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 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

Rackspace Hosting, Inc. is a world leader in hosting and cloud computing. Our growth is the result of our commitment to serving our customers, known as Fanatical SupportŪ, and our exclusive focus on hosting and 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 both traditional dedicated hosting and cloud computing. We are committed to maintaining our service-centric focus and will follow our vision to be considered one of the world's greatest service companies.

We offer services to support websites, web-based IT systems, and computing as a service. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by us. Rackspace offers a full suite of hosting services, including managed hosting, email hosting, as well as emerging services such as cloud hosting.

We sell our services to small and medium-sized businesses as well as large enterprises. During the first three months of 2009, 23.8% of our net revenues were generated by our operations outside of the U.S., mainly from the U.K. Late in 2008, we also began operations of a Hong Kong data center and a sales office, which generated minimal revenue in 2008 and the first three months of 2009. Our growth strategy includes among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. During the first three months of 2009, no individual customer accounted for greater than 2% of our net revenues.

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.

                                                                 Three Months Ended
(Dollar amounts in thousands,
except annualized net
revenue per average technical        March 31,      June 30,       September,       December 31,      March 31,
square foot)                            2008          2008            2008              2008             2009
                                                                  (Unaudited)
Growth
Managed hosting customers at
period end                               16,352        17,220           18,012             18,480         19,048
Cloud customers at period end*           15,310        16,387           18,173             34,820         43,030

Number of customers at period end        31,662        33,607           36,185             53,300         62,078

Managed hosting, net revenues        $  115,175     $ 125,498     $    131,908     $      134,275     $  134,204
Cloud, net revenues                  $    4,438     $   5,331     $      6,446     $        8,862     $   10,873

Net revenues                         $  119,613     $ 130,829     $    138,354     $      143,137     $  145,077
Revenue growth (year over year)            59.0 %        55.7 %           44.0 %             34.2 %         21.3 %

Net upgrades (monthly average)              2.1 %         2.1 %            1.8 %              1.4 %          0.9 %
Churn (monthly average)                    -1.2 %        -1.1 %           -1.2 %             -1.3 %         -1.1 %

Growth in installed base (monthly
average)                                    0.9 %         1.0 %            0.6 %              0.1 %         -0.2 %

Number of employees (Rackers) at
period end                                2,254         2,422            2,536              2,611          2,661
Number of servers deployed at
period end                               39,755        42,424           45,231             47,518         50,038

Profitability
Income from operations               $   10,138     $   8,396     $      9,490     $       12,125     $   13,021
Depreciation and amortization        $   19,051     $  21,637     $     23,174     $       26,310     $   27,804
Share-based compensation expense
Cost of revenues                     $      365     $     603     $        819     $          678     $      629
Sales & marketing                    $      401     $     533     $        612     $          595     $      698
General & administrative             $    1,986     $   2,668     $      2,886     $        2,871     $    2,910

Total share-based compensation
expense                              $    2,752     $   3,804     $      4,317     $        4,144     $    4,237

Adjusted EBITDA (1)                  $   31,941     $  33,837     $     36,981     $       42,579     $   45,062


Adjusted EBITDA margin                     26.7 %        25.9 %           26.7 %             29.7 %         31.1 %

Operating income margin                     8.5 %         6.4 %            6.9 %              8.5 %          9.0 %

Income from operations               $   10,138     $   8,396     $      9,490     $       12,125     $   13,021
Effective tax rate                         39.9 %        37.9 %           29.6 %             27.7 %         36.6 %

Net operating profit after tax
(NOPAT) (1)                          $    6,093     $   5,214     $      6,681     $        8,766     $    8,255
NOPAT margin                                5.1 %         4.0 %            4.8 %              6.1 %          5.7 %

Capital efficiency and returns
Interest bearing debt                $  145,130     $ 183,553     $    297,933     $      300,413     $  201,507
Stockholders' equity                 $  105,770     $ 117,417     $    269,008     $      269,684     $  282,880
Less: Excess cash                    $       -      $      -      $   (235,421 )   $     (200,620 )   $ (117,611 )

Capital base                         $  250,900     $ 300,970     $    331,520     $      369,477     $  366,776
Average capital base                 $  229,612     $ 275,935     $    316,245     $      350,497     $  368,127
Capital turnover (annualized)              2.08          1.90             1.75               1.63           1.58
Return on capital (annualized) (1)         10.6 %         7.6 %            8.5 %             10.0 %          9.0 %

Capital expenditures
Purchases of property and
equipment, net                       $   47,248     $  40,273     $     45,328     $       32,547     $   25,589
Vendor financed equipment
purchases                            $   21,619     $  26,014     $     23,009     $       14,848     $   11,683

Total capital expenditures           $   68,867     $  66,287     $     68,337     $       47,395     $   37,272

Customer gear                        $   27,558     $  27,347     $     27,627     $       23,073     $   19,255
Data center build outs               $   25,392     $  18,509     $     21,679     $       14,240     $   11,386
Office build outs                    $    8,832     $  12,815     $     11,227     $        8,340     $    2,239
Capitalized software and other
projects                             $    7,085     $   7,616     $      7,804     $        1,742     $    4,392

Total capital expenditures           $   68,867     $  66,287     $     68,337     $       47,395     $   37,272

Infrastructure capacity and
utilization
Technical square feet of data
center space at period end              114,749       133,462          136,962            134,923        157,523
Annualized net revenue per average
technical square foot                $    4,170     $   4,217     $      4,093     $        4,212     $    3,969
Utilization rate at period end             67.3 %        59.1 %           63.4 %             70.4 %         64.6 %

* December 31, 2008 and March 31, 2009 amounts include customers resulting from the Slicehost acquisition, and March 31, 2009 includes SaaS customers for Jungle Disk.

