale of certain assets of a non-strategic product line during the first quarter of 2016. In addition, net income margin was also positively impacted by a decrease in our effective tax rate to 32.1% for the three months ended March 31, 2016 from 42.6% in the three months ended December 31, 2015. The higher rate for the three months ended December 31, 2015 reflected the impact of an increase to our full year 2015 effective tax rate driven by the geographical distribution of taxable income.

On a year-over-year basis, Adjusted EBITDA margin increased to 34.5% in the three months ended March 31, 2016 from 33.3% in the same period of 2015, as revenue growth of 7.9% outpaced growth in expenses. Operating income margin improved to 15.7% from 8.9% and net income margin increased to 9.4% from 5.7%, primarily due to the positive impact from the gain on sale of 470 basis points on operating income margin and 320 basis points on net income margin.


- 17 -


Capital Efficiency, Infrastructure Capacity and Utilization
 
 
 
Three Months Ended
 
(Dollar amounts in millions)
 
March 31, 2015
 
December 31, 2015
 
March 31, 2016
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
 
 
 
 
 
 
Customer gear
 
$
58.7

 
$
61.8

 
$
46.2

 
Data center build outs
 
$
13.4

 
$
10.6

 
$
13.1

 
Office build outs
 
$
2.3

 
$
7.8

 
$
0.3

 
Capitalized software and other projects
 
$
15.8

 
$
16.3

 
$
19.2

 
Total capital expenditures
 
$
90.2

 
$
96.5

 
$
78.8

 
 
 
 
 
 
 
 
 
Capital efficiency and returns
 
 
 
 
 
 
 
Average capital base
 
$
947.0

 
$
1,052.8

 
$
1,026.6

 
Capital turnover (annualized)
 
2.03

 
1.99

 
2.02

 
Return on capital (annualized)
 
12.3
%
 
12.6
%
 
14.4
%
 
 
 
 
 
 
 
 
 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
Megawatts under contract at period end (1)
 
63.2

 
62.2

 
62.2

 
Megawatts available for customer use at period end (2)
 
52.0

 
54.4

 
56.0

 
Megawatts utilized at period end
 
31.0

 
32.2

 
32.1

 
Annualized net revenue per average Megawatt of power utilized
 
$
62.5

 
$
64.5

 
$
64.5


(1)
Megawatts under contract at period end represents data center capacity for which we have a contract enabling us to take control of the space.
(2)
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.

Capital expenditures in the three months ended March 31, 2016 were lower than historical periods primarily due to the timing of purchases of customer gear and further improvements in purchase prices and asset utilization. We expect capital expenditures to increase in the remaining quarters of 2016. On a sequential quarter basis, Return on Capital ("ROC") increased from 12.6% for the three months ended December 31, 2015 to 14.4% for the three months ended March 31, 2016. The increase is primarily due to the positive impact of a lower effective tax rate of 32.1% for the first three months of 2016 compared to 42.6% for the last three months of 2015.

On a year-over-year basis, ROC increased from 12.3% to 14.4%, primarily due to the increase in income from operations between periods, partially offset by an 8% increase in our average capital base. Our capital turnover for the three months ended March 31, 2016 of 2.02 decreased slightly from 2.03 for the same period of 2015.


- 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)
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
 
December 31,
2015
 
March 31,
2016
Net revenue
 
$
480.2

 
$
489.4

 
$
508.9

 
$
522.8

 
$
518.1

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
162.8

 
165.4

 
172.7

 
180.7

 
180.4

Research and development
 
32.0

 
33.2

 
29.9

 
29.8

 
27.6

Sales and marketing
 
59.0

 
64.4

 
61.8

 
58.3

 
63.7

General and administrative
 
86.6

 
86.5

 
88.2

 
90.1

 
85.7

Depreciation and amortization
 
96.9

 
97.7

 
101.3

 
104.0

 
104.0

Total costs and expenses
 
437.3

 
447.2

 
453.9

 
462.9

 
461.4

Gain on sale
 

 

 

 

 
24.5

Income from operations
 
42.9

 
42.2

 
55.0

 
59.9

 
81.2

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.4
)
 
