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EX-32.2 - SECTION 906 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-322_093016.htm
EX-32.1 - SECTION 906 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-321_093016.htm
EX-31.2 - SECTION 302 CERTIFICATION OF CFO - RACKSPACE HOSTING, INC.raxex-312_093016.htm
EX-31.1 - SECTION 302 CERTIFICATION OF CEO - RACKSPACE HOSTING, INC.raxex-311_093016.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, 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)

 rackspacelogoclra05a01a05.jpg
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 4, 2016, 100 shares of the registrant’s Common Stock, $0.01 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,” “predicts,” “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/A 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
 
September 30,
2016
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
484.7

 
$
632.1

Accounts receivable, net of allowance for doubtful accounts and customer credits of $7.3 as of December 31, 2015 and $6.2 as of September 30, 2016
 
174.4

 
166.0

Prepaid expenses
 
46.6

 
49.0

Other current assets
 
12.7

 
17.2

Total current assets
 
718.4

 
864.3

 
 
 
 
 
Property and equipment, net
 
1,148.0

 
1,031.7

Goodwill
 
81.1

 
80.2

Intangible assets, net
 
9.1

 
3.6

Other non-current assets
 
57.6

 
68.3

Total assets
 
$
2,014.2

 
$
2,048.1

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

 
$
139.7

Accrued compensation and benefits
 
57.3

 
34.4

Income and other taxes payable
 
12.0

 
7.1

Deferred revenue
 
29.6

 
43.2

Capital lease obligations
 
1.7

 
0.3

Total current liabilities
 
236.9

 
224.7

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Debt
 
492.4

 
493.1

Finance lease obligations for build-to-suit leases
 
164.3

 
150.9

Deferred income taxes
 
54.8

 
64.9

Deferred rent
 
49.5

 
49.4

Deferred revenue
 
1.6

 
8.3

Capital lease obligations
 
0.2

 
0.3

Other liabilities
 
46.4

 
49.1

Total liabilities
 
1,046.1

 
1,040.7

 
 
 
 
 
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; 126.4 shares issued and outstanding as of September 30, 2016
 
0.1

 
0.1

Additional paid-in capital
 
834.5

 
877.8

Accumulated other comprehensive loss
 
(36.2
)
 
(68.9
)
Retained earnings
 
169.7

 
198.4

Total stockholders’ equity
 
968.1

 
1,007.4

Total liabilities and stockholders’ equity
 
$
2,014.2

 
$
2,048.1


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)
 
2015
 
2016
 
2015
 
2016
Net revenue
 
$
508.9

 
$
516.2

 
$
1,478.5

 
$
1,557.9

Costs and expenses:
 
 
 
 
 
 
 
 
Cost of revenue
 
172.7

 
183.9

 
500.9

 
535.8

Research and development
 
29.9

 
24.5

 
95.1

 
79.0

Sales and marketing
 
61.8

 
63.3

 
185.2

 
190.8

General and administrative
 
88.2

 
85.9

 
261.3

 
264.1

Depreciation and amortization
 
101.3

 
100.9

 
295.9

 
309.5

Total costs and expenses
 
453.9

 
458.5

 
1,338.4

 
1,379.2

Gain on sale
 

 
12.5

 

 
37.0

Income from operations
 
55.0

 
70.2

 
140.1

 
215.7

Other income (expense):
 
 
 
 
 
 
 
 
Interest expense
 
(2.8
)
 
(10.0
)
 
(5.1
)
 
(30.8
)
Interest and other income (expense)
 
(1.1
)
 
(0.2
)
 
(1.7
)
 
1.3

Total other income (expense)
 
(3.9
)
 
(10.2
)
 
(6.8
)
 
(29.5
)
Income before income taxes
 
51.1

 
60.0

 
133.3

 
186.2

Income taxes
 
15.6

 
21.4

 
42.0

 
63.0

Net income
 
$
35.5

 
$
38.6

 
$
91.3

 
$
123.2

 
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
$
(10.2
)
 
$
(6.1
)
 
$
(9.0
)
 
$
(32.7
)
Other comprehensive loss
 
(10.2
)
 
(6.1
)
 
(9.0
)
 
(32.7
)
Comprehensive income
 
$
25.3

 
$
32.5

 
$
82.3

 
$
90.5

 
 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
 
Basic
 
$
0.26

 
$
0.31

 
$
0.65

 
$
0.97

Diluted
 
$
0.25

 
$
0.30

 
$
0.64

 
$
0.96

 
 
 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
 
 
Basic
 
139.0

 
126.1

 
140.9

 
127.5

Diluted
 
140.6

 
127.8

 
143.3

 
128.6

 
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)
 
2015
 
2016
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
91.3

 
$
123.2

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
295.9

 
309.5

Deferred income taxes
 
(35.8
)
 
9.2

Share-based compensation expense
 
60.0

 
53.9

Excess tax benefits from share-based compensation arrangements
 
(51.5
)
 
(34.2
)
Gain on sale
 

 
(37.0
)
Other operating activities
 
7.1

 
8.1

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable
 
(26.3
)
 
(2.7
)
Prepaid expenses and other current assets
 
(25.1
)
 
(4.1
)
Accounts payable, accrued expenses, and other current liabilities
 
45.7

 
15.6

Deferred revenue
 
9.5

 
21.1

Deferred rent
 

 
(0.7
)
Other non-current assets and liabilities
 
8.8

 
8.0

Net cash provided by operating activities
 
379.6

 
469.9

Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(331.9
)
 
(235.3
)
Proceeds from sale
 

 
35.3

Other investing activities
 
(4.6
)
 
(13.7
)
Net cash used in investing activities
 
(336.5
)
 
(213.7
)
Cash Flows From Financing Activities
 
 
 
 
Proceeds from debt
 
140.0

 

Repayments of debt
 
(25.1
)
 

Payments for debt issuance costs
 

 
(0.4
)
Proceeds from finance lease obligations for build-to-suit leases
 
2.5

 

Principal payments of capital and build-to-suit leases
 
(13.3
)
 
(1.6
)
Payments for deferred acquisition obligations
 
(0.2
)
 

Repurchase of common stock
 
(250.1
)
 
