XNYS:RAX Rackspace Hosting Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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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, 2012.
 
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.)

5000 Walzem Rd.
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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   R    No o
 
Indicate by check mark 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 3, 2012, 135,161,658 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

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 
December 31,
2011
 
March 31,
2012
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
159,856

 
$
186,531

Accounts receivable, net of allowance for doubtful accounts and customer credits of $3,420 as of December 31, 2011 and $3,633 as of March 31, 2012
 
68,709

 
77,095

Deferred income taxes
 
9,841

 
6,478

Prepaid expenses
 
22,006

 
19,563

Other current assets
 
2,953

 
3,793

Total current assets
 
263,365

 
293,460

 
 
 
 
 
Property and equipment, net
 
627,490

 
659,867

Goodwill
 
59,993

 
62,177

Intangible assets, net
 
26,034

 
25,470

Other non-current assets
 
49,600

 
48,419

Total assets
 
$
1,026,482

 
$
1,089,393

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
156,004

 
$
153,668

Current portion of deferred revenue
 
14,835

 
16,795

Current portion of obligations under capital leases
 
66,031

 
67,469

Current portion of debt
 
879

 
440

Total current liabilities
 
237,749

 
238,372

 
 
 
 
 
Non-current deferred revenue
 
3,446

 
3,400

Non-current obligations under capital leases
 
72,216

 
76,069

Non-current deferred income taxes
 
68,781

 
52,896

Non-current deferred rent
 
23,343

 
25,433

Other non-current liabilities
 
21,524

 
24,787

Total liabilities
 
427,059

 
420,957

 
 
 
 
 
COMMITMENTS AND CONTINGENCIES
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 131,912,829 shares issued and outstanding as of December 31, 2011; 134,981,378 shares issued and outstanding as of March 31, 2012
 
132

 
135

Additional paid-in capital
 
383,031

 
424,369

Accumulated other comprehensive loss
 
(14,732
)
 
(10,240
)
Retained earnings
 
230,992

 
254,172

Total stockholders’ equity
 
599,423

 
668,436

Total liabilities and stockholders’ equity
 
$
1,026,482

 
$
1,089,393


See accompanying notes to the unaudited condensed consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended March 31,
(In thousands, except per share data)
 
2011
 
2012
 
 
 
 
 
Net revenue
 
$
230,002

 
$
301,355

Costs and expenses:
 
 
 
 
Cost of revenue
 
69,742

 
87,240

Sales and marketing
 
29,738

 
38,502

General and administrative
 
62,441

 
83,378

Depreciation and amortization
 
44,098

 
55,151

Total costs and expenses
 
206,019

 
264,271

Income from operations
 
23,983

 
37,084

Other income (expense):
 
 
 
 
Interest expense
 
(1,491
)
 
(1,272
)
Interest and other income (expense)
 
(78
)
 
137

Total other income (expense)
 
(1,569
)
 
(1,135
)
Income before income taxes
 
22,414

 
35,949

Income taxes
 
8,593

 
12,769

Net income
 
$
13,821

 
$
23,180

 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
Foreign currency translation adjustments
 
2,974

 
4,492

Other comprehensive income
 
2,974

 
4,492

Comprehensive income
 
$
16,795

 
$
27,672

 
 
 
 
 
Net income per share
 
 
 
 
Basic
 
$
0.11

 
$
0.17

Diluted
 
$
0.10

 
$
0.17

 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
Basic
 
127,845

 
133,062

Diluted
 
136,224

 
139,964

 
See accompanying notes to the unaudited condensed consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
 
Three Months Ended March 31,
(In thousands)
 
2011
 
2012
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
13,821

 
$
23,180

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
Depreciation and amortization
 
44,098

 
55,151

Loss on disposal of equipment, net
 
182

 
279

Provision for bad debts and customer credits
 
1,603

 
1,455

Deferred income taxes
 
3,680

 
4,275

Deferred rent
 
3,031

 
1,930

Share-based compensation expense
 
7,810

 
8,509

Excess tax benefits from share-based compensation arrangements
 
(898
)
 
(20,235
)
Changes in certain assets and liabilities
 
 
 
 
Accounts receivable
 
(5,716
)
 
(9,008
)
Prepaid expenses and other current assets
 
1,210

 
1,708

Accounts payable and accrued expenses
 
16,690

 
1,989

Deferred revenue
 
153

 
1,496

All other operating activities
 
2,589

 
(820
)
Net cash provided by operating activities
 
88,253

 
69,909

 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(57,651
)
 
(59,752
)
Acquisitions, net of cash acquired
 
(952
)
 
(712
)
All other investing activities
 

 
7

Net cash used in investing activities
 
(58,603
)
 
(60,457
)
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
Principal payments of capital leases
 
(15,222
)
 
(17,273
)
Principal payments of notes payable
 
(608
)
 
(439
)
Payments of earn-out provisions for acquisitions
 

 
(1,826
)
Receipt of Texas Enterprise Fund Grant
 

 
3,500

Proceeds from employee stock plans
 
13,751

 
12,381

Excess tax benefits from share-based compensation arrangements
 
898

 
20,235

Net cash provided by (used in) financing activities
 
(1,181
)
 
16,578

 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
458

 
645

 
 
 
 
 
Increase in cash and cash equivalents
 
28,927

 
26,675

 
 
 
 
 
Cash and cash equivalents, beginning of period
 
104,941

 
159,856

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
133,868

 
$
186,531

 
 
 
 
 
Supplemental cash flow information:
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
19,009

 
$
22,564

Cash payments for interest, net of amount capitalized
 
$
1,463

 
$
1,258

Cash payments for income taxes
 
$
4,570

 
$
1,955


See accompanying notes to the unaudited condensed consolidated financial statements.

- 5 -


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

1. Company Overview and Summary of Significant Accounting Policies

Nature of Operations

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

Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000. However, our operations began in 1998 as a limited partnership which became our subsidiary through a corporate reorganization completed on August 21, 2001.

We operate consolidated subsidiaries which include, among others, Rackspace US, Inc., our domestic operating entity, and Rackspace Limited, our United Kingdom operating entity.