(1.9
)
 
(2.8
)
 
(6.2
)
 
(10.5
)
Interest and other income (expense)
 
(2.0
)
 
1.4

 
(1.1
)
 
0.5

 
1.1

Total other income (expense)
 
(2.4
)
 
(0.5
)
 
(3.9
)
 
(5.7
)
 
(9.4
)
Income before income taxes
 
40.5

 
41.7

 
51.1

 
54.2

 
71.8

Income taxes
 
13.0

 
13.4

 
15.6

 
23.1

 
23.0

Net income
 
$
27.5

 
$
28.3

 
$
35.5

 
$
31.1

 
$
48.8

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Three Months Ended
(Percent of net revenue)
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
 
December 31,
2015
 
March 31,
2016
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
33.9
 %
 
33.8
 %
 
34.0
 %
 
34.6
 %
 
34.8
 %
Research and development
 
6.7
 %
 
6.8
 %
 
5.9
 %
 
5.7
 %
 
5.3
 %
Sales and marketing
 
12.3
 %
 
13.2
 %
 
12.1
 %
 
11.2
 %
 
12.3
 %
General and administrative
 
18.0
 %
 
17.7
 %
 
17.3
 %
 
17.2
 %
 
16.6
 %
Depreciation and amortization
 
20.2
 %
 
20.0
 %
 
19.9
 %
 
19.9
 %
 
20.1
 %
Total costs and expenses
 
91.1
 %
 
91.4
 %
 
89.2
 %
 
88.5
 %
 
89.1
 %
Gain on sale
 
 %
 
 %
 
 %
 
 %
 
4.7
 %
Income from operations
 
8.9
 %
 
8.6
 %
 
10.8
 %
 
11.5
 %
 
15.7
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.1
)%
 
(0.4
)%
 
(0.5
)%
 
(1.2
)%
 
(2.0
)%
Interest and other income (expense)
 
(0.4
)%
 
0.3
 %
 
(0.2
)%
 
0.1
 %
 
0.2
 %
Total other income (expense)
 
(0.5
)%
 
(0.1
)%
 
(0.8
)%
 
(1.1
)%
 
(1.8
)%
Income before income taxes
 
8.5
 %
 
8.5
 %
 
10.0
 %
 
10.4
 %
 
13.9
 %
Income taxes
 
2.7
 %
 
2.7
 %
 
3.1
 %
 
4.4
 %
 
4.4
 %
Net income
 
5.7
 %
 
5.8
 %
 
7.0
 %
 
6.0
 %
 
9.4
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 19 -


Three Months Ended March 31, 2016 Compared to Three Months Ended March 31, 2015
 
Net Revenue

Net revenue increased $38 million, or 8%, 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 the functional currencies of our foreign operations and our sale of a non-strategic product line in the three months ended March 31, 2016 compared to the three months ended March 31, 2015. Net revenue for the three months ended March 31, 2016 would have been approximately $6 million higher had foreign exchange rates remained constant from the prior year. In addition, the sale of a non-strategic product line had a negative impact of $3 million.

Net revenue for the Americas segment increased $34 million, or 10%, to $384 million for the three months ended March 31, 2016 compared to $349 million for the three months ended March 31, 2015. Net revenue for the International segment increased $4 million, or 3%, to $135 million from $131 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015.

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 $18 million, or 11%. Of this increase, $11 million was attributable to employee-related expenses, including salaries, benefits, and incentive compensation, driven by an 9% increase in average headcount to support business growth, higher average salaries, and an increase in employee paid time off expense due to a modification of our paid time off benefit policy in 2015. These increases were partially offset by a decrease in non-equity incentive bonus expense due to a lower bonus payout percentage. License costs increased $3 million, reflecting higher volume to support our growth. Data center costs increased $1 million due to higher maintenance expense, partially offset by a decrease in rent and electricity due in part to the consolidation of our London data centers into our new, more efficient facility, which opened in 2015. As a percentage of net revenue, cost of revenue increased 90 basis points, from 33.9% in the three months ended March 31, 2015 to 34.8% in the three months ended March 31, 2016 due to higher employee-related expenses.