(133.2
)
Shares of common stock withheld for employee taxes
 

 
(1.3
)
Proceeds from employee stock plans
 
29.2

 
3.9

Excess tax benefits from share-based compensation arrangements
 
51.5

 
34.2

Net cash used in financing activities
 
(65.5
)
 
(98.4
)
Effect of exchange rate changes on cash and cash equivalents
 
(2.1
)
 
(10.4
)
Increase (decrease) in cash and cash equivalents
 
(24.5
)
 
147.4

Cash and cash equivalents, beginning of period
 
213.5

 
484.7

Cash and cash equivalents, end of period
 
$
189.0

 
$
632.1

 
 
 
 
 
Supplemental Cash Flow Information
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
2.2

 
$
27.1

Cash payments for income taxes, net of refunds
 
$
17.0

 
$
15.8

 
 
 
 
 
Non-cash Investing and Financing Activities
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
0.4

 
$
0.2

Increase (decrease) in property and equipment in accounts payable and accrued expenses
 
37.2

 
(8.4
)
Non-cash purchases of property and equipment
 
$
37.6

 
$
(8.2
)
 
 
 
 
 
Additional finance lease obligations for build-to-suit leases and other
 
$
48.6

 
$
6.3


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, Subsequent Events, 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. Our operations began in 1998 as a limited partnership, and Rackspace Hosting, Inc. was incorporated in Delaware in March 2000. We are a provider of managed cloud services in the business information technology ("IT") market and 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 some of the world's leading technology platforms. We are experts in IT, so our customers do not have to be.

Subsequent Events

On November 3, 2016 (the “Closing Date”), Rackspace was acquired by an entity controlled by funds affiliated with or controlled by Apollo Global Management, LLC and its subsidiaries ("Apollo"). Pursuant to the Agreement and Plan of Merger (the "Merger Agreement"), dated as of August 26, 2016, on the Closing Date, Inception Merger Sub, Inc. (“Merger Sub”), a Delaware corporation and a wholly-owned subsidiary of Inception Parent, Inc., a Delaware corporation ("Parent"), merged with and into Rackspace, with Rackspace surviving as a wholly-owned subsidiary of Parent (the “Merger”).

At the effective time of the Merger, subject to certain exceptions, each share of common stock of Rackspace that was issued and outstanding immediately prior to the effective time of the Merger was cancelled and automatically converted into the right to receive $32.00 per share in cash, without interest and less any applicable withholding taxes. Total consideration paid to Rackspace's equityholders at closing of the Merger was approximately $4.1 billion (the “Merger Consideration”) based on the number of shares of common stock issued and outstanding and based on payments required to be made under the Merger Agreement to certain holders of Rackspace stock options and Rackspace stock-based awards. In addition, a total of up to approximately $213.2 million will be payable under the Merger Agreement to certain holders of Rackspace stock-based awards following the closing of the Merger, subject to the continued employment of such holders or their experiencing a qualifying termination of employment, with up to approximately $103.1 million payable in 2017, up to approximately $80.2 million payable in 2018, and up to approximately $29.8 million payable in 2019.

In connection with the Merger, the following events occurred, which are collectively referred to as the "Transactions":

Funds affiliated with or controlled by Apollo and certain co-investors, including certain funds managed by Searchlight Capital Partners, L.P., directly or indirectly contributed an aggregate amount of approximately $1.2 billion in cash, which amount was contributed to Merger Sub and used to fund a portion of the Merger Consideration and to pay fees and expenses related to the Transactions;

Merger Sub entered into the following debt arrangements:
A five-year $225.0 million senior secured first lien revolving credit facility, which was undrawn on the Closing Date;
A seven-year $2,000.0 million senior secured first lien term loan credit facility, which was fully drawn on the Closing Date; and
$1,200.0 million aggregate principal amount of 8.625% Senior Notes due 2024.

On the Closing Date, at the direction of Rackspace, the trustee for Rackspace's existing 6.5% Senior Notes due 2024 (the "6.5% Notes") delivered a notice of redemption (the "Redemption Notice") to holders of the 6.5% Notes. The Redemption Notice provided for Rackspace's redemption of the 6.5% Notes on December 5, 2016 (the "Redemption Date") at the redemption price set forth in the Indenture governing the 6.5% Notes (the "6.5% Notes Indenture"). Rackspace satisfied and discharged its obligations under the 6.5% Notes Indenture on the Closing Date by depositing with the trustee funds sufficient to pay the redemption price on the Redemption Date.

Rackspace terminated its existing $200.0 million unsecured revolving facility, under which no borrowings were outstanding as of the Closing Date.

As a result of the Merger, all obligations of Merger Sub under the debt arrangements described above became obligations of Rackspace as of the effective time of the Merger.

- 6 -


During the three and nine months ended September 30, 2016, we recorded $3.6 million and $3.9 million, respectively, of costs in connection with the Merger. These costs are included in “general and administrative” expense on our consolidated statements of comprehensive income.

References to "our board," "the board," and similar phrases throughout this report refer to the Board of Directors of Rackspace as it was constituted immediately prior to the Merger.

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 and nine months ended September 30, 2016 was $0.1 million and $0.4 million, respectively. There was no income tax expense allocated during the three or nine months ended September 30, 2015.

Unaudited Interim Financial Information
 
The accompanying consolidated financial statements as of September 30, 2016, and for the three and nine months ended September 30, 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/A filed with the Securities and Exchange Commission on June 13, 2016 (the "Amended 2015 Annual Consolidated Financial Statements"). The unaudited interim consolidated financial statements have been prepared on the same basis as the Amended 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 September 30, 2016, our results of operations for the three and nine months ended September 30, 2015 and 2016, and our cash flows for the nine months ended September 30, 2015 and 2016.
 
The results of operations for the three and nine months ended September 30, 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 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.

Significant Accounting Policies and Estimates

Our Amended 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 nine months ended September 30, 2016.