Basis of Consolidation

The consolidated financial statements include the accounts of Rackspace Hosting and our wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.
 
Basis of Presentation
 
The accompanying consolidated financial statements as of March 31, 2012, and for the three months ended March 31, 2011 and 2012, 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.  The unaudited interim consolidated financial statements have been prepared on the same basis as the 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, 2012 and our results of operations and cash flows for the three months ended March 31, 2011 and 2012.
 
These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2011 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 17, 2012.  The results for the three months ended March 31, 2012 are not necessarily indicative of the results to be expected for the year ending December 31, 2012, or for any other interim period, or for any other future year.

Significant Accounting Policies
 
The accompanying financial statements reflect the application of certain significant accounting policies. There have been no material changes to our significant accounting policies that are disclosed in our audited consolidated financial statements and notes thereto as of December 31, 2011, included in our Annual Report on Form 10-K.


- 6 -


Use of Estimates
 
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and customer credits, property and equipment, fair values of intangible assets and goodwill, useful lives of intangible assets, fair value of share-based compensation, contingencies, and income taxes, among others. Whenever possible, we base our estimates and assumptions on historical experience. However, certain estimates require us to make assumptions about expected future cash flow, events and usage patterns that we cannot influence or control. Our judgments, assumptions and estimates are based upon facts and circumstances known to us when we prepare the financial statements and that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities or recording expenses in our financial statements. Changes in facts and circumstances may cause us to change our assumptions and estimates in future periods, and it is possible that actual results could differ from our estimates. We engaged third-party consultants to assist management in the valuation of acquired assets or other intangibles.

Recently Adopted Accounting Pronouncements

In May 2011, the FASB issued guidance to amend certain fair value measurement principles and disclosure requirements in order to reduce differences between US GAAP and International Financial Reporting Standards. Specifically, the new guidance limits the "highest and best use" measure to non-financial instruments, provides guidance on the applicability of premiums and discounts, and expands the disclosure requirements related to Level 3 fair value measurements. This guidance became effective for us at the beginning of this quarter but did not have a material impact on our consolidated financial statements.

In June 2011, the FASB issued guidance that eliminates the option to report other comprehensive income and its components in the statement of stockholders’ equity.  Instead, an entity will be required to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements.  This guidance became effective for us this quarter, and we have modified our presentation of other comprehensive income accordingly.

In September 2011, the FASB issued guidance that is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a “qualitative” assessment to determine whether further impairment testing is necessary. Specifically, an entity has the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test.  If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. This standard became effective for our annual and interim goodwill impairment tests performed after January 1, 2012.  The adoption of this new guidance did not have a material impact on our financial statements.




- 7 -


2. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share: 
 
 
Three Months Ended March 31,
(In thousands, except per share data)
 
2011
 
2012
Basic net income per share:
 
 
 
 
Net income
 
$
13,821

 
$
23,180

Weighted average shares outstanding:
 
 
 
 
Common stock
 
127,845

 
133,062

Number of shares used in per share computations
 
127,845

 
133,062

Earnings per share
 
$
0.11

 
$
0.17

 
 
 
 
 
Diluted net income per share:
 
 
 
 
Net income
 
$
13,821

 
$
23,180

Weighted average shares outstanding:
 
 
 
 
Common stock
 
127,845

 
133,062

Stock options, awards and employee share purchase plan
 
8,379

 
6,902

Number of shares used in per share computations
 
136,224

 
139,964

Earnings per share
 
$
0.10

 
$
0.17


We excluded 1.6 million potential common shares from the computation of dilutive earnings per share for the three months ended March 31, 2011 and 2012 because the effect would have been anti-dilutive.

3. Cash and Cash Equivalents

Cash and cash equivalents consisted of:
(In thousands)
 
December 31,
2011
 
March 31,
2012
Cash deposits
 
$
119,115

 
$
145,789

Money market funds
 
40,741

 
40,742

Cash and cash equivalents
 
$
159,856

 
$
186,531


Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. We actively monitor the third-party depository institutions that hold our deposits. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds.

Our money market mutual funds invest exclusively in high-quality, short-term securities that are issued or guaranteed by the U.S. government or by U.S. government agencies.


- 8 -


4.  Fair Value Measurements
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-tier fair value of hierarchy, which prioritizes the inputs used in measuring fair value as follows:
 
Level 1 – Observable inputs such as quoted prices in active markets for identical assets or liabilities;
 
Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
 
Level 3 – Unobservable inputs that are supported by little or no market activity, which require management judgment or estimation.

There have been no material changes to the valuation techniques utilized in the fair value measurement of assets and liabilities presented on our balance sheet as disclosed in our Form 10-K for the year ended December 31, 2011.
 
Assets and liabilities measured at fair value on a recurring basis are summarized by level below.  The table does not include assets and liabilities that are measured at historical costs or any other basis other than fair value.
 
 
 
December 31, 2011
(In thousands)
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Assets/Liabilities at Fair Value
Assets:
 
 
 
 
 
 
 
 
Money market funds (1)
 
$
40,741

 
$

 
$

 
$
40,741

Rabbi trust (2)
 
293

 

 

 
293

     Total
 
$
41,034

 
$

 
$

 
$
41,034

 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Deferred compensation (3)
 
$
187

 
$

 
$

 
$
187

     Total
 
$
187

 
$

 
$

 
$
187

 
 
 
March 31, 2012
(In thousands)
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Assets/Liabilities at Fair Value
Assets:
 
 
 
 
 
 
 
 
Money market funds (1)
 
$
40,742

 
$

 
$

 
$
40,742

Rabbi trust (2)
 
382

 

 

 
382

     Total
 
$
41,124

 
$

 
$

 
$
41,124

 
 
 
 
 
 
 
 
 

Liabilities:
 
 
 
 
 
 
 
 
Deferred compensation (3)
 
$
276

 
$

 
$

 
$
276

     Total
 
$
276

 
$

 
$

 
$
276


(1)
Money market funds are classified in cash and cash equivalents.
(2)
Investments in marketable securities held in a Rabbi Trust associated with a non-qualified deferred compensation plan are classified in other non-current assets.
(3)
Obligations to pay benefits under a non-qualified deferred compensation plan are classified in other non-current liabilities.