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 $4 million, or 14%, primarily due to a decrease in employee-related expenses driven by a 13% decrease in average headcount, lower non-equity incentive bonus expense due to a lower bonus payout percentage, and lower share-based compensation expense, partially offset by an increase in employee paid time off expense due to a modification of our paid time off benefit policy in 2015.

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 $5 million, or 8%, primarily due to an increase in employee-related expenses driven by higher average salaries and an increase in employee paid time off expense due to a modification of our paid time off benefit policy in 2015.


- 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 decreased $1 million, or 1%. Employee-related expenses were flat as a 7% increase in average headcount and an increase in employee paid time off expense were offset by an increase in salaries capitalized for the development of software for internal use and a decrease in non-equity incentive bonus expense due to a lower bonus payout percentage. As a percentage of net revenue, general and administrative expenses decreased 140 basis points, from 18.0% in the three months ended March 31, 2015 to 16.6% in the three months ended March 31, 2016. This decrease was primarily driven by an 80 basis point decrease in employee-related expenses and a 30 basis point decrease in professional and consulting fees.

Depreciation and Amortization Expense

Depreciation and amortization expense includes depreciation of our data center equipment, leasehold improvements and infrastructure, and 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 $7 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. As a percentage of net revenue, depreciation and amortization expense decreased 10 basis points, from 20.2% in the three months ended March 31, 2015 to 20.1% in the three months ended March 31, 2016.

Gain on Sale

On January 5, 2016, we completed the sale of assets, consisting primarily of intellectual property with an immaterial remaining net book value, of a non-strategic product line. This resulted in a pre-tax gain of $24.5 million. See "Notes to the Unaudited Consolidated Financial Statements - Note 11. Gain on Sale" for more information on this transaction.

Other Income (Expense)

Other expense was $9 million and $2 million for the three months ended March 31, 2016 and 2015, respectively. The $7 million increase was primarily due to interest expense on our Senior Notes issued in November 2015.

Income before income taxes

Income before income taxes increased $31 million, or 77%. Income before income taxes for the Americas segment increased $36 million to $41 million for the three months ended March 31, 2016 compared to $5 million for the same period of 2015, driven by the $24.5 million gain on sale as described above. Income before income taxes for the International segment decreased $5 million, to $31 million from $35 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015.

Income Taxes

Our effective tax rate decreased from 32.2% for the three months ended March 31, 2015 to 32.1% for the three months ended March 31, 2016. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, tax credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. Our U.S. earnings are generally taxed at higher rates than our foreign earnings.

Net Income

Net income increased $21 million, or 77%, driven by higher net revenue and the gain from our sale of a non-strategic product line, partially offset by higher expenses to support our growth. Net income per diluted share was $0.37 in the three months ended March 31, 2016, an increase of $0.18 from the same period of 2015.


- 21 -


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 existing cash on hand together with 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. As of March 31, 2016, our target debt level under our capital structure policy is 0.75X Adjusted EBITDA for the most recent four quarters.

At March 31, 2016, we held $534 million in cash and cash equivalents, of which $155 million is held by foreign entities. We consider the undistributed earnings of our foreign subsidiaries as of March 31, 2016 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.

We have a revolving credit facility with a total commitment of $200 million and the option to increase this amount by up to an additional $200 million, subject to certain terms and conditions. As of March 31, 2016, we had no outstanding borrowings under the revolving credit facility and $0.4 million of undrawn letters of credit, and we were in compliance with all of the covenants under the facility.

We also have $500 million aggregate principal amount of Senior Notes outstanding. The Senior Notes will mature on January 15, 2024 and bear interest at a rate of 6.5% per year, with the first semi-annual interest payment due on July 15, 2016. As of March 31, 2016, we were in compliance with all covenants under the Senior Notes indenture.

Our board of directors has authorized a share repurchase program under which shares may be repurchased from time to time through both open market and privately negotiated transactions. During the three months ended March 31, 2016, we repurchased $68 million, or 3.2 million shares, of our common stock on the open market under this program; these shares were subsequently retired. Of these repurchases, $61 million had been settled as of March 31, 2016, and the remaining $7 million was recorded as a liability in "Accounts payable and accrued expenses" on the Consolidated Balance Sheet. As of March 31, 2016, approximately $566 million of the amount authorized by the board under the current program remained available for additional purchases.