- 7 -


Revision to Prior Period Financial Statements

As described in our Amended 2015 Annual Consolidated Financial Statements, we have retrospectively revised our financial statements for all periods presented to reflect the correction of an immaterial error for under-reported license expense and the related income tax effect. The impact of this revision on the consolidated statements of comprehensive income for the three and nine months ended September 30, 2015 and the consolidated statement of cash flows for the nine months ended September 30, 2015 is as follows:
 
 
Three Months Ended September 30, 2015
(In millions, except per share data)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Statement of Comprehensive Income:
 
 
 
 
 
 
Cost of revenue
 
$
171.2

 
$
1.5

 
$
172.7

Income from operations
 
56.5

 
(1.5
)
 
55.0

Income before income taxes
 
52.6

 
(1.5
)
 
51.1

Income taxes
 
16.1

 
(0.5
)
 
15.6

Net income
 
36.5

 
(1.0
)
 
35.5

Comprehensive income
 
$
26.3

 
$
(1.0
)
 
$
25.3

Net income per share
 
 
 
 
 
 
Basic
 
$
0.26

 
$

 
$
0.26

Diluted
 
$
0.26

 
$
(0.01
)
 
$
0.25

 
 
Nine Months Ended September 30, 2015
(In millions, except per share data)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Statement of Comprehensive Income:
 
 
 
 
 
 
Cost of revenue
 
$
496.4

 
$
4.5

 
$
500.9

Income from operations
 
144.6

 
(4.5
)
 
140.1

Income before income taxes
 
137.8

 
(4.5
)
 
133.3

Income taxes
 
43.7

 
(1.7
)
 
42.0

Net income
 
94.1

 
(2.8
)
 
91.3

Comprehensive income
 
$
85.1

 
$
(2.8
)
 
$
82.3

Net income per share
 
 
 
 
 
 
Basic
 
$
0.67

 
$
(0.02
)
 
$
0.65

Diluted
 
$
0.66

 
$
(0.02
)
 
$
0.64

 
 
Nine Months Ended September 30, 2015
(In millions)
 
As Previously Reported
 
Adjustments
 
As Revised
Consolidated Statement of Cash Flows:
 
 
 
 
 
 
Net income
 
$
94.1

 
$
(2.8
)
 
$
91.3

Deferred income taxes
 
(34.1
)
 
(1.7
)
 
(35.8
)
Other non-current assets and liabilities
 
$
4.3

 
$
4.5

 
$
8.8


During the second quarter of 2016, we reached an agreement with the license vendor to settle our liability for the under-reported license expense with a cash payment of $10.5 million. Under the terms of the agreement, the vendor legally released us from any additional claims or obligations with respect to certain software license usage for the prior impacted periods. Upon payment in June 2016, we recorded a $4.7 million benefit to license expense within "Cost of revenue" in the consolidated statement of comprehensive income, reflecting the difference between the cash payment of $10.5 million and the total contractual liability of $15.2 million we had accrued as of March 31, 2016.

- 8 -


Recent Accounting Pronouncements Not Yet Adopted

In May 2014, the Financial Accounting Standards Board (“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 will become effective for Rackspace on January 1, 2018, 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 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. 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. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

In June 2016, the FASB issued a new standard that requires financial assets measured at amortized cost to be presented at the net amount expected to be collected using an allowance for expected credit losses, to be estimated by management based on historical experience, current conditions, and reasonable and supportable forecasts. The movement from an incurred loss model, required under current GAAP, to an expected loss model will result in the timelier recording of credit losses on financial instruments. This new guidance will become effective for Rackspace on January 1, 2020, with early adoption permitted for annual and interim periods beginning after December 15, 2018, and will be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption. We are currently evaluating the impact this guidance will have on our consolidated financial statements.

In August 2016, the FASB issued a new standard to provide clarification on how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The standard addresses eight specific cash flow issues where diversity in practice exists. The standard will become effective for Rackspace on January 1, 2018. We are currently evaluating the impact this guidance will have on our consolidated financial statements.


- 9 -


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)
 
2015
 
2016
 
2015
 
2016
Basic net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
35.5

 
$
38.6

 
$
91.3

 
$
123.2

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
139.0

 
126.1

 
140.9

 
127.5

Number of shares used in per share computations
 
139.0

 
126.1

 
140.9

 
127.5

Net income per share
 
$
0.26

 
$
0.31

 
$
0.65

 
$
0.97

 
 
 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
35.5

 
$
38.6

 
$
91.3

 
$
123.2

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
139.0

 
126.1

 
140.9

 
127.5

Stock options, awards and employee share purchase plans
 
1.6

 
1.7

 
2.4

 
1.1

Number of shares used in per share computations
 
140.6

 
127.8

 
143.3

 
128.6

Net income per share
 
$
0.25

 
$
0.30

 
$
0.64

 
$
0.96


We excluded 5.2 million and 4.1 million potential common shares from the computation of dilutive net income per share for the three months ended September 30, 2015 and 2016, respectively, and 3.8 million and 4.4 million potential shares for the nine months ended September 30, 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 September 30, 2016 consisted of the following: 
(In millions)
 
December 31,
2015
 
September 30,
2016
Computers and equipment
 
$
1,787.2

 
$
1,839.7

Computer software
 
370.6

 
401.2

Furniture and fixtures
 
63.5

 
62.8

Buildings and leasehold improvements
 
355.7

 
332.2

Land
 
28.1

 
26.8

Property and equipment, at cost
 
2,605.1

 
2,662.7

Less: Accumulated depreciation and amortization
 
(1,539.7
)
 
(1,733.2
)
Work in process
 
82.6

 
102.2

Property and equipment, net
 
$
1,148.0

 
$
1,031.7


The composition of the work in process balance was as follows:
(In millions)
 
December 31,
2015
 
September 30,
2016
Office facility build outs
 
$
11.5

 
$
12.5

Data center build outs
 
49.0

 
50.1

Capitalized software
 
22.1

 
39.6

Work in process
 
$
82.6

 
$
102.2



- 10 -


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 our Jungle Disk business. During the third quarter of 2016, we sold our Cloud Sites business and reduced goodwill by an additional $0.2 million. See Note 11, "Gain on Sale" for more information on these transactions. There were no additional changes to goodwill during 2016.

As of September 30, 2016, the goodwill balance by operating segment was as follows:
(In millions)
 
September 30,
2016
Americas
 
$
57.9

International
 
22.3

Total goodwill
 
$
80.2


5. Cost-Method Investments

We have several direct investments accounted for under the cost method. The aggregate carrying amount of these investments, which are recorded as "Other non-current assets" in the consolidated balance sheets, was $11.6 million and $22.8 million as of December 31, 2015 and September 30, 2016, respectively. 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 September 30, 2016.


