|• FORM 10-Q • LEASE AGREEMENT BY AND BETWEEN FOX PROPERTIES LLC AND RACKPSACE US, INC., DATED APRIL 26, 2012 • 2007 LONG-TERM INCENTIVE PLAN AS AMENDED AND RESTATED • SECTION 302 CERTIFICATION OF CEO • SECTION 302 CERTIFICATION OF CFO • SECTION 906 CERTIFICATION OF CEO • SECTION 906 CERTIFICATION OF CFO • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA DOCUMENT • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION LABEL LINKBASE DOCUMENT • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE DOCUMENT|
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2012.
For the transition period from ______ to ______.
Commission file number 001-34143
RACKSPACE HOSTING, INC.
(Exact name of registrant as specified in its charter)
5000 Walzem Rd.
San Antonio, Texas 78218
(Address of principal executive offices, including zip code)
(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.
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 August 2, 2012, 135,596,974 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
See accompanying notes to the unaudited condensed consolidated financial statements.
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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to the unaudited condensed consolidated financial statements.
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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to the unaudited condensed consolidated financial statements.
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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®.
Our operations began in 1998 as a limited partnership, and Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000.
Basis of Consolidation
The consolidated financial statements include the accounts of Rackspace Hosting 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.
Basis of Presentation
The accompanying consolidated financial statements as of June 30, 2012, and for the three and six months ended June 30, 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 June 30, 2012, our results of operations for the three and six months ended June 30, 2011 and 2012, and our cash flows for the six months ended June 30, 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 and six months ended June 30, 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.
The Company corrected immaterial errors in its Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 2011 by decreasing purchases of property and equipment reflected in investing activities by $10.4 million with an equal and offsetting reduction in the change in accounts payable and accrued expenses in operating activities. These amounts were inadvertently overstated because property and equipment acquired but unpaid as of the end of the reporting period was included in the amounts previously reported. The correction reduces the Company's net cash provided by operating activities and net cash used in investing activities included within the Condensed Consolidated Statement of Cash Flows by $10.4 million. This correction does not impact the Company's previously reported amounts in its Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2011 or the Company's Condensed Consolidated Balance Sheet as of December 31, 2011.
In connection with (i) the filing of the Company's Form 10-Q for the third quarter of 2012, (ii) the filing of the 2012 Form 10-K, and (iii) the filing of the Company's Form 10-Q for the first quarter of 2013, similar adjustments will be made to the Company's Statements of Cash Flows that will decrease (increase) cash flows from operating activities with an equal and offsetting adjustment to cash flows used in investing activities by $12.9 million for the nine months ended September 30, 2011, $23.3 million and $3.7 million for the years ended December 31, 2011 and 2010, and $(7.9) million for the three months ended March 31, 2012, respectively.
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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.
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 revenue and 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 U.S. 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 year 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 year, 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.
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2. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
We excluded 0.9 million and 1.1 million potential common shares from the computation of dilutive earnings per share for the three months ended June 30, 2011 and 2012, respectively, and 1.1 million and 0.9 million potential shares for the six months ended June 30, 2011 and 2012, respectively, because the effect would have been anti-dilutive.
3. Cash and Cash Equivalents
Cash and cash equivalents consisted of:
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.
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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.
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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 and six months ended June 30, 2011 and June 30, 2012, we recognized minimal net gains as interest and other income.
5. Property and Equipment, net
Property and equipment consisted of:
Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $45.7 million and $58.9 million for the three months ended June 30, 2011 and 2012, respectively, and $88.3 million and $112.3 million for the six months ended June 30, 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 June 30, 2012, the work in process balance consisted of build outs of $28.9 million for office facilities, $0.8 million for data centers, and $21.0 million for capitalized software and other projects.
There was no interest capitalized during the three or six months ended June 30, 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 was allocated based on the estimated fair values of the individual assets acquired and liabilities assumed at the date of acquisition. 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 comprehensive 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 six months of 2012, we paid $5.3 million related to these previous acquisitions, and as of June 30, 2012, the fair value of the remaining liability recorded was $2.1 million.
The following table provides a roll forward of our goodwill balance.
The $2.2 million of goodwill recorded for the acquisition in February 2012 is deductible for tax purposes.