- 22 -


Cash Flows

The following table sets forth a summary of certain cash flow information for the periods indicated: 
 
 
Three Months Ended March 31,
(In millions)
 
2015
 
2016
Cash provided by operating activities
 
$
145.3

 
$
156.2

Cash used in investing activities
 
$
(91.8
)
 
$
(58.9
)
Cash provided by (used in) financing activities
 
$
11.2

 
$
(46.3
)

Cash Provided by Operating Activities

Net cash provided by operating activities increased $11 million, or 8%, from the first three months of 2015 compared to the first three months of 2016. This was driven by a $25 million increase in net income adjusted for non-cash and non-operating items such as depreciation and amortization expense, deferred income taxes, share-based compensation expense, excess tax benefits from share-based compensation arrangements, and the gain on sale of certain assets of a non-strategic product line. This increase was partially offset by a $14 million decrease in cash provided by net changes in operating assets and liabilities. The change in accounts payable, accrued expenses and other current liabilities resulted in a $6 million decrease in operating cash flow, driven by the timing of payments to vendors, partially offset by interest accrued on our Senior Notes. The change in deferred revenue also resulted in a $6 million decrease in operating cash flow as we received a larger amount of advance payments during the first three months of 2015 than we did during the first three months of 2016.

Cash Used in Investing Activities

Net cash used in investing activities decreased $33 million, or 36%, from the first three months of 2015 compared to the first three months of 2016 largely driven by $27 million of proceeds received in 2016 from the sale of certain assets of a non-strategic product line. Additionally, there was a $10 million decrease in cash purchases of property and equipment, primarily due to the timing of customer gear purchases.
 
Cash Provided by or Used in Financing Activities
 
Net cash used in financing activities was $46 million during the first three months of 2016 compared to net cash provided by financing activities of $11 million during the first three months of 2015, a change of $58 million. The largest driver of this change was a cash outflow of $61 million during the first three months of 2016 for the repurchase of common stock under our share repurchase program. Additionally, proceeds from employee stock plans were $22 million lower during the first three months of 2016 compared to the first three months of 2015. The impact of these drivers was partially offset by the repayment of $25 million on our previous credit facility during the first three months of 2015.

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 February 26, 2016 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 Item 1 of Part I, "Financial Statements - Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies."


- 23 -


Supplemental Information

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

 
 
Three Months Ended
(In millions)
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
 
December 31,
2015
 
March 31,
2016
Income from operations
 
$
42.9

 
$
42.2

 
$
55.0

 
$
59.9

 
$
81.2

Adjustment for gain on sale
 

 

 

 

 
(24.5
)
Adjustment for build-to-suit lease impact (1)
 

 
(0.4
)
 
(1.1
)
 
(2.3
)
 
(2.2
)
Income from operations, adjusted
 
$
42.9

 
$
41.8

 
$
53.9

 
$
57.6

 
$
54.5

Effective tax rate
 
32.2
%
 
32.2
%
 
30.4
%
 
42.6
%
 
32.1
%
Net operating profit after tax (NOPAT)
 
$
29.1

 
$
28.4

 
$
37.5

 
$
33.1

 
$
37.0

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
27.5

 
$
28.3

 
$
35.5

 
$
31.1

 
$
48.8

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,685.4

 
$
1,826.6

 
$
1,749.2

 
$
2,014.2

 
$
2,025.4

Add: Unamortized debt issuance costs (2)
 

 

 

 
7.6

 
7.4

Less: Excess cash (3)
 
(218.1
)
 
(258.4
)
 
(128.0
)
 
(422.0
)
 
(472.0
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(214.8
)
 
(256.4
)
 
(236.9
)
 
(205.6
)
 
(213.0
)
Less: Deferred revenue (current and non-current)
 
(26.1
)
 
(29.7
)
 
(31.8
)
 
(31.2
)
 
(29.0
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for build-to-suit leases
 
(286.3
)
 
(299.7
)
 
(294.9
)
 
(315.0
)
 