- 11 -


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


 
September 30, 2016
(In millions)
Revolving Credit Facility
 
Senior Notes due 2024
 
Total
Principal balance
$

 
$
500.0

 
$
500.0

Unamortized debt issuance costs

 
(6.9
)
 
(6.9
)
Total debt

 
493.1

 
493.1

Less: Current portion of debt

 

 

Debt, excluding current portion
$

 
$
493.1

 
$
493.1


Revolving Credit Facility

We are party to a $200 million unsecured revolving credit facility (the "Revolving Credit Facility"). As of September 30, 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 September 30, 2016, the outstanding principal amount of the 6.5% 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 was made on July 15, 2016. As of September 30, 2016, we were in compliance with all covenants under the Senior Notes indenture.

The fair value of the Senior Notes as of September 30, 2016 was $547.5 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.


- 12 -


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 or otherwise harm our business. We have disputed the allegations 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.

Rackspace, each member of Rackspace's Board of Directors, Apollo, Parent and Merger Sub have been named as defendants in a putative class action challenging the merger between Apollo and Rackspace in the Court of Chancery of the State of Delaware. The suit is captioned Luger v. Rackspace Hosting Inc., et al. (Case No. 12819) (filed October 11, 2016). The complaint alleges that the Proxy Statement fails to disclose material information to Rackspace stockholders and that the Rackspace Board breached its fiduciary duties by failing to ensure that such disclosure was made. The complaint seeks rescission, damages, and injunctive relief. The complaint also alleges that Rackspace, Apollo, Parent and Merger Sub have aided and abetted the Rackspace Board's breach of its fiduciary duties. Rackspace believes the allegations of the complaint are without merit and intends to defend against the lawsuit vigorously.

8. Share-Based Compensation
 
Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In millions)
 
2015
 
2016
 
2015
 
2016
Cost of revenue
 
$
4.2

 
$
4.5

 
$
12.3

 
$
13.0

Research and development
 
2.4

 
2.3

 
11.3

 
6.9

Sales and marketing
 
2.7

 
2.9

 
8.2

 
8.3

General and administrative
 
10.3

 
8.0

 
28.2

 
25.7

Pre-tax share-based compensation
 
19.6

 
17.7

 
60.0

 
53.9

Less: Income tax benefit
 
(5.9
)
 
(6.3
)
 
(19.0
)
 
(18.2
)
Total share-based compensation expense, net of tax
 
$
13.7

 
$
11.4

 
$
41.0

 
$
35.7


As of September 30, 2016, there was $163.0 million of unrecognized compensation cost, which will be recognized using the straight-line method over a weighted average period of 2.7 years.


- 13 -


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 nine months ended September 30, 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 nine months ended September 30, 2016, we repurchased $133.2 million, or 6.0 million shares, of our common stock on the open market under this program; these shares were subsequently retired.

11. Gain on Sale

During 2016, we sold certain assets of two non-strategic product lines, resulting in a total pre-tax gain of $12.5 million and $37.0 million for the three and nine months ended September 30, 2016, respectively, reported within “Gain on sale” in the consolidated statements of comprehensive income.

On January 5, 2016, we completed the sale of certain assets of our Jungle Disk business, consisting primarily of intellectual property with an immaterial remaining net book value, for total consideration of $27.0 million. After adjustments for the net book value of the assets, goodwill, and transaction costs, we recorded a pre-tax gain of $24.5 million.

On August 25, 2016, we completed the sale of certain assets of our Cloud Sites business, consisting primarily of intellectual property with an immaterial remaining net book value, and entered into a transition services agreement with the buyer. Under the transition services agreement, we will provide certain services, mainly hosting and email services, over a transition period of up to 18 months and will sell specified data center equipment to the buyer at the conclusion of the transition period. Total consideration for this arrangement was $39.0 million, for which a cash payment of $31.4 million was received on August 25, 2016, with an additional $3.5 million placed in escrow for general representations and warranties and the remaining $4.0 million due upon transfer of the data center equipment at the end of the transition period. In addition, the transition services agreement requires monthly payments from the buyer for hosting services. These monthly payments, together with $23.1 million of the arrangement consideration classified as deferred revenue, represent fair value for the services and will be recognized as the services are provided over the estimated period of 18 months. The remaining $15.9 million of arrangement consideration was allocated to the sale of the business; after adjustments for the net book value of the assets, goodwill, and transaction costs, we recorded a pre-tax gain of $12.5 million.


- 14 -


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 metrics our chief operating decision maker ("CODM") uses to manage our business, including the allocation of resources and performance assessment. In addition, these metrics 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, gains on the sale of certain assets of non-strategic product lines, as described in Note 11, "Gain on Sale," have been reflected in the Americas segment. 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 September 30,
 
Nine Months Ended September 30,
(In millions)
 
2015
 
2016
 
2015
 
2016
Net revenue:
 
 
 
 
 
 
 
 
Americas
 
$
371.5

 
$
389.0

 
$
1,077.8

 
$
1,158.7

International
 
137.4

 
127.2

 
400.7

 
399.2

Total net revenue
 
$
508.9

 
$
516.2

 
$
1,478.5

 
$
1,557.9

 
 
 
 
 
 
 
 
 
Income before income taxes:
 
 
 
 
 
 
 
 
Americas
 
$
18.3

 
$
31.9

 
$
33.1

 
$
95.4

International
 
32.8

 
28.1

 
100.2

 
90.8

Total income before income taxes
 
$
51.1

 
$
60.0

 
$
133.3

 
$
186.2

 
 
 
 
 
 
 
 
 
Depreciation and amortization:
 
 
 
 
 
 
 
 
Americas
 
$
77.1

 
$
79.2

 
$
229.5

 
$
238.7

International
 
24.2

 
21.7

 
66.4

 
70.8

Total depreciation and amortization
 
$
101.3

 
$
100.9

 
$
295.9

 
$
309.5



- 15 -


We offer a broad portfolio of integrated IT solutions (products) for common business needs across four primary form factors:
 
Single Tenant provides servers and storage space dedicated to a single customer. The latter can deploy either a traditional managed hosting or private cloud environment. For customers who either run legacy applications, have high security or compliance needs, or run applications with consistently high usage patterns, Single Tenant hosting solutions are preferable and more cost effective than do-it-yourself or public cloud alternatives.