- 9 -


Our Rabbi Trust was established in 2009, and we elected the fair value option, which allows for the recognition of gains and losses to be recorded in the statement of income in the same period as the gains and losses are incurred as part of the non-qualified deferred compensation plan. During the three months ended March 31, 2011 and March 31, 2012, we recognized minimal net gains as interest and other income.

5. Property and Equipment, net
 
Property and equipment consisted of: 
(In thousands)
 
Estimated Useful Lives
 
December 31,
2011
 
March 31,
2012
Computers, software and equipment
 
1
-
5
years
 
$
898,045

 
$
963,593

Furniture and fixtures
 
7
years
 
34,000

 
35,983

Buildings and leasehold improvements
 
2
-
30
years
 
201,639

 
210,879

Land
 
 
 
 
 
 
13,860

 
13,860

Property and equipment, at cost
 
 
 
 
 
 
1,147,544

 
1,224,315

Less accumulated depreciation and amortization
 
 
 
 
 
 
(582,794
)
 
(628,241
)
Work in process
 
 
 
 
 
 
62,740

 
63,793

Property and equipment, net
 
 
 
 
 
 
$
627,490

 
$
659,867

 
Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $42.6 million and $53.4 million for the three months ended March 31, 2011 and 2012, respectively.

At December 31, 2011, the work in process balance consisted of build outs of $28.0 million for office facilities, $3.6 million for data centers, and $31.2 million for capitalized software and other projects.  At March 31, 2012, the work in process balance consisted of build outs of $26.3 million for office facilities, $2.3 million for data centers, and $35.2 million for capitalized software and other projects.
 
There was no interest capitalized for the three months ended March 31, 2011 and 2012

6. Business Combinations and Goodwill

In February 2012, we acquired a company with expertise in SharePoint consulting, training, and services. The acquisition, which was accounted for using the acquisition method, included an initial cash payment and additional cash payments due on the first anniversary of the closing date and each month thereafter for 36 months. The purchase price has been preliminarily allocated based on the estimated fair values of the individual assets acquired and liabilities assumed at the date of acquisition pending completion of an independent appraisal and other evaluations. The fair value of the remaining payments of $1.4 million was recorded as a liability as of the date of acquisition. The consolidated statements of income include the results of operations for the acquired company commencing on February 14, 2012.

In prior periods, we acquired companies that required additional future payments in addition to the initial cash payment. During the first three months of 2012, we paid $2.0 million related to these previous acquisitions, and as of March 31, 2012, the fair value of the remaining liability recorded was $5.4 million.

The following table provides a roll forward of our goodwill balance.

(In thousands)
 
December 31, 2011
$
59,993

Acquisition
2,184

March 31, 2012
$
62,177


The $2.2 million of goodwill recorded for the acquisition in February 2012 is deductible for tax purposes.

- 10 -


7. Accounts Payable and Accrued Expenses
 
Accounts payable and accrued expenses consisted of: 
(In thousands)
 
December 31,
2011
 
March 31,
2012
Trade payables
 
$
51,097

 
$
50,319

Accrued compensation and benefits
 
41,767

 
39,437

Income and other taxes payable
 
16,778

 
17,260

Vendor accruals
 
32,458

 
32,374

Other liabilities
 
13,904

 
14,278

Accounts payable and accrued expenses
 
$
156,004

 
$
153,668

 
8. Debt
 
Debt outstanding at December 31, 2011 and March 31, 2012 consisted of current notes payable of $0.9 million and $0.4 million, respectively. This debt, which relates to financing arrangements with multiple equipment and software vendors, has various terms extending to June 2012.

We have a revolving credit facility, which has a total commitment of $200 million and matures in September 2016. As of March 31, 2012, there were no borrowings outstanding under the facility except for outstanding letters of credit of $0.4 million, resulting in $199.6 million being available for future borrowings. As of the same date, we were in compliance with all of the covenants under our facility.

9. Commitments and Contingencies
 
Legal Proceedings
 
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, on October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston was filed in the 37th District Court in Bexar County Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We do not expect the results of this claim or any other current proceeding to have a material adverse effect on our business, results of operations or financial condition.

We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business, and we defend ourselves vigorously against any such claims. Although the outcome of these matters is currently not determinable, management expects that any losses that are incurred as a result of these matters, which are in excess of amounts already accrued in its consolidated balance sheet, would not be material to the financial statements as a whole.

Contingent Liability

We recorded a $1.0 million charge in the first quarter of 2012 as cost of revenue related to an unresolved contractual issue with a vendor. We have recorded a loss contingency liability with respect to this matter, but due to the uncertainty regarding the interpretation of certain contractual terms, it is possible the ultimate loss may exceed the amount currently accrued.

Incentive Arrangements

During the first quarter of 2012, we received $3.5 million related to our agreement with the State of Texas, under which we are eligible to receive up to an additional $13.5 million from the Texas Enterprise Fund in multiple installments to be used for capital improvements, provided that we meet certain new job levels in the State of Texas. We are responsible for maintaining the jobs until January 2022. If we eliminate jobs for which we have drawn funds, we are subject to a clawback on the amounts we have drawn plus 3.4% interest on such amounts per year. As of March 31, 2012, the total $8.5 million received under this agreement was deferred and recorded as other non-current liabilities. Amounts will be recognized into income upon the achievement of the performance criteria and the determination that the cash is no longer refundable to the State of Texas.

- 11 -


10. Share-Based Compensation
 
The following have been granted under our Amended and Restated 2007 Long-Term Incentive Plan ("the 2007 Plan") in 2012: stock options, restricted stock units (RSUs) and restricted stock awards (RSAs). Collectively, all such grants are referred to as "awards". All awards deduct one share from the 2007 Plan shares available for issuance for each share granted. To the extent awards granted under the 2007 Plan terminate, expire or lapse for any reason, shares subject to such awards will again be available for future grant. In January 2012, an additional 5.9 million shares became available for future grants pursuant to the automatic share reserve increase or “evergreen” provision under the 2007 Plan.  As of March 31, 2012, the total number of shares authorized under all of our plans was 48.9 million shares, of which approximately 17.8 million shares were available for future grants.
 