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7. Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consisted of:
Debt outstanding at December 31, 2011 consisted of current notes payable of $0.9 million, which was paid during the first six months of 2012. In the quarter ended June 30, 2012, we entered into a new financing arrangement with a software vendor, resulting in a $2.1 million notes payable balance at June 30, 2012, $0.7 million of which was current. As the note, which matures in July 2014, does not have a stated interest rate, we have imputed an interest rate of 5.75%.
We also have a revolving credit facility, which has a total commitment of $200 million and matures in September 2016. As of June 30, 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.
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9. Commitments and Contingencies
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. 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. In addition, we are involved in the following legal proceedings:
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 also a party to various claims that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, products, or services, and may also cause us to change our business practices and require development of non-infringing products or technologies, which could result in a loss of revenue for us and otherwise harm our business. We have disputed the allegations of wrongdoing in these proceedings and intend to vigorously defend ourselves in all such matters.
We 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.
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 June 30, 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.
10. Share-Based Compensation
At our 2012 annual meeting of the stockholders held on May 2, 2012, our stockholders approved certain amendments to our Amended and Restated 2007 Long-Term Incentive Plan (the "2007 Plan"). The amendments included, among other things, setting a fixed number of shares available of 12 million, removing the evergreen provision and requiring new grants of restricted stock, restricted stock units, performance units and performance shares to count against the numerical limits of the 2007 Plan as 1.76 shares for every one share that is subject to such an award.
The following have been granted under our 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, except as described above. 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 awards pursuant to the automatic share reserve increase or “evergreen” provision under the 2007 Plan; however, as stated above, the authorized shares available for issuance under the Plan was reduced upon approval of our stockholders at our 2012 annual meeting of the stockholders. Therefore, as of June 30, 2012, the total number of shares authorized under all of our plans, including shares issued pursuant to awards, total outstanding awards and shares available for future awards under the plans, was 43.0 million shares, of which approximately 11.9 million shares were available for future awards.
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Outstanding awards were as follows:
The following table summarizes our RSU and RSA activity for the six months ended June 30, 2012:
(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 June 30, 2011 and 2012 was $41.32 and $52.62, respectively, and $37.86 and $48.31 during the six months ended June 30, 2011 and 2012, respectively. The total pre-tax intrinsic value of the RSUs and RSAs released during the three months ended June 30, 2011 and 2012 was $0.6 million and $0.1 million, respectively, and $4.2 million and $64.1 million for the six months ended June 30, 2011 and 2012, respectively.
We granted 287,414 RSUs and 205,689 RSAs in 2012. The RSUs and 61,801 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 34,437 of these RSAs is dependent upon the total shareholder return (TSR) on our common stock for a three-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 3 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 June 30, 2012, there was $51.1 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 2.2 years.
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The following table summarizes the stock option activity for the six months ended June 30, 2012:
*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 seven years.
The total pre-tax intrinsic value of the stock options exercised during the three months ended June 30, 2011 and 2012 was $36.7 million and $21.4 million, respectively, and $104.1 million and $98.6 million for the six months ended June 30, 2011 and 2012, respectively.
The following table presents the assumptions used to estimate the fair values of the stock options granted in the periods presented:
As of June 30, 2012, there was $54.7 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 2.3 years.
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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. During the six months ended June 30, 2012, the Company issued 68,203 shares under the ESPP. The fair value on the date of enrollment was determined using the Black-Scholes option-pricing model.
The fair values estimated from the Black-Scholes option-pricing model were calculated using the following assumptions:
The weighted average fair value of $15.51 per share will be recognized ratably over the two-year term.
Share-based compensation expense was recognized as follows:
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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.
As of June 30, 2012, approximately $2.8 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 June 30, 2012 are liabilities of $12.6 million that, if recognized, would be recorded as an adjustment to other current and non-current assets.
12. Comprehensive Income
The income tax benefit allocated to foreign currency translation adjustments during the three and six months ended June 30, 2011 was $0.1 million and $0.2 million, respectively. Minimal income tax expense was allocated to these adjustments during the three and six months ended June 30, 2012.
The change in accumulated other comprehensive income (loss) for the six months ended June 30, 2012 was as follows:
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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:
Total net revenue by our product categories was as follows:
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:
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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 industry-leading service, known as Fanatical Support. We also distinguish ourselves through our exclusive focus on cloud computing, our broad portfolio of services and our promotion of open standards that give customers freedom of movement among various cloud providers. 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 and seamlessly integrates the two through a product called RackConnect®. We are committed to maintaining our service 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 (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) required 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 six months of 2012, 26% 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 the Asia-Pacific region. For the first six months of 2012, no individual customer accounted for greater than 2% of our net revenue.