(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.

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 revenues- other non-current liabilities)

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.

For the period ending March 31, 2009, we define excess cash as the amount of cash and cash equivalents that exceeds our operating cash requirements, which for this period is calculated as three percent of our annualized net revenues for the three months ended March 31, 2009. For prior periods, we defined excess cash as our investments in money market funds. As a result of slower growth and a decrease in capital requirements due to the recent completion of the last phase of our DFW data center build out and signing of a lease to occupy a new data center later in 2009 that has minimal data center build out costs, our operating cash needs have declined. 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 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. 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 decreased from 10.6% for the first quarter of 2008 to 9.0% for the first quarter of 2009. These decreases were due to a proportionately larger increase in the average capital base compared to the increase in income from operations over the same time period. Included in the average capital base for 2008 are capital expenditures related to our new corporate headquarters facility and data centers that were or are in the process of being built out. For the fourth quarter of 2008, our tax rate was lower, favorably impacting the ROC calculation for that period. Return on assets decreased from 6.6% for the first quarter of 2008 to 4.1% for the first quarter of 2009 due to the significant investments over these time periods and the timing of such investments. Also, during the second half of 2008 through March 2009 we held additional amounts of cash and cash equivalents due to our IPO in August 2008, and borrowings under our revolving credit facility. We repaid $100.0 million on our revolving credit facility in March 2009.

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

                                                                  Three Months Ended
                                    March 31,      June 30,       September 30,       December 31,      March 31,
(Dollars in thousands)                 2008          2008             2008                2008             2009
                                                                     (Unaudited)
Income from operations              $   10,138     $   8,396     $         9,490     $       12,125     $   13,021
Effective tax rate                        39.9 %        37.9 %              29.6 %             27.7 %         36.6 %

Net operating profit after tax
(NOPAT)                             $    6,093     $   5,214     $         6,681     $        8,766     $    8,255

Net income                          $    5,442     $   4,182     $         5,235     $        6,844     $    6,588

Average total assets                $  328,567     $ 381,815     $       546,761     $      685,236     $  643,349
Less: Average excess cash           $       -      $      -      $      (117,710 )   $     (218,021 )   $ (159,116 )
Less: Average accounts payable
and accrued expenses                $  (71,071 )   $ (76,494 )   $       (79,837 )   $      (76,564 )   $  (71,299 )
Less: Average deferred revenues
(current and non-current)           $  (18,684 )   $ (19,762 )   $       (20,077 )   $      (20,111 )   $  (20,271 )
Less: Average other non-current
liabilities                         $   (9,200 )   $  (9,624 )   $       (12,892 )   $      (20,043 )   $  (24,536 )

Average capital base                $  229,612     $ 275,935     $       316,245     $      350,497     $  368,127

Return on assets (annualized)              6.6 %         4.4 %               3.8 %              4.0 %          4.1 %
Return on capital (annualized)            10.6 %         7.6 %               8.5 %             10.0 %          9.0 %

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.

EBITDA has increased steadily due to increased revenues with lower general and administrative costs as a percentage of revenues, while cost of revenues and sales and marketing costs have remained relatively flat as a percentage of revenues. During 2008 and continuing into 2009, we implemented a series of operational excellence initiatives and focused on reducing costs. Income from operations have also been favorably impacted by these initiatives, but was partially offset by higher depreciation as a percentage of revenues due to capital investments, and increasing share based compensation expense from grants of stock options and awards to employees. Income from operations decreased from the first quarter of 2008 to the second quarter of 2008 due to our capital investments and increasing share based compensation costs; however it gradually increased in the subsequent quarters as a result of our operational excellence initiatives and focus on cost reductions.

See our Adjusted EBITDA reconciliation below.

                                                                Three Months Ended
                                  March 31,       June 30,       September 30,       December 31,      March 31,
(Dollars in thousands)               2008           2008             2008                2008             2009
                                                                    (Unaudited)
Net revenues                      $  119,613     $  130,829     $       138,354     $      143,137     $  145,077

Income from operations            $   10,138     $    8,396     $         9,490     $       12,125     $   13,021

Net income                        $    5,442     $    4,182     $         5,235     $        6,844     $    6,588
Plus: Income taxes                $    3,613     $    2,553     $         2,199     $        2,620     $    3,807
Plus: Total other (income)
expense                           $    1,083     $    1,661     $         2,056     $        2,661     $    2,626
Plus: Depreciation and
amortization                      $   19,051     $   21,637     $        23,174     $       26,310     $   27,804
Plus: Share-based compensation
expense                           $    2,752     $    3,804     $         4,317     $        4,144     $    4,237

Adjusted EBITDA                   $   31,941     $   33,837     $        36,981     $       42,579     $   45,062

Operating income margin                  8.5 %          6.4 %               6.9 %              8.5 %          9.0 %

Adjusted EBITDA margin                  26.7 %         25.9 %              26.7 %             29.7 %         31.1 %

Results of Operations

The following tables set forth our results of operations for the specified periods and as a percentage of our revenues for those same periods. The period-to-period comparison of financial results is not necessarily indicative of future results.