Outstanding awards were as follows: 
 
 
December 31,
2011
 
March 31,
2012
Restricted stock
 
3,446,970
 
2,637,620
Stock options
 
12,043,413
 
10,900,162
     Total outstanding awards
 
15,490,383
 
13,537,782
 
Restricted Stock

The following table summarizes our RSU and RSA activity for the three months ended March 31, 2012:
 
 
Number of Units
 
Weighted Average Grant Date Fair Value
Outstanding at December 31, 2011
 
3,446,970
 
$
14.87

     Granted
 
455,789
 
$
47.95

     Released (1)
 
(1,195,934)
 
$
6.17

     Cancelled
 
(69,205)
 
$
24.76

Outstanding at March 31, 2012
 
2,637,620
 
$
24.27

 
 
 
 
 
Expected to vest after March 31, 2012*
 
2,397,834
 
$
22.61

(1) Includes 5,360 shares of RSUs issued to certain members of our board of directors. 
*Includes reduction of shares outstanding due to estimated forfeitures

The weighted average grant date fair value of RSUs and RSAs granted during the three months ended March 31, 2011 and 2012 was $37.78 and $47.95, respectively. The total pre-tax intrinsic value of the RSUs and RSAs released during the three months ended March 31, 2011 and 2012 was $3.6 million and $64.0 million, respectively.

We granted 252,209 RSUs and 203,580 RSAs in 2012. The RSUs and 61,108 of the RSAs granted in 2012 vest as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date.  The fair value of these service-vesting awards is measured based on the closing fair market value of our common stock on the date of grant, and share-based compensation expense is recognized ratably over the four-year service period.  The remaining RSAs were granted to members of our executive team. The vesting of 33,021 of these RSAs is dependent upon the total shareholder return (TSR) on our common stock for a 3-year performance period as compared to the components of the NASDAQ Internet Index over this same period. In addition, the company’s TSR must be positive for vesting to occur.  The vesting of 109,451 of these RSAs is dependent upon a market condition as well as certain predetermined operating results over the next three years. The fair values of these performance-vesting and market-vesting awards was measured using a Monte Carlo simulation based on the date of grant, and share-based compensation expense is recognized ratably over the three-year vesting period.
 
As of March 31, 2012, there was $53.8 million of total unrecognized compensation cost related to non-vested RSUs and RSAs, which will be amortized using the straight-line method over a remaining weighted average period of 3.2 years.


- 12 -


Stock Options

The following table summarizes the stock option activity for the three months ended March 31, 2012
 
 
Number of Shares
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Life
 
Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2011
 
12,043,413
 
$
13.22

 
5.93
 
$
358,754

     Granted
 
666,466
 
$
54.12

 
 
 
 

     Exercised
 
(1,664,735)
 
$
7.44

 
 
 
 

     Cancelled
 
(144,982)
 
$
25.40

 
 
 
 

Outstanding at March 31, 2012
 
10,900,162
 
$
16.44

 
5.77
 
$
450,685

 
 
 
 
 
 
 
 
 
Vested and exercisable at March 31, 2012
 
6,099,801
 
$
7.15

 
5.22
 
$
308,887

 
 
 
 
 
 
 
 
 
Vested and exercisable at March 31, 2012 and expected to vest thereafter*
 
10,148,850
 
$
15.22

 
5.72
 
$
432,071

*Includes reduction of shares outstanding due to estimated forfeitures

The stock options granted in 2012 vest as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date and have a term of 7 years.
 
The total pre-tax intrinsic value of the stock options exercised during the three months ended March 31, 2011 and 2012 was $67.4 million and $77.2 million, respectively.

The following table presents the assumptions used to estimate the fair values of the stock options granted in the periods presented:
 
 
Three Months Ended March 31,
 
 
2011

2012
Expected stock volatility
 
56%
 
57%
Expected dividend yield
 
—%
 
—%
Risk-free interest rate
 
2.30% - 2.35%
 
0.77%
Expected life
 
4.75 years
 
4.75 years
Weighted average grant date fair value of options granted during the period
 
$18.85
 
$25.80
 
As of March 31, 2012, there was $59.3 million of total unrecognized compensation cost related to non-vested stock options that we have granted, which will be amortized using the straight-line method over a weighted average period of 2.5 years.
 
Employee Stock Purchase Plan

An Employee Stock Purchase Plan (ESPP) was approved by the Company's Board of Directors in 2011 and adopted by the Company on January 1, 2012. Under the ESPP, eligible employees may purchase a limited number of shares of the Company's common stock at the lesser of 85% of the market value on the enrollment date or the purchase date. The ESPP is made up of a series of offering periods. Each offering period has a maximum term of 24 months and is divided into four semi-annual purchase intervals. The first purchase under this Employee Stock Purchase Plan will occur on June 30, 2012. The fair value on the date of enrollment was determined using the Black-Scholes option-pricing model.


- 13 -


The fair values estimated from the Black-Scholes option-pricing model were calculated using the following assumptions:
 
Purchase Interval #1
 
Purchase Interval #2
 
Purchase Interval #3
 
Purchase Interval #4
Expected stock volatility
53%
 
49%
 
48%
 
49%
Expected dividend yield
—%
 
—%
 
—%
 
—%
Risk-free interest rate
0.06%
 
0.12%
 
0.19%
 
0.25%
Expected life
0.5 years
 
1.0 year
 
1.5 years
 
2.0 years
Fair value
$12.82
 
$14.73
 
$16.40
 
$18.09

The weighted average fair value of $15.51 per share will be recognized ratably over the two-year term.