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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 because 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 because we believe the two complement one another, allowing customers to choose the best platform for each of their applications. 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 are creating new technologies to help businesses leverage the benefits of Public Cloud hosting.
Our product strategy includes the development of a variety of new capabilities and features and building a support business around the OpenStack® cloud computing platform. In April 2012, we launched new cloud capabilities featuring the world's first large-scale, production ready cloud built on open-source software and backed by Fanatical Support. Powered by OpenStack, our Rackspace open cloud will incorporate 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. Some of these new capabilities have already been made available and others will be made available in the near future as we roll out our full portfolio of capabilities on this new platform. Additionally, based on our experience working with customers running OpenStack, we introduced a new service we call Rackspace Private Cloud. This offering enables 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 and could become a meaningful part of our growth strategy in the long term. These initiatives are still in the early stages, and while we believe that these new capabilities and features could drive future incremental demand, there are certain risks associated with such a significant product transition and platform shift.
We believe these risks could adversely impact our ability to execute on our growth strategy and therefore capitalize on the current market opportunity, both in the short and long term. They include (i) the acceptance by current and prospective customers of our new Public Cloud platform and product set, (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources; larger customer bases; longer operating histories; greater brand recognition; more established relationships in the industry; and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities, (iii) new pricing strategies that may include lowering price points for Cloud products to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our Cloud products to certain significant Cloud customers, (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases, (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve, including the current volatile economic environment found in Europe, and (vi) other risks as set forth in the section titled “Risk Factors”.
In February 2012 we acquired SharePoint911, an industry leader in SharePoint consulting, training, and "JumpStart" services within SharePoint. While the acquisition did not have a material impact on the results of the quarter, the acquisition provides capabilities to deliver unparalleled SharePoint hosting solutions along with expert services to our customers. We expect to make additional, similar acquisitions in the future that can increase our service capabilities and product offerings.
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.
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(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) Purchases of property and equipment in prior periods were corrected for immaterial errors. The change was a reclassification between purchases of property and equipment and non-cash purchases of property and equipment. There was no impact on total capital expenditures.
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 calculate directly from amounts on the Statement of Comprehensive Income and the Balance Sheet. 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 14.4% for the three months ended June 30, 2011 to 15.5% for the three months ended June 30, 2012, primarily due to a reduction of operating costs as a percentage of revenue, partially offset by growth in our capital base. Included in the average capital base are capital expenditures of $41.5 million and $53.5 million related to the build-out of our corporate headquarters and data centers, respectively, since the beginning of the second quarter of 2011.
Return on assets increased from 8.2% for the three months ended June 30, 2011 to 9.0% for the three months ended June 30, 2012. This increase was primarily due to operating expenses decreasing as a percentage of revenue, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.
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See our reconciliation of the calculation of return on assets to ROC in the following table:
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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 $30.3 million, or 37.1%, from $81.6 million in the three months ended June 30, 2011 to $111.9 million in the three months ended June 30, 2012. Adjusted EBITDA as a percentage of revenue increased from 33.0% for the three months ended June 30, 2011 to 35.1% for the three months ended June 30, 2012. The primary drivers of the increase in Adjusted EBITDA margin were decreases in Cost of Revenue and Sales and Marketing expenses 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 $2.8 million in the three months ended June 30, 2011 to $2.1 million in the three months ended June 30, 2012. Overall, non-equity incentive compensation for the three months ended June 30, 2012 increased $6.6 million from the three months ended June 30, 2011 due to an increase in the payout percentage and increased headcount. Adjusted EBITDA as a percentage of revenue increased from 33.4% for the three months ended March 31, 2012 to 35.1% for the three months ended June 30, 2012 primarily due to decreases in Cost of Revenue, Sales and Marketing, and General and Administrative 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 Sales and Marketing expenses as a percentage of revenue. Our operating income margin increased from 11.6% for the three months ended June 30, 2011 to 12.8% for the three months ended June 30, 2012.
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See our Adjusted EBITDA reconciliation below.