Public Cloud provides computing resources on an as-needed basis. Rackspace's Public Cloud is based on OpenStack technology and customers' workloads run on a shared pool of servers, storage, and networking resources. Customers who have workloads with variable needs find this a cost-effective solution as they are charged on a pay-as-you-go basis.

Cloud Office provides outsourced management of applications for email, Microsoft Office 365, and collaboration tools such as Microsoft SharePoint. Email hosting represents the predominant source of revenue and these products are offered on a monthly subscription model with tiered pricing levels based upon number of users and support levels.

Managed Cloud Services resells Amazon Web Services or Microsoft Azure infrastructure and provides managed services on top of it. Managed Cloud Services demand is driven by the adoption of public clouds and the customers' lack of in-house resources to manage these complex cloud platforms.

Net revenue by product line is as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In millions)
 
2015
 
2016
 
2015
 
2016
Single Tenant
 
$
364.7

 
$
365.3

 
$
1,062.4

 
$
1,108.0

Public Cloud
 
117.1

 
114.4

 
337.1

 
350.8

Cloud Office
 
27.1

 
29.9

 
79.0

 
88.0

Managed Cloud Services
 

 
6.6

 

 
11.1

Total net revenue
 
$
508.9

 
$
516.2

 
$
1,478.5

 
$
1,557.9



- 16 -


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/A 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 and nine months ended September 30, 2015 and 2016.
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 a leading global multi-cloud solutions provider in the business information technology ("IT") market. Rackspace was founded in 1998 and has grown its revenue every year since inception (from zero to over $2 billion). As a global company, we sell our services in more than 120 countries and serve our customers from 11 data centers located on four continents. We help customers tap the power of cloud computing by delivering world-class service on some of the world's leading technology platforms. We are experts in IT, so our customers do not have to be.

We primarily market our services to Fortune 2000 companies. These companies often do not possess the resources and scale to cost-effectively employ an in-house IT department to meet their data service needs or deploy infrastructure to host their applications. Workloads are rapidly increasing in scale and complexity for businesses of all sizes, and many of our target clients need flexible, sophisticated and secure solutions only experts can offer. As such, the industry is shifting from in-house IT to outsourced solutions.

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.


- 17 -


Subsequent Events

On November 3, 2016 (the “Closing Date”), Rackspace was acquired by an entity controlled by funds affiliated with or controlled by Apollo Global Management, LLC and its subsidiaries ("Apollo"). Pursuant to the Agreement and Plan of Merger (the "Merger Agreement"), dated as of August 26, 2016, on the Closing Date, Inception Merger Sub, Inc. (“Merger Sub”), a Delaware corporation and a wholly-owned subsidiary of Inception Parent, Inc., a Delaware corporation ("Parent"), merged with and into Rackspace, with Rackspace surviving as a wholly-owned subsidiary of Parent (the “Merger”).
At the effective time of the Merger, subject to certain exceptions, each share of common stock of Rackspace that was issued and outstanding immediately prior to the effective time of the Merger was cancelled and automatically converted into the right to receive $32.00 per share in cash, without interest and less any applicable withholding taxes. Total consideration paid to Rackspace's equityholders at closing of the Merger was approximately $4.1 billion (the “Merger Consideration”) based on the number of shares of common stock issued and outstanding and based on payments required to be made under the Merger Agreement to certain holders of Rackspace stock options and Rackspace stock-based awards. In addition, a total of up to approximately $213.2 million will be payable under the Merger Agreement to certain holders of Rackspace stock-based awards following the closing of the Merger, subject to the continued employment of such holders or their experiencing a qualifying termination of employment, with up to approximately $103.1 million payable in 2017, up to approximately $80.2 million payable in 2018, and up to approximately $29.8 million payable in 2019.

In connection with the Merger, the following events occurred, which are collectively referred to as the "Transactions":

Funds affiliated with or controlled by Apollo and certain co-investors, including certain funds managed by Searchlight Capital Partners, L.P., directly or indirectly contributed an aggregate amount of approximately $1.2 billion in cash, which amount was contributed to Merger Sub and used to fund a portion of the Merger Consideration and to pay fees and expenses related to the Transactions;

Merger Sub entered into the following debt arrangements:
A five-year $225.0 million senior secured first lien revolving credit facility, which was undrawn on the Closing Date;
A seven-year $2,000.0 million senior secured first lien term loan credit facility, which was fully drawn on the Closing Date; and
$1,200.0 million aggregate principal amount of 8.625% Senior Notes due 2024.

On the Closing Date, at the direction of Rackspace, the trustee for Rackspace's existing 6.5% Senior Notes due 2024 (the "6.5% Notes") delivered a notice of redemption (the "Redemption Notice") to holders of the 6.5% Notes. The Redemption Notice provided for Rackspace's redemption of the 6.5% Notes on December 5, 2016 (the "Redemption Date") at the redemption price set forth in the Indenture governing the 6.5% Notes (the "6.5% Notes Indenture"). Rackspace satisfied and discharged its obligations under the 6.5% Notes Indenture on the Closing Date by depositing with the trustee funds sufficient to pay the redemption price on the Redemption Date.

Rackspace terminated its existing $200.0 million unsecured revolving facility, under which no borrowings were outstanding as of the Closing Date.

As a result of the Merger, all obligations of Merger Sub under the debt arrangements described above became obligations of Rackspace as of the effective time of the Merger.

During the three and nine months ended September 30, 2016, we recorded $3.6 million and $3.9 million, respectively, of costs in connection with the Merger. These costs are included in “general and administrative” expense on our consolidated statements of comprehensive income.

References to "our board," "the board," and similar phrases throughout this report refer to the Board of Directors of Rackspace as it was constituted immediately prior to the Merger.


- 18 -


Revision to Prior Period Financial Statements

As described in our Annual Report on Form 10-K/A for the year ended December 31, 2015 and in Item 1 of Part I, "Financial Statements - Note 1, Company Overview, Subsequent Events, Basis of Presentation, and Summary of Significant Accounting Policies," we have retrospectively revised our financial statements for all periods presented to reflect the correction of an immaterial error for under-reported license expense and the related income tax effect.

During the second quarter of 2016, we reached an agreement with the license vendor to settle our liability for the under-reported license expense with a cash payment of $10.5 million. Under the terms of the agreement, the vendor legally released us from any additional claims or obligations with respect to certain software license usage for the prior impacted periods. Upon payment in June 2016, we recorded a $4.7 million benefit to license expense within "Cost of revenue" in the consolidated statement of comprehensive income, reflecting the difference between the cash payment of $10.5 million and the total contractual liability of $15.2 million we had accrued as of March 31, 2016.

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 directly comparable GAAP measure in the “Supplemental Information” section of this MD&A.


- 19 -


Growth
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except average monthly revenue per server)
 
September 30, 2015
 
June 30, 2016
 
September 30, 2016
 
 
Net revenue
 
$
508.9

 
$
523.6

 
$
516.2

 
Revenue growth (year over year)
 
10.7
%
 
7.0
%
 
1.4
%
 
Constant currency revenue growth (year over year)
 
12.9
%
 
8.2
%
 
4.4
%
 
 
 
 
 
 
 
 
 
Number of servers deployed at period end
 
118,654

 
114,231

 
113,131

 
Average monthly revenue per server
 
$
1,444

 
$
1,513

 
$
1,513

 
 
 
 
 
 
 
 
 
Number of employees (Rackers) at period end
 
6,177

 
6,199

 
6,115


Total net revenue for the three months ended September 30, 2016 decreased $7 million, or 1.4%, from the three months ended June 30, 2016. Net revenue growth was negatively impacted by a stronger U.S. dollar relative to other foreign currencies on a sequential quarter basis. Net revenue for the three months ended September 30, 2016 would have been approximately $8 million higher had foreign exchange rates remained constant from the three months ended June 30, 2016, resulting in a constant currency revenue growth rate of 0.1%.

On a year-over-year basis, net revenue grew $7 million, or 1.4%, due, in part, to the favorable impact of a large, multi-year agreement that began to materialize in the third quarter of 2015. Net revenue for the three months ended September 30, 2016 includes the negative impact of approximately $15 million due to changes in foreign exchange rates, resulting in a constant currency growth rate of 4.4%. In addition, the sale of certain assets of our Jungle Disk business in January 2016 had a negative impact on revenue of $3 million when compared to the three months ended September 30, 2015.

The sale of our Cloud Sites business in August 2016 had an immaterial impact on our quarterly revenue growth on both a sequential and year-over-year basis, as the negative impact from the sale was offset by revenue earned from ongoing hosting and other services we are providing to the buyer under a transition services agreement as described in "Notes to the Unaudited Consolidated Financial Statements - Note 11, Gain on Sale."

We had a total of 113,131 servers deployed as of September 30, 2016, a decrease of 5,523 servers from September 30, 2015 and a decrease of 1,100 servers from June 30, 2016. During the third quarter of 2016, we decommissioned approximately 2,800 servers due to the migration of customers on our legacy public cloud platform onto our OpenStack public cloud. The decommissioned equipment was fully depreciated and retired as of September 30, 2016.


- 20 -


Profitability
 
 
 
Three Months Ended
 
(Dollar amounts in millions, except per share amounts)
 
September 30, 2015
 
June 30, 2016
 
September 30, 2016
 
 
Income from operations
 
$
55.0

 
$
64.3

 
$
70.2

 
Operating income margin
 
10.8
%
 
12.3
%
 
13.6
%
 
 
 
 
 
 
 
 
 
Net income
 
$
35.5

 
$
35.8

 
$
38.6

 
Net income margin
 
7.0
%
 
6.8
%
 
7.5
%
 
Diluted net income per share
 
$
0.25

 
$
0.28

 
$
0.30

 
 
 
 
 
 
 
 
 
Adjusted EBITDA
 
$
175.9

 
$
187.3

 
$
176.3

 
Adjusted EBITDA margin
 
34.6
%
 
35.8
%
 
34.2
%

On a sequential quarter basis, operating income margin and net income margin increased 130 basis points and 70 basis points, respectively, primarily due to a gain in the third quarter on the sale of our Cloud Sites business, which contributed 240 basis points and 160 basis points to third quarter operating income margin and net income margin, respectively. Operating income margin and net income margin were also positively impacted by lower employee-related expenses reflecting the impact of decreased non-equity incentive bonus expense due to a lower bonus payout percentage. The positive impact of these items was partially offset by a $12 million increase in sequential license expense, as second quarter license expense was positively impacted by a $4.7 million benefit related to a previously recorded contractual obligation that was settled in the second quarter and a $3.8 million benefit from the release of certain other license accruals during the second quarter. Adjusted EBITDA margin decreased 160 basis points to 34.2% for the three months ended September 30, 2016 compared to 35.8% for the three months ended June 30, 2016, primarily due to the negative impact of higher license expense in the third quarter.

On a year-over-year basis, operating income margin increased 280 basis points to 13.6% and net income margin increased 50 basis points to 7.5%, primarily due to the positive impact of the gain on sale on the third quarter of 2016 results as described above. The positive impact on our net income margin was offset by a $7 million increase in interest expense related to our Senior Notes issued in November 2015 and an increase in our effective tax rate from 30.4% to 35.7%. Adjusted EBITDA margin decreased 40 basis points to 34.2% reflecting the impact of decreased non-equity incentive bonus expense due to a lower bonus payout percentage, partially offset by increased license and internal software support and maintenance expenses.


- 21 -


Capital Efficiency, Infrastructure Capacity and Utilization
 
 
 
Three Months Ended
 
(Dollar amounts in millions)
 
September 30, 2015
 
June 30, 2016
 
September 30, 2016
 
 
Capital expenditures
 
 
 
 
 
 
 
Customer gear
 
$
87.1

 
$
47.4

 
$
31.6

 
Data center build outs
 
18.8

 
9.7

 
6.9

 
Office build outs
 
6.1

 
1.1

 
1.3

 
Capitalized software and other projects
 
15.7

 
23.9

 
26.4

 
Total capital expenditures
 
$
127.7

 
$
82.1

 
$
66.2

 
 
 
 
 
 
 
 
 
Capital efficiency and returns
 
 
 
 
 
 
 
Average total assets
 
$
1,787.9

 
$
2,011.1

 
$
2,022.4

 
Return on assets (annualized)
 
8.0
%
 
7.1
%
 
7.6
%
 
 
 
 
 
 
 
 
 
Average capital base
 
$
1,020.0

 
$
991.0

 
$
957.4

 
Return on capital (annualized)
 
14.7
%
 
16.4
%
 
14.8
%
 
Capital turnover (annualized)
 
2.00

 
2.11

 
2.16

 
 
 
 
 
 
 
 
 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
Megawatts under contract at period end (1)
 
63.6

 
62.2

 
62.2

 
Megawatts available for customer use at period end (2)
 
55.3

 
56.4

 
56.4

 
Megawatts utilized at period end
 
32.7

 
32.0

 
31.4

 
Annualized net revenue per average Megawatt of power utilized
 
$
63.3

 
$
65.3

 
$
65.1

(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 September 30, 2016 decreased to $66.2 million from $82.1 million in the three months ended June 30, 2016 due to a reduction in customer gear server purchases. Higher capital expenditures in the three months ended September 30, 2015 were mainly due to increased purchases of customer gear to support the opening of a new London data center.

On a sequential quarter basis, Return on Assets ("ROA") increased from 7.1% for the three months ended June 30, 2016 to 7.6% for the three months ended September 30, 2016 due to higher net income, as previously described. Return on Capital ("ROC") decreased from 16.4% for the three months ended June 30, 2016 to 14.8% for the three months ended September 30, 2016, primarily due to a decrease in sequential quarter income from operations, as adjusted for the gain on sale recorded in the third quarter. The positive impact of a 3% decrease in the average capital base was partially offset by a higher effective tax rate. The decrease in our average capital base also resulted in an increase in capital turnover, from 2.11 for the three months ended June 30, 2016 to 2.16 for the three months ended September 30, 2016.

On a year-over-year basis, ROA decreased from 8.0% to 7.6% as the 13% increase in our average total assets more than offset the 9% increase in net income. ROC increased from 14.7% to 14.8% primarily due to a 6% decrease in our average capital base and, to a lesser extent, an increase in income from operations, adjusted for the gain on sale recorded in the third quarter of 2016. These positive impacts to ROC were partially offset by an increase in our effective tax rate. Capital turnover increased to 2.16 for the three months ended September 30, 2016 from 2.00 for the same period of 2015 due to the decrease in average capital base discussed above.


- 22 -


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,
2015
 
December 31,
2015
 
March 31,
2016
 
June 30,
2016
 
September 30,
2016
Net revenue
 
$
508.9

 
$
522.8

 
$
518.1

 
$
523.6

 
$
516.2

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
172.7

 
180.7

 
180.4

 
171.5

 
183.9

Research and development
 
29.9

 
29.8

 
27.6

 
26.9

 
24.5

Sales and marketing
 
61.8

 
58.3

 
63.7

 
63.8

 
63.3

General and administrative
 
88.2

 
90.1

 
85.7

 
92.5

 
85.9

Depreciation and amortization
 
101.3

 
104.0

 
104.0

 
104.6

 
100.9

Total costs and expenses
 
453.9

 
462.9

 
461.4

 
459.3

 
458.5

Gain on sale
 

 

 
24.5

 

 
12.5

Income from operations
 
55.0

 
59.9

 
81.2

 
64.3

 
70.2

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(2.8
)
 
(6.2
)
 
(10.5
)
 
(10.3
)
 
(10.0
)
Interest and other income (expense)
 
(1.1
)
 
0.5

 
1.1

 
0.4

 
(0.2
)
Total other income (expense)
 
(3.9
)
 
(5.7
)
 
(9.4
)
 
(9.9
)
 
(10.2
)
Income before income taxes
 
51.1

 
54.2

 
71.8

 
54.4

 
60.0

Income taxes
 
15.6

 
23.1

 
23.0

 
18.6

 
21.4

Net income
 
$
35.5

 
$
31.1

 
$
48.8

 
$
35.8

 
$
38.6

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Three Months Ended
(Percent of net revenue)
 
September 30,
2015
 
December 31,
2015
 
March 31,
2016
 
June 30,
2016
 
September 30,
2016
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
34.0
 %
 
34.6
 %
 
34.8
 %
 
32.8
 %
 
35.6
 %
Research and development
 
5.9
 %
 
5.7
 %
 
5.3
 %
 
5.1
 %
 
4.7
 %
Sales and marketing
 
12.1
 %
 
11.2
 %
 
12.3
 %
 
12.2
 %
 
12.3
 %
General and administrative
 
17.3
 %
 
17.2
 %
 
16.6
 %
 
17.7
 %
 
16.6
 %
Depreciation and amortization
 
19.9
 %
 
19.9
 %
 
20.1
 %
 
20.0
 %
 
19.6
 %
Total costs and expenses
 
89.2
 %
 
88.5
 %
 
89.1
 %
 
87.7
 %
 
88.8
 %
Gain on sale
 
 %
 
 %
 
4.7
 %
 
 %
 
2.4
 %
Income from operations
 
10.8
 %
 
11.5
 %
 
15.7
 %
 
12.3
 %
 
13.6
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.5
)%
 
(1.2
)%
 
(2.0
)%
 
(2.0
)%
 
(1.9
)%
Interest and other income (expense)
 
(0.2
)%
 
0.1
 %
 
0.2
 %
 
0.1
 %
 
0.0
 %
Total other income (expense)
 
(0.8
)%
 
(1.1
)%
 
(1.8
)%
 
(1.9
)%
 
(2.0
)%
Income before income taxes
 
10.0
 %
 
10.4
 %
 
13.9
 %
 
10.4
 %
 
11.6
 %
Income taxes
 
3.1
 %
 
4.4
 %
 
4.4
 %
 
3.5
 %
 
4.2
 %
Net income
 
7.0
 %
 
6.0
 %
 
9.4
 %
 
6.8
 %
 
7.5
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 23 -


Three Months Ended September 30, 2016 Compared to Three Months Ended September 30, 2015
 
Net Revenue

Net revenue increased $7 million, or 1%, 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, 2016 was favorably impacted by a large, multi-year agreement that began to materialize in the third quarter of 2015.

Net revenue was negatively impacted by a stronger U.S. dollar relative to the functional currencies of our foreign operations, as net revenue for the three months ended September 30, 2016 would have been $15 million higher had foreign exchange rates remained constant from the prior year. In addition, the sale of our Jungle Disk business in January 2016 had a negative impact on net revenue of $3 million when compared to the three months ended September 30, 2015. The sale of our Cloud Sites business in August 2016 had an immaterial impact on net revenue for the three months ended September 30, 2016, as the negative impact from the sale was offset by revenue earned from ongoing hosting and other services we are providing to the buyer under a transition services agreement as described in Item 1 of Part I, "Financial Statements - Note 11, Gain on Sale."

Net revenue for the Americas segment increased $18 million, or 5%, to $389 million for the three months ended September 30, 2016 compared to $372 million for the three months ended September 30, 2015. Net revenue for the International segment decreased $10 million, or 7%, to $127 million for the three months ended September 30, 2016 compared to $137 million for the three months ended September 30, 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 $11 million, or 6%, largely due to a $5 million increase in expenses related to our managed cloud offerings on third party clouds. Employee-related expenses increased $4 million driven by a 5% 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 that resulted in lower expense 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.

As a percentage of net revenue, cost of revenue increased 160 basis points, from 34.0% in the three months ended September 30, 2015 to 35.6% in the three months ended September 30, 2016. This increase was driven by a 100 basis point increase in third party cloud expenses and a 60 basis point increase in 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 $5 million, or 18%, primarily due to a decrease in employee-related expenses driven by a 14% decline in average headcount and lower non-equity incentive bonus expense due to a lower bonus payout percentage. As a percentage of net revenue, research and development expenses decreased 120 basis points, from 5.9% in the three months ended September 30, 2015 to 4.7% in the three months ended September 30, 2016.

Sales and Marketing Expenses

Sales and marketing expenses consist of employee-related costs of our sales and marketing employees, including sales commissions, compensation paid to certain channel partners, and costs for advertising and promoting our services and to generate customer demand.

Sales and marketing expenses increased $2 million, or 2%, as an increase in employee-related expenses was partially offset by a decrease in professional fees. As a percentage of net revenue, sales and marketing expenses increased 20 basis points, from 12.1% in the three months ended September 30, 2015 to 12.3% in the three months ended September 30, 2016.

- 24 -


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 $2 million, or 3%. Employee-related expenses decreased $7 million driven by a 2% decrease in average headcount, lower non-equity incentive bonus expense due to a lower bonus payout percentage, and lower share-based compensation expense. These decreases were partially offset by $4 million of costs incurred in connection with the Merger. As a percentage of net revenue, general and administrative expenses decreased 70 basis points, from 17.3% in the three months ended September 30, 2015 to 16.6% in the three months ended September 30, 2016.

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 of $101 million for the three months ended September 30, 2016 did not fluctuate significantly from the three months ended September 30, 2015. As a percentage of net revenue, depreciation and amortization expense decreased 30 basis points, from 19.9% in the three months ended September 30, 2015 to 19.6% in the three months ended September 30, 2016.

Gain on Sale

On August 25, 2016, we completed the sale of our Cloud Sites business resulting in a pre-tax gain of $12.5 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 increased $6 million, from $4 million for the three months ended September 30, 2015 to $10 million for the three months ended September 30, 2016, primarily due to interest expense of $8 million on our Senior Notes issued in November 2015.

Income before Income Taxes

Income before income taxes increased $9 million, or 17%. Income before income taxes for the Americas segment increased $14 million to $32 million for the three months ended September 30, 2016 compared to $18 million for the same period of 2015, driven by the $12.5 million gain on sale as described above. Income before income taxes for the International segment decreased $5 million, to $28 million from $33 million for the three months ended September 30, 2016 compared to the three months ended September 30, 2015.

Income Taxes

Our effective tax rate increased from 30.4% for the three months ended September 30, 2015 to 35.7% for the three months ended September 30, 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 $3 million, or 9%. Net income per diluted share was $0.30 in the three months ended September 30, 2016, an increase of $0.05 from the same period of 2015. Net income per diluted share for the three months ended September 30, 2016 includes the positive impact of a 9% decrease in our weighted-average diluted shares outstanding, primarily due to the purchase and retirement of shares under our share repurchase program.


- 25 -


Nine Months Ended September 30, 2016 Compared to Nine Months Ended September 30, 2015

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,
2015
 
September 30,
2016
Net revenue
 
$
1,478.5

 
$
1,557.9

Costs and expenses:
 
 
 
 
Cost of revenue
 
500.9

 
535.8

Research and development
 
95.1

 
79.0

Sales and marketing
 
185.2

 
190.8

General and administrative
 
261.3

 
264.1

Depreciation and amortization
 
295.9

 
309.5

Total costs and expenses
 
1,338.4

 
1,379.2

Gain on sale
 

 
37.0

Income from operations
 
140.1

 
215.7

Other income (expense):
 
 
 
 
Interest expense
 
(5.1
)
 
(30.8
)
Interest and other income (expense)
 
(1.7
)
 
1.3

Total other income (expense)
 
(6.8
)
 
(29.5
)
Income before income taxes
 
133.3

 
186.2

Income taxes
 
42.0

 
63.0

Net income
 
$
91.3

 
$
123.2

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Nine Months Ended
(Percent of net revenue)
 
September 30,
2015
 
September 30,
2016
Net revenue
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
Cost of revenue
 
33.9
 %
 
34.4
 %
Research and development
 
6.4
 %
 
5.1
 %
Sales and marketing
 
12.5
 %
 
12.2
 %
General and administrative
 
17.7
 %
 
17.0
 %
Depreciation and amortization
 
20.0
 %
 
19.9
 %
Total costs and expenses
 
90.5
 %
 
88.5
 %
Gain on sale
 
 %
 
2.4
 %
Income from operations
 
9.5
 %
 
13.8
 %
Other income (expense):
 
 
 
 
Interest expense
 
(0.3
)%
 
(2.0
)%
Interest and other income (expense)
 
(0.1
)%
 
0.1
 %
Total other income (expense)
 
(0.5
)%
 
(1.9
)%
Income before income taxes
 
9.0
 %
 
12.0
 %
Income taxes
 
2.8
 %
 
4.0
 %
Net income