Share-based Compensation

Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended March 31,
(in thousands)
 
2011
 
2012
Cost of revenue
 
$
1,412

 
$
1,236

Sales and marketing
 
1

 
1,114

General and administrative
 
6,397

 
6,159

     Pre-tax share-based compensation
 
7,810

 
8,509

         Less: Income tax benefit
 
(2,991
)
 
(3,022
)
Total share-based compensation expense, net of tax
 
$
4,819

 
$
5,487


During the three months ended March 31, 2011, share-based compensation expense within Sales and Marketing was positively impacted by the reversal of previously recorded expense related to terminated employees. The offset of the reversal was a true-up of the forfeiture rate across Cost of Revenue and General and Administrative expenses for options that fully vested within the quarter, negatively impacting these categories.

11. 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 2012, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2012.  As a result, we have recognized an income tax receivable or excess tax benefit in the U.S. and U.K. during the current period.

The following table provides a roll forward of our balance of unrecognized tax benefits, excluding accrued interest.

(In thousands)
 
December 31, 2011
$
16,729

Additions based on tax positions related to the current year

Additions for tax positions of prior years

Reductions for tax positions of prior years
(60
)
Settlements

March 31, 2012
$
16,669


As of March 31, 2012, approximately $2.6 million of these unrecognized tax benefits, if recognized, would favorably impact our effective tax rate in any future period. Also included in the balance of unrecognized tax benefits at March 31, 2012 are liabilities of $12.6 million that, if recognized, would be recorded as an adjustment to other current and non-current assets.

- 14 -


12. Comprehensive Income
 
The income tax benefit allocated to foreign currency translation adjustments during the three months ended March 31, 2011 was $0.1 million. Minimal income tax expense was allocated to these adjustments during the three months ended March 31, 2012.

The change in accumulated other comprehensive income (loss) for the three months ended March 31, 2012 was as follows:
(In thousands)
Accumulated other comprehensive loss
Balance at December 31, 2011
$
(14,732
)
Foreign currency cumulative translation adjustment, net of taxes
4,492

Balance at March 31, 2012
$
(10,240
)

13. Segment Information
 
We operate as one reportable segment based upon the financial information that our chief executive officer, who is the chief operating decision maker, regularly reviews to decide how to allocate resources and assess performance. We periodically review and align our internal reporting structure as our product and service offerings and our customer base expand in reach and presence to ensure our organization effectively serves the diverse and evolving Cloud Computing market. Since we operate in one reportable segment, all relevant financial information used to allocate resources and assess performance can be found in the consolidated financial statements.

Revenue is attributed to geographic location based on the Rackspace Hosting operating location that enters into the contractual relationship with the customer, either the U.S. or International, primarily the U.K. Total net revenue by geographic region was as follows: 

 
 
Three Months Ended March 31,
(In thousands)
 
2011
 
2012
United States
 
$
172,298

 
$
224,710

International
 
57,704

 
76,645

Total net revenue
 
$
230,002

 
$
301,355

 
Total net revenue by our product categories was as follows:

 
 
Three Months Ended March 31,
(In thousands)
 
2011
 
2012
Dedicated Cloud
 
$
192,895

 
$
236,604

Public Cloud
 
37,107

 
64,751

Total net revenue
 
$
230,002

 
$
301,355


Our long-lived assets are primarily located in the U.S. and the U.K., and to a lesser extent Hong Kong.  Property and equipment, net by geographic region was as follows: 

(In thousands)
 
December 31,
2011
 
March 31,
2012
United States
 
$
485,608

 
$
495,590

International
 
141,882

 
164,277

   Total property and equipment, net
 
$
627,490

 
$
659,867



- 15 -


14. Subsequent Events

In April 2012, we entered into a lease for a new data center in Ashburn, Virginia with a maximum critical load power of 9.75 megawatts. The lease provides for two separate commencement dates. The first commencement date is applicable to approximately 55% of the maximum critical load power, and the second is applicable to approximately 45% of the maximum critical load power of the total leased space. The anticipated lease commencement dates are January 1, 2013 and January 1, 2014, although those dates could be triggered earlier in the event that Rackspace begins to draw power from the applicable leased spaces. The initial terms for the leased spaces are 20 years. Upon the expiration of the 20-year term, Rackspace has the option to renew either or both of the two leased space areas for three successive five-year periods.


- 16 -


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

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries.  We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, are subject to the “safe harbor” created by those sections. The forward-looking statements in this report are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “aspires,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this document in greater detail under the heading “Risk Factors.” We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The risks described in “Risk Factors” included in this report, as well as any other cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of the events described in “Risk Factors” and elsewhere in this report could harm our business.
 
Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this document completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.
 
The following discussion should be read in conjunction with our consolidated financial statements and the related notes contained elsewhere in this document.
 
Overview of our Business

We are the service leader in cloud computing. Our growth is the result of our commitment to serving our customers, known as Fanatical Support, and our exclusive focus on cloud computing. We have been successful in attracting and retaining thousands of customers and in growing our business. We are a pioneer in an emerging category, Hybrid Hosting, which combines the benefits of hosted computing on dedicated hardware and on pools of shared resources. We are committed to maintaining our service-centric focus, and we will follow our vision to be considered one of the world’s greatest service companies.

We offer a portfolio of cloud computing services, including Dedicated Cloud hosting and Public Cloud hosting. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by us.

We sell our services to small and medium-sized businesses, as well as large enterprises. For the first three months of 2012, 25% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, we operate a Hong Kong data center and sales office. Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. For the first three months of 2012, no individual customer accounted for greater than 2% of our net revenue.


- 17 -


Product and Service Offerings

We continue to invest in our Public Cloud service and believe it is a critical part of our future success. Public Cloud continues to emerge as a new technology with high adoption rates and investment, which is reflected in its high revenue growth rate. The primary benefit of Public Cloud is the value proposition that it provides for businesses. It enables them to match costs directly to revenue and to scale up and down on a real-time basis as necessary. We do not believe that Public Cloud will replace traditional Dedicated Cloud hosting offerings. We believe the two complement one another, allowing customers to choose from a portfolio of offerings to meet their business needs.

A focus in our growth strategy is to build our product portfolio to include higher service levels and additional capabilities. We are investing heavily in this strategy and creating new technologies to help businesses leverage the benefits of Public Cloud hosting. Hosted virtual desktop, our managed Cloud service, the U.K. Cloud, and Cloud Load Balancers are a few of the recent examples of new capabilities we have developed that are available in the market today that make us more competitive, drive revenue growth, and improve returns.

Our product road-map includes a variety of new capabilities and features including Cloud Block Storage, enhancements to RackConnect, and building a support business around the OpenStack® cloud computing platform. Based on our experience working with customers running OpenStack, we are ready to move into the next phase of our OpenStack strategy with the introduction of a new service we call Rackspace Cloud: Private Edition. This new offering will enable Rackspace to extend Fanatical Support beyond the bounds of our data centers by remotely supporting and managing OpenStack environments that run in almost any data center. While this initiative is still in its early stages of development, Rackspace Cloud: Private Edition is an opportunity to drive incremental demand.

In April 2012, we launched new cloud capabilities featuring the world's first large-scale, production ready next generation cloud, powered by OpenStack and backed by Fanatical Support. Built on OpenStack, the next generation cloud incorporates a portfolio of cloud solutions such as Cloud Servers, Cloud Databases, Cloud Block Storage, Cloud Networks, a completely new cloud Control Panel, Cloud Monitoring and support for the OpenStack API. These new product offerings could drive future incremental demand.

Key Metrics

We carefully track several financial and operational metrics to monitor and manage our growth, financial performance, and capacity. Our key metrics are structured around growth, profitability, capital efficiency, infrastructure capacity, and utilization. The following data should be read in conjunction with the consolidated financial statements, the notes to the financial statements and other financial information included in this Quarterly Report on Form 10-Q.

- 18 -


 
 
Three Months Ended
 
 
(Unaudited)
(Dollar amounts in thousands, except average monthly revenue per server)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
March 31,
2012
 
 
 
 
 
Growth
 
 
 
 
 
 
 
 
 
 
Dedicated Cloud, net revenue
 
$
192,895

 
$
204,275

 
$
213,899

 
$
224,808

 
$
236,604

Public Cloud, net revenue
 
$
37,107

 
$
42,954

 
$
50,673

 
$
58,453

 
$
64,751

Net revenue
 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

 
$
301,355

Revenue growth (year over year)
 
28.6
 %
 
32.0
 %
 
32.5
 %
 
31.9
 %
 
31.0
 %
Net upgrades (monthly average)
 
1.8
 %
 
1.8
 %
 
1.8
 %
 
2.0
 %
 
1.5
 %
Churn (monthly average)
 
-0.9
 %
 
-0.9
 %
 
-0.9
 %
 
-0.8
 %
 
-0.8
 %
Growth in installed base (monthly average) (2)
 
0.9
 %
 
0.9
 %
 
0.9
 %
 
1.2
 %
 
0.7
 %
Number of customers at period end (3)
 
142,441

 
152,578

 
161,422

 
172,510

 
180,866

Number of employees (Rackers) at period end
 
3,492

 
3,712

 
3,799

 
4,040

 
4,335

Number of servers deployed at period end
 
70,473

 
74,028

 
78,717

 
79,805

 
82,438

Average monthly revenue per server
 
$
1,123

 
$
1,141

 
$
1,155

 
$
1,191

 
$
1,238

Profitability
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
$
37,084

Depreciation and amortization
 
$
44,098

 
$
46,952

 
$
49,518

 
$
54,844

 
$
55,151

Share-based compensation expense
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
$
1,412

 
$
756

 
$
1,005

 
$
1,047

 
$
1,236

Sales and marketing (4)
 
$
1

 
$
609

 
$
864

 
$
839

 
$
1,114

General and administrative
 
$
6,397

 
$
4,618

 
$
5,526

 
$
5,699

 
$
6,159

Total share-based compensation expense
 
$
7,810

 
$
5,983

 
$
7,395

 
$
7,585

 
$
8,509

Adjusted EBITDA (1)
 
$
75,891

 
$
81,588

 
$
87,983

 
$
102,194

 
$
100,744

Adjusted EBITDA margin
 
33.0
 %
 
33.0
 %
 
33.3
 %
 
36.1
 %
 
33.4
 %
Operating income margin
 
10.4
 %
 
11.6
 %
 
11.7
 %
 
14.0
 %
 
12.3
 %
Income from operations
 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
$
37,084

Effective tax rate
 
38.3
 %
 
33.8
 %
 
31.7
 %
 
34.5
 %
 
35.5
 %
Net operating profit after tax (NOPAT) (1)
 
$
14,798

 
$
18,968

 
$
21,221

 
$
26,046

 
$
23,919

NOPAT margin
 
6.4
 %
 
7.7
 %
 
8.0
 %
 
9.2
 %
 
7.9
 %
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
Interest bearing debt
 
$
134,905

 
$
138,841

 
$
144,152

 
$
139,126

 
$
143,978

Stockholders' equity
 
$
478,307

 
$
511,843

 
$
551,049

 
$
599,423

 
$
668,436

Less: Excess cash
 
$
(106,268
)
 
$
(102,358
)
 
$
(92,931
)
 
$
(125,865
)
 
$
(150,368
)
Capital base
 
$
506,944

 
$
548,326

 
$
602,270

 
$
612,684

 
$
662,046

Average capital base
 
$
499,180

 
$
527,635

 
$
575,298

 
$
607,477

 
$
637,365

Capital turnover (annualized)
 
1.84

 
1.87

 
1.84

 
1.87

 
1.89

Return on capital (annualized) (1)
 
11.9
 %
 
14.4
 %
 
14.8
 %
 
17.2
 %
 
15.0
 %
Capital expenditures
 
 
 
 
 
 
 
 
 
 
Purchases of property and equipment
 
$
57,651

 
$
74,754

 
$
70,379

 
$
67,020

 
$
59,752

Vendor-financed equipment purchases
 
$
19,009

 
$
20,567

 
$
23,179

 
$
12,335

 
$
22,564

Total capital expenditures
 
$
76,660

 
$
95,321

 
$
93,558

 
$
79,355

 
$
82,316

Customer gear
 
$
46,300

 
$
48,777

 
$
53,643

 
$
47,376

 
$
52,999

Data center build outs
 
$
9,173

 
$
17,491

 
$
16,715

 
$
6,568

 
$
9,473

Office build outs
 
$
2,957

 
$
14,074

 
$
8,806

 
$
9,915

 
$
4,666

Capitalized software and other projects
 
$
18,230

 
$
14,979

 
$
14,394

 
$
15,496

 
$
15,178

Total capital expenditures
 
$
76,660

 
$
95,321

 
$
93,558

 
$
79,355

 
$
82,316

Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end
 
35.7

 
38.0

 
41.9

 
48.1

 
47.8

Megawatts available for use at period end
 
24.7

 
27.0

 
29.7

 
30.7

 
32.2

Megawatts utilized at period end
 
18.0

 
19.0

 
20.2

 
20.9

 
21.4

Annualized net revenue per average Megawatt of power utilized
 
$
53,026

 
$
53,455

 
$
53,994

 
$
55,136

 
$
56,994


- 19 -


(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.
(2) Due to rounding, totals may not equal the sum of the line items in the table above.
(3) Customers are counted on an account basis, and therefore a customer with more than one account with us would be included as more than one customer. Furthermore, amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third-party storage solution are excluded.
(4) During the three months ended March 31, 2011, share-based compensation expense within Sales and Marketing was positively impacted by the reversal of previously recorded expense related to terminated employees. The offset of the reversal was a true-up of the forfeiture rate across Cost of Revenue and General and Administrative expenses for options that fully vested within the quarter, negatively impacting these categories.

Non-GAAP Financial Measures
 
Return on Capital (ROC) (Non-GAAP financial measure)
 
We define Return on Capital as follows: ROC = Net operating profit after tax (NOPAT) / Average capital base

NOPAT = Income from operations x (1 – Effective tax rate)

Average capital base = Average of (Interest bearing debt + stockholders’ equity – excess cash) = Average of (Total assets – excess cash – accounts payables and accrued expenses – deferred revenue – other non-current liabilities, deferred income taxes, and deferred rent)
 
Year-to-date average balances are based on an average calculated using the quarter-end balances at the beginning of the period and all other quarter-ending balances included in the period.

We define excess cash 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.  We will periodically review the calculation and adjust it to reflect our projected cash requirements for the upcoming year.

We believe that ROC is an important metric for investors in evaluating our company’s performance. ROC relates to after-tax operating profits with the capital that is placed into service. It is therefore a performance metric that incorporates both the Statement of Comprehensive Income and the Balance Sheet.  ROC measures how successfully capital is deployed within a company.

Note that ROC is not a measure of financial performance under GAAP and should not be considered a substitute for return on assets, which we consider to be the most directly comparable GAAP measure. ROC has limitations as an analytical tool, and when assessing our operating performance, you should not consider ROC in isolation, or as a substitute for other financial data prepared in accordance with GAAP. Other companies may calculate ROC differently than we do, limiting its usefulness as a comparative measure.
 
ROC increased from 11.9% for the three months ended March 31, 2011 to 15.0% for the three months ended March 31, 2012, primarily due to a reduction of operating costs as a percentage of revenue and a lower tax rate, partially offset by growth in our capital base.  Included in the average capital base are capital expenditures of $40.4 million and $59.4 million related to the build-out of our corporate headquarters and data centers, respectively, since the beginning of the first quarter of 2011.
 
Return on assets increased from 6.9% for the three months ended March 31, 2011 to 8.8% for the three months ended March 31, 2012. This increase was primarily due to operating expenses decreasing as a percentage of revenue, as well as a lower tax rate, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.
 

- 20 -


See our reconciliation of the calculation of return on assets to ROC in the following table: 
 
 
Three Months Ended
(In thousands)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
March 31,
2012
Income from operations
 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
$
37,084

Effective tax rate
 
38.3
%
 
33.8
%
 
31.7
%
 
34.5
%
 
35.5
%
Net operating profit after tax (NOPAT)
 
$
14,798

 
$
18,968

 
$
21,221

 
$
26,046

 
$
23,919

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

 
$
23,180

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
831,414

 
$
887,576

 
$
970,677

 
$
1,026,482

 
$
1,089,393

Less: Excess cash
 
(106,268
)
 
(102,358
)
 
(92,931
)
 
(125,865
)
 
(150,368
)
Less: Accounts payable and accrued expenses
 
(132,308
)
 
(145,609
)
 
(148,464
)
 
(156,004
)
 
(153,668
)
Less: Deferred revenue (current and non-current)
 
(19,149
)
 
(18,687
)
 
(17,772
)
 
(18,281
)
 
(20,195
)
Less: Other non-current liabilities, deferred income taxes, and deferred rent
 
(66,745
)
 
(72,596
)
 
(109,240
)
 
(113,648
)
 
(103,116
)
Capital base
 
$
506,944

 
$
548,326

 
$
602,270

 
$
612,684

 
$
662,046

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
796,496

 
$
859,495

 
$
929,127

 
$
998,580

 
$
1,057,938

Average capital base
 
$
499,180

 
$
527,635

 
$
575,298

 
$
607,477

 
$
637,365

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
6.9
%
 
8.2
%
 
8.6
%
 
10.0
%
 
8.8
%
Return on capital (annualized)
 
11.9
%
 
14.4
%
 
14.8
%
 
17.2
%
 
15.0
%


- 21 -


Adjusted EBITDA (Non-GAAP financial measure)
 
We use Adjusted EBITDA as a supplemental measure to review and assess our performance.  We define Adjusted EBITDA as Net income, plus income taxes, total other (income) expense, depreciation and amortization, and non-cash charges for share-based compensation. Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.
 
Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation, or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP.  Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.
 
Adjusted EBITDA increased $24.9 million, or 32.7%, from $75.9 million in the three months ended March 31, 2011 to $100.7 million in the three months ended March 31, 2012.  Adjusted EBITDA as a percentage of revenue increased from 33.0% for the three months ended March 31, 2011 to 33.4% for the three months ended March 31, 2012.  The primary driver of the increase in Adjusted EBITDA margin was a decrease in Cost of Revenue as a percentage of revenue, partially offset by an increase in General and Administrative expenses as a percentage of revenue.  Also impacting our results were changes in non-cash deferred rent and non-equity incentive compensation. Non-cash rent decreased from $3.0 million in the three months ended March 31, 2011 to $1.9 million in the three months ended March 31, 2012.  Overall, non-equity incentive compensation increased $2.7 million due to an increase in the payout percentage and increased headcount. Adjusted EBITDA as a percentage of revenue decreased from 36.1% for the three months ended December 31, 2011 to 33.4% for the three months ended March 31, 2012 primarily due to an increase in General and Administrative and Sales and Marketing expenses as a percentage of revenue.

Employee non-equity incentive compensation through our current non-equity incentive plan, in effect since January 1, 2009, is dependent upon the financial results of the company in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense.  If company achievement of the pre-set target results in a 10% increase in the non-equity incentive compensation percentage payout, this would increase total non-equity incentive compensation by approximately $0.7 million on an after-tax basis and increase net income by $0.7 million.  Company achievement resulting in a 10% decrease in the non-equity incentive compensation percentage payout would decrease total non-equity incentive compensation by approximately $0.7 million on an after-tax basis and decrease net income by $0.7 million. Additionally, the Compensation Committee has the discretion to increase or decrease a payout under the plan at any time in the event that it determines that circumstances warrant adjustment or to pay bonuses outside of the plan. The metric we use for evaluating the financial results of the company is called NOPAT Before Bonus, which is calculated as NOPAT (as defined above) without the inclusion of any impact of non-equity incentive compensation and assumes a statutory tax rate. This cannot be calculated from our financial statements as we do not separately disclose total non-equity incentive compensation for the period.
 
Income from operations has been favorably impacted by decreases in our Cost of Revenue and Depreciation and Amortization expenses as a percentage of revenue. Our operating income margin increased from 10.4% for the three months ended March 31, 2011 to 12.3% for the three months ended March 31, 2012.
 
    

- 22 -


See our Adjusted EBITDA reconciliation below. 
 
 
Three Months Ended
(Dollars in thousands)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
March 31,
2012
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

 
$
301,355

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
$
37,084

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

 
$
23,180

   Plus: Income taxes
 
8,593

 
8,956

 
9,281

 
13,188

 
12,769

   Plus: Total other (income) expense
 
1,569

 
2,136

 
1,807

 
1,530

 
1,135

   Plus: Depreciation and amortization
 
44,098

 
46,952

 
49,518

 
54,844

 
55,151

   Plus: Share-based compensation expense
 
7,810

 
5,983

 
7,395

 
7,585

 
8,509

Adjusted EBITDA
 
$
75,891

 
$
81,588

 
$
87,983

 
$
102,194

 
$
100,744

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
10.4
%
 
11.6
%
 
11.7
%
 
14.0
%
 
12.3
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
33.0
%
 
33.0
%
 
33.3
%
 
36.1
%
 
33.4
%


- 23 -


Adjusted Free Cash Flow (Non-GAAP financial measure)
 
We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditures (including vendor-financed equipment purchases), cash payments for interest, net, and cash payments for income taxes, net.
 
We believe that Adjusted Free Cash Flow is an important metric for investors in evaluating how a company is currently using cash generated and may indicate its ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, payment of dividends, etc. Note that Adjusted Free Cash Flow is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.
 
See our Adjusted Free Cash Flow reconciliation to Adjusted EBITDA below, as well as our reconciliation of Net income to Adjusted EBITDA provided above. 
 
Three Months Ended
(In thousands)
March 31,
2012
Adjusted EBITDA
$
100,744

Non-cash deferred rent
1,930

Total capital expenditures
(82,316
)
Cash payments for interest, net
(1,226
)
Cash payments for income taxes, net
(1,675
)
Adjusted free cash flow
$
17,457

 
Net Leverage (Non-GAAP financial measure)
 
We define Net Leverage as Net Debt divided by Adjusted EBITDA (trailing twelve months). We believe that Net Leverage is an important metric for investors in evaluating a company’s liquidity. Note that Net Leverage is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies. We believe that Net Leverage provides an additional indicator when assessing our liquidity, capital structure and leverage and provides insight into a company's ability to assume more debt if and when required. A negative Net Leverage indicates that our cash and cash equivalents is greater than our total debt as of the balance sheet date.
 
See our Net Leverage calculation below. 
(Dollars in thousands)
As of
 
 
March 31, 2012
 
Obligations under capital leases
$
143,538

 
Debt
440

 
Total debt
$
143,978

 
Less: Cash and cash equivalents
(186,531
)
 
Net debt
$
(42,553
)
 
Adjusted EBITDA (trailing twelve months)
$
372,509

 
Net leverage
(0.11
)
x


- 24 -


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 (Unaudited):

 
 
Three Months Ended
(In thousands)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
March 31,
2012
Net revenue
 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

 
$
301,355

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
69,742

 
74,057

 
82,445

 
82,851

 
87,240

Sales and marketing
 
29,738

 
31,477

 
31,838

 
33,452

 
38,502

General and administrative
 
62,441

 
66,090

 
69,701

 
72,349

 
83,378

Depreciation and amortization
 
44,098

 
46,952

 
49,518

 
54,844

 
55,151

Total costs and expenses
 
206,019

 
218,576

 
233,502

 
243,496

 
264,271

Income from operations
 
23,983

 
28,653

 
31,070

 
39,765

 
37,084

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(1,491
)
 
(1,522
)
 
(1,531
)
 
(1,304
)
 
(1,272
)
Interest and other income (expense)
 
(78
)
 
(614
)
 
(276
)
 
(226
)
 
137

Total other income (expense)
 
(1,569
)
 
(2,136
)
 
(1,807
)
 
(1,530
)
 
(1,135
)
Income before income taxes
 
22,414

 
26,517

 
29,263

 
38,235

 
35,949

Income taxes
 
8,593

 
8,956

 
9,281

 
13,188

 
12,769

Net income
 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

 
$
23,180

 
 
Consolidated Statements of Income, as a Percentage of Net Revenue (Unaudited):
 
 
 
Three Months Ended
(Percent of net revenue)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
March 31,
2012
Net revenue
 
100.0
 %<