(313.6
)
Capital base
 
$
940.1

 
$
982.4

 
$
1,057.6

 
$
1,048.0

 
$
1,005.2

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,650.7

 
$
1,756.0

 
$
1,787.9

 
$
1,881.7

 
$
2,019.8

Average capital base
 
$
947.0

 
$
961.2

 
$
1,020.0

 
$
1,052.8

 
$
1,026.6

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
6.7
%
 
6.4
%
 
8.0
%
 
6.6
%
 
9.7
%
Return on capital (annualized)
 
12.3
%
 
11.8
%
 
14.7
%
 
12.6
%
 
14.4
%

(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)
Amount recorded as a direct deduction from the carrying value of the long-term debt liability in the consolidated balance sheets.
(3)
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.


- 24 -


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, non-cash charges for share-based compensation, and gain on sale. The following table presents a reconciliation of Adjusted EBITDA to net income.

 
 
Three Months Ended
(In millions)
 
March 31,
2015
 
June 30,
2015
 
September 30,
2015
 
December 31,
2015
 
March 31,
2016
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
480.2

 
$
489.4

 
$
508.9

 
$
522.8

 
$
518.1

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
42.9

 
$
42.2

 
$
55.0

 
$
59.9

 
$
81.2

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
27.5

 
$
28.3

 
$
35.5

 
$
31.1

 
$
48.8

   Plus: Income taxes
 
13.0

 
13.4

 
15.6

 
23.1

 
23.0

   Plus: Total other (income) expense
 
2.4

 
0.5

 
3.9

 
5.7

 
9.4

   Plus: Depreciation and amortization
 
96.9

 
97.7

 
101.3

 
104.0

 
104.0

   Plus: Share-based compensation expense
 
20.0

 
20.4

 
19.6

 
18.1

 
17.8

Less: Gain on sale
 

 

 

 

 
(24.5
)
Adjusted EBITDA
 
$
159.8

 
$
160.3

 
$
175.9

 
$
182.0

 
$
178.5

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
8.9
%
 
8.6
%
 
10.8
%
 
11.5
%
 
15.7
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
33.3
%
 
32.8
%
 
34.6
%
 
34.8
%
 
34.5
%


- 25 -


Constant currency revenue growth

We use constant currency revenue growth as an additional metric for understanding and assessing our growth excluding the effect of foreign currency rate fluctuations on our international business operations. We also believe this is an important metric to help investors evaluate our performance in comparison to prior periods. The information presented is calculated by translating current period results using the average exchange rate from the comparative period rather than the actual exchange rates in effect during the respective period. The following table presents a reconciliation of constant currency revenue growth.
 
 
Three Months Ended
(In millions)
 
Net Revenue
 
Foreign Currency Translation
 
Net Revenue in Constant Currency
March 31, 2016
 
$
518.1

 
$
5.7

 
$
523.8

December 31, 2015
 
522.8

 

 
522.8

Dollar change
 
$
(4.7
)
 
 
 
$
1.0

Percent change
 
(0.9
)%
 
 
 
0.2
%
 
 
 
 
 
 
 
March 31, 2016
 
$
518.1

 
$
6.4

 
$
524.5

March 31, 2015
 
480.2

 

 
480.2

Dollar change
 
$
37.9

 
 
 
$
44.3

Percent change
 
7.9
 %
 
 
 
9.2
%
 
 
 
 
 
 
 
December 31, 2015
 
$
522.8

 
$
6.3

 
$
529.1

December 31, 2014
 
472.5

 

 
472.5

Dollar change
 
$
50.3

 
 
 
$
56.6

Percent change
 
10.7
 %
 
 
 
12.0
%
 
 
 
 
 
 
 
March 31, 2015
 
$
480.2

 
$
10.9

 
$
491.1

March 31, 2014
 
421.0

 

 
421.0

Dollar change
 
$
59.2

 
 
 
$
70.1

Percent change
 
14.1
 %
 
 
 
16.6
%

Adjusted Free Cash Flow
 
We believe that Adjusted Free Cash Flow is a performance metric used by investors to evaluate the strength and performance of a company's ongoing business. We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditure