This Quarterly Report on Form 10-Q contains 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, which are subject to the "safe harbor" created by those sections. Forward-looking statements 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 Quarterly Report on Form 10-Q in greater detail under the heading "Risk Factors." 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 Quarterly Report on Form 10-Q 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 interim consolidated financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission, or SEC, filings, including the audited consolidated financial statements included in our Registration Statement on Form S-1, filed with the SEC on August 5, 2008, relating to our initial public offering.

Overview

Rackspace Hosting is the world's leader in hosting. We deliver websites, web-based IT systems, and computing as a service. Our rapid growth is the result of our commitment to serving our customers, known as Fanatical Support ®, and our exclusive focus on hosting. We have been successful in attracting and retaining thousands of customers and in growing our business at high rates. We aspire to maintain our service-centric focus in the future and will follow our vision to be considered one of the world's great service companies. As of September 30, 2008, we served over 36,000 customers running on over 45,000 servers within our data centers in the United States, or U.S., the United Kingdom, or U.K., and Hong Kong, or H.K.

Our subscription-based business model generates almost all of our revenues on a recurring basis. Our customers pay us a recurring fee based on the size and complexity of the IT systems we manage and the level of service intensity we provide, pursuant to service agreements that typically provide for monthly payments. Recurring revenues are reduced by credits issued to customers, primarily for service interruptions, and also include revenues related to customers who have cancelled their service. A minor portion of our revenues are non-recurring, which includes certain usage charges, set up fees, and professional services. Net revenues for the three months ended September 30, 2007 and 2008 were $96.1 million and $138.4 million, respectively, an increase of 44.0%. Net revenues for the nine months ended September 30, 2007 and 2008 were $255.3 million and $388.8 million, respectively, an increase of 52.3%.

We sell our services to small and medium-sized businesses as well as large enterprises. During 2008, 26.7% of our net revenues were generated by our operations outside of the U.S., mainly from the U.K. We intend to continue to target international customers and plan to expand our activities in continental Europe and Asia. In 2008, no individual customer has accounted for greater than 1% of our net revenues.

Our revenue growth is primarily due to increased volume of services provided, both due to an increasing number of customers and due to incremental services rendered to existing customers. We analyze our growth performance through the increase in the number of new customers and the growth in our existing customers (growth in installed base). Our customers may upgrade or downgrade the services we provide to meet the changing demands of their businesses, or may terminate their service agreements. We use the metric "growth in installed base" to measure how fast our existing customer base is growing before we add any new customers. For the three months ended September 30, 2008, our average monthly growth in installed base was 0.6% per month.

The growth in installed base metric consists of net upgrades minus churn. Net upgrades measure the incremental monthly recurring revenues from customer upgrades less downgrades as a percentage of total monthly recurring revenues. Churn measures the reduction of monthly revenue as a percentage of total monthly recurring revenues due to customer terminations. Terminations typically result from customers who (i) no longer need hosting services, (ii) are unable to pay for hosting services, (iii) decide to provide their services in-house, or
(iv) switch to another hosting provider.

We do not typically increase unit prices of our services. Our customers have strong expectations of unit prices being constant or slightly falling over time, reflecting the general belief that technology solutions become more cost-effective over time. While pricing is a factor for all of our service offerings, we believe that our growth rates are a reflection of our ability to sell our services at competitive and reasonable price levels, while also providing superior customer service. This focus has contributed to our ability to maintain relatively stable price levels over time. Our pricing strategy follows two main principles: to set a price that enables us to recover the full cost of doing business and also allows us to compete successfully. These principles have allowed us to grow at rates higher than the industry average, while being profitable on an overall company basis.

As we grow our revenues and customer base, we incur incremental costs. When we acquire a new customer or increase our business with an existing customer, we generally require additional customer related hardware and software, which we deploy in our data centers. The placement in service of additional equipment also typically increases our power and bandwidth costs. As our customer base grows, we continue to expand our support organization to maintain our commitment to Fanatical Support ®. As of September 30, 2008, our total headcount was 2,536 and our operating expenses for the three months ended September 30, 2008 were $128.9 million. As we grow, we would expect to incur additional costs and headcount in certain functions to support our customers.

We also strive to align our investment in data center infrastructure with our revenue growth to keep utilization rates high. We measure our utilization rate as the power being consumed by all electrical equipment relative to the total available capacity in our data centers. We pursue a modular build out strategy within our data centers that expands the operational footprint when needed. From time to time, we will be required to make significant investments in new data centers or enter into long term facility leases to support expected growth beyond our ability to build out additional modules in existing facilities.

Generally, our recurring revenue model and our just-in-time approach to resource allocation lead to relatively stable margins over time. However, funding needs may increase and margins will likely decrease in periods when we make large investments in our future. Such investments may be made in connection with data center and office expansion, as well as significant product and market development initiatives. We made such investments in 2007 and have continued to make similar investments in 2008.

Although we accept lower margins and higher cash flow deficits during periods of investments, we focus on customer level profitability, which we measure and manage on an on-going basis. A key requirement for our growth strategy is that incremental revenue we acquire is profitable and adds to shareholder value. We seek to avoid unprofitable contracts for the sake of growth, loss leader products, or retaining unprofitable customers with the hope of up-selling them later. Our disciplined approach aims to engage in profitable customer relationships where we can observe returns on capital that are consistently above our internal hurdle rate and where our customers can expect to experience outstanding service at competitive and relatively stable price levels.

Our operations and financial results are exposed to certain risks and uncertainties that may impact our financial condition and results of operations. See the section entitled "Risk Factors" for further discussion of these risks.

Expanding and maintaining our talent base: We rely heavily on knowledgeable and experienced employees to provide a high level of service on a continuous basis in a complex technology-driven environment. This requires us to hire and retain professionals, many of whom may have employment opportunities elsewhere. We may have to adjust salary levels in the future to remain competitive in the market for talent which may increase our cost structure and may depress our margins.

Exposure to increasing energy costs: We have been exposed to the recent increases in energy costs (see the section entitled "Quantitative and Qualitative Disclosures about Market Risk"). For the nine months ended September 30, 2008, we paid $9.7 million for electricity usage in our data centers, representing 2.5% of our net revenues. While most of our data centers operate in regulated energy markets, power cost increases are possible and we may not be able to impose those cost increases on our customers through higher unit prices, which could increase our operating costs and depress our margins.

Customer acquisition costs: Our installed base growth reduces our need to spend marketing dollars to acquire new revenues. If the installed base growth declines, or if downgrades and customer terminations exceed upgrades, our sales and marketing expenses would increase on a relative basis in order to overcome lost revenue from downgrading and customer terminations. This would in turn increase our operating costs and decrease our margins.

Aligning infrastructure needs with revenues: We build out infrastructure such as data centers and office space to accommodate future revenue growth. While we try to minimize the amount of excess capacity, we do need to consider appropriate lead times for these build outs, which requires us to build capacity ahead of actual revenue growth. There is no guarantee as to if and when this future revenue growth will occur, which exposes us to costs related to excess capacity and associated margin reductions.

New markets and service offerings: We are expanding our geographic footprint and are in the process of developing new services. Those new ventures may not yield the returns that we expect and we may incur development costs beyond what we expect today. Delays or unexpected costs may depress margins temporarily or permanently.

Key Metrics

We carefully track several financial and operational metrics to monitor and control 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. The results of the three months ended June 30, 2008, three and nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for the year ending December 31, 2008, or for any other interim period, or for any other future year.

                                                    Three Months Ended                                Nine Months Ended
                                     September 30,       June 30,        September 30,        September 30,        September 30,
                                         2007              2008              2008                 2007                 2008
Growth
Number of employees (Rackers) at
period end                                    1,829          2,422                2,536                1,829                2,536
Number of customers at period
end *                                        26,909         33,607               36,185               26,909               36,185
Number of servers deployed at
period end                                   33,972         42,424               45,231               33,972               45,231
Net upgrades (monthly average)                  2.7 %          2.1 %                1.8 %                2.6 %                2.0 %
Churn (monthly average)                        -0.9 %         -1.1 %               -1.2 %               -1.0 %               -1.2 %

Growth in Installed Base
(monthly average)                               1.8 %          1.0 %                0.6 %                1.6 %                0.8 %
Net revenues (in thousands)         $        96,097      $ 130,829      $       138,354      $       255,334      $       388,796
Revenue growth (year over year)                62.8 %         55.7 %               44.0 %               62.9 %               52.3 %
Profitability
Operating income margin                        11.4 %          6.4 %                6.9 %               10.2 %                7.2 %

Income from Operations (in
thousands)                          $        10,996      $   8,396      $         9,490      $        26,029      $        28,024
Effective Tax Rate                             38.7 %         37.9 %               29.6 %               37.2 %               36.0 %

Net Operating Profit After Tax
(NOPAT, in thousands) (1)           $         6,741      $   5,214      $         6,681      $        16,346      $        17,935
NOPAT margin                                    7.0 %          4.0 %                4.8 %                6.4 %                4.6 %
Capital efficiency and returns
Interest bearing debt (in
thousands)                          $       103,678      $ 183,553      $       297,933      $       103,678      $       297,933
Stockholders' equity (in
thousands)                          $        93,491      $ 117,417      $       269,008      $        93,491      $       269,008
Less: Excess cash                   $            -       $      -       $      (235,421 )    $            -       $      (235,421 )

Capital (in thousands)              $       197,169      $ 300,970      $       331,520      $       197,169      $       331,520
Average capital base (in
thousands)                          $       161,069      $ 275,935      $       316,245      $       128,897      $       272,929
Capital turnover (annualized)                  2.39           1.90                 1.75                 2.64                 1.90

Return on Capital (annualized)
(1)                                            16.7 %          7.6 %                8.5 %               16.9 %                8.8 %
Capital expenditures (in
thousands)
Purchases of property and
equipment, net                      $        59,143      $  40,273      $        45,328      $       109,552      $       132,849
Vendor financed equipment
purchases                           $        17,731      $  26,014      $        23,009      $        34,105      $        70,642

Total capital expenditures          $        76,874      $  66,287      $        68,337      $       143,657      $       203,491

Customer gear                       $        20,073      $  27,347      $        27,627      $        69,110      $        82,533
Data center build outs              $        19,278      $  18,509      $        21,679      $        24,400      $        65,580
Office build outs                   $        29,096      $  12,815      $        11,227      $        30,317      $        32,874
Capitalized software and other
projects                            $         8,427      $   7,616      $         7,804      $        19,830      $        22,504

Total capital expenditures          $        76,874      $  66,287      $        68,337      $       143,657      $       203,491
Infrastructure capacity and
utilization
Technical square feet of data
center space at period end                  111,749        133,462              136,962              111,749              136,962
Annualized net revenue per
average technical square foot       $         3,775      $   4,217      $         4,093      $         3,515      $         4,148
Utilization rate at period end                 57.9 %         59.1 %               63.4 %               57.9 %               63.4 %

* Includes 11,265 and 15,102 mail customers as of September 30, 2007 and 2008, and 13,893 customers as of June 30, 2008, respectively.

(1) See discussion and reconciliation of our Non-GAAP financial measure to the most comparable GAAP measure included within this document.

Recent Developments and Third Quarter Results

In the third quarter 2008, we continued to deliver on our growth strategy. Net revenues for the three months ended September 30, 2008 were $138.4 million, up 5.8% from the second quarter of 2008 and up 44.0% from the three months ended September 30, 2007. This growth rate was impacted by the broader economic environment as well as a strengthening U.S. dollar relative to the pound sterling. In the current quarter, approximately 26% of our revenue was generated in markets outside the U.S., and sequential growth in U.S. dollars was less than 1%, but when measured in local currency was approximately 5%. During the quarter we experienced a monthly average churn rate of 1.2%, which slightly increased from 0.9% for the comparative three months in 2007. Overall, our installed base continued to provide a portion of our growth during the third quarter 2008, growing at an average rate of 0.6% per month.

Also during the third quarter, we focused on the cost structure of our business and scaled certain investments. As a result, our general and administrative sequential growth decreased to 1.6% in the third quarter compared to the 13.3% growth in the second quarter versus the first. We remain focused on the scaling of all costs.

As of September 30, 2008, we held $260.3 million in cash and short-term liquid investments. As a result, we believe that this positions us well to capitalize on strategic acquisitions and the purchase of capital equipment to grow our business. Additionally, we expect to continue to make significant investments that are designed to enhance our business fundamentals and enable us to provide a better overall experience for our customers, which we believe will lead to greater profit over time. This is evidenced by our recently completed acquisitions of Jungle Disk and Slicehost, which are examples of our strategic use of cash.

As of September 30, 2008, we served 36,185 customers (includes 15,102 mail customers) running on 45,231 servers within our data centers, an increase of 7.7% and 6.6% relative to the three months ended June 30, 2008, respectively.

Significant events of our third quarter 2008 results compared to the second quarter 2008 were:

• The number of employees (Rackers) grew from 2,422 as of June 30, 2008 to 2,536 as of September 30, 2008, an increase of 4.7%. Our total payroll, including share-based compensation expense, grew from $56.6 million for the second quarter 2008 to $57.9 million for the third quarter 2008, an increase of 2.3%. Share-based compensation grew from $3.8 million in the second quarter 2008 to $4.3 million in the third quarter 2008.

• Cost of revenues grew 6.3% from $42.8 million in the second quarter 2008 to $45.5 million in the third quarter 2008. Major drivers of the cost increase include salaries and benefits, and an increase in data center costs, including power.

• We continued to increase our sales and marketing expenses from $19.8 million in the second quarter 2008 to $21.5 million in the third quarter 2008, an increase of 8.6%. Major drivers for this cost increase are salaries, wages and commissions (including share-based compensation) and costs of marketing programs.

• General and administrative expenses increased from $38.1 million in the second quarter 2008 to $38.7 million in the third quarter 2008, an increase of 1.6%.

• Depreciation and amortization expenses increased from $21.6 million in the second quarter of 2008 to $23.2 million in the third quarter 2008, an increase of 7.4%. The majority of this increase was due to additions of computer hardware, software, software licenses, and leasehold improvements in connection with our growth.

• The addition of 6,500 technical square feet in our new H.K. data center in August 2008, as part of our expansion efforts into the Asia Pacific region.

• Migrated 3,000 technical square feet from a colocation facility to our Slough, U.K. datacenter.

• Interest expense increased from $1.8 million in the second quarter of 2008 to $1.9 million in the third quarter 2008 as a result of higher overall borrowings.

• Income taxes decreased from $2.6 million in the second quarter of 2008 to $2.2 million in the third quarter 2008 due to lower income before income taxes and a decrease in our effective rate due to a higher than anticipated percentage of our earnings being realized in countries where we have lower statutory rates.

• We successfully completed our initial public offering (IPO). We are listed on the New York Stock Exchange and are traded under the symbol RAX. Through this offering, the company received net proceeds of $144.6 million after deducting the underwriters discount and IPO expenses.

Operating income for the third quarter 2008 was $9.5 million, up 13.1% from $8.4 million in the second quarter 2008. Our net income increased 23.8% from $4.2 million for the second quarter of 2008 to $5.2 million for the third quarter 2008.

Our cash flow from operating activities was $33.2 million for the third quarter of 2008. Our capital expenditures were $68.3 million, including $27.6 million for purchases of customer gear, $21.7 million for data center build outs, $11.2 million for office build outs, and $7.8 million for capitalized software and other expenditures. Of the $68.3 million in capital expenditures, $23.0 million were vendor financed equipment purchases.

At the end of the third quarter, we had $24.9 million in cash deposits and $235.4 million in money market funds. Our debt obligations totaled $297.9 million. Of those, $212.1 million were related to current and non-current debt, and $85.9 million were related to obligations under capital and finance method leases. As of September 30, 2008, we had access to an additional $44.2 million under our current credit facility.

We used $57.3 million of the net IPO proceeds to reduce our outstanding borrowings on our credit facility to $50.0 million. Subsequently in the third quarter, we borrowed an additional $150.0 million on our credit facility due to uncertain economic conditions in the credit and banking markets to ensure we have the liquidity we need to grow our business over the long term.

Subsequent to the end of the third quarter, we acquired Jungle Disk, a company specializing in cloud storage solutions that allow users to easily share an unlimited amount of cloud storage between multiple users, and Slicehost, a cloud hosting company specializing in Xen-based virtual machine hosting. These acquisitions are a result of our cloud hosting strategy, extending the company's technology and service leadership to cloud hosting. Over time, we intend to integrate our capabilities into a complete hosting portfolio to provide business customers a suite of hosting solutions to meet all of their IT needs. The purchase price of the combined acquisitions was approximately $11.5 million payable in cash and stock, with the potential for up to $16.5 million in additional payouts of cash and stock based on certain earnout provisions.

Return on Capital (ROC) (Non-GAAP financial measure)

We define Return on Capital (ROC) 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 revenues - other non-current liabilities)

We define excess cash as our investments in money market funds.

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 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 accounting principles generally accepted in the United States (GAAP) and should not be considered a substitute for return on assets, which we consider to be the most directly comparable GAAP measure, and may not be comparable to similarly titled measures reported by other companies.

ROC decreased from 16.9% for the nine months ended September 30, 2007 to 8.8% for the nine months ended September 30, 2008. This decrease was due to an increase in income from operations and a proportionately larger increase in the average capital base over the same time period. Included in the average capital base for the nine months ended September 30, 2008 are capital expenditures related to our new corporate headquarter facilities and data centers that are in the process of being built out. Return on assets decreased from 10.8% to 4.5% for the nine months ended September 30, 2007 and 2008, respectively. For the three months ended September 30, 2008, ROC was 8.5% and return on assets was 3.8%.

See our reconciliation of the calculation of return on assets to ROC in the following table:

                                                                    Three Months Ended                           Nine Months Ended September 30,
                                                     September 30,       June 30,        September 30,
(In thousands, financial metrics)                        2007              2008              2008                  2007                   2008
. . .