The following Management's Discussion and Analysis ("MD&A") is intended to help the reader understand the results of operations and financial condition of Rackspace. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements.

Overview of our Business

We are the open cloud company, delivering open source technologies at web scale with a portfolio of cloud computing services. Our growth is the result of our technology leadership and our renowned service, known as Fanatical Support. We have made significant investments in cloud computing, and over the last several years, we have made acquisitions that have expanded our product set into new areas of cloud computing, including Private Cloud and OpenStack. We will continue to identify and pursue strategic investments that have the potential to increase our capabilities to serve customers, enhance our competitive advantage, and generate savings.

We sell our services to small and medium-sized businesses, as well as large enterprises. During 2012, 26% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, we have operations in Hong Kong and recently opened a data center and sales office in Australia. Our growth strategy includes, among other strategies, targeting international customers as we plan to continue our expansion in continental Europe, the Asia-Pacific region and Latin America.

How We Earn Revenue and Measure Growth

Our subscription-based business model generates the majority of our revenue 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. Our Public Cloud service offers pay-as-you go services that are earned and recognized as recurring revenue as the services are provided. Revenue is reduced by credits issued to customers, primarily for service issues.

Our revenue growth is primarily due to the increased volume of services provided, both because of an increasing number of new customers and incremental services rendered to existing customers, as well as a broader suite of cloud computing services acquired through acquisitions and research and development activities. We use a metric called "installed base growth" to measure revenue growth derived only from our existing customer base.

Our net revenue is denominated in U.S. dollars as well as other foreign currencies, including the pound sterling, the euro, and the Hong Kong dollar. Changes in related currency exchange rates may affect our net revenue.

Nature of Our Operating Expenses

Our operating expense categories are cost of revenue, sales and marketing, general and administrative, and depreciation and amortization.

Employee-related costs have historically been the primary driver of our operating expenses, and we expect this to continue. Employee-related costs include items such as wages, commissions, non-equity incentive compensation, earned time off, benefits, and share-based compensation. Employee non-equity incentive compensation through our current non-equity incentive plan 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. 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 used for evaluating the financial results of the company is called NOPAT Before Bonus, which is calculated as net operating profit after tax (NOPAT) without the inclusion of any impact of non-equity incentive compensation. This cannot be calculated from our financial statements as we do not separately disclose total non-equity incentive compensation for the period. Beginning in 2013, we will begin using net revenue instead of NOPAT Before Bonus.

We had 4,040 and 4,852 employees as of December 31, 2011 and 2012, respectively. The year-over-year increase was primarily attributable to increases in our customer and data center support teams, as well as an increase in general and administrative positions, many of which are involved in the development of internal-use software. To maintain our service focus, our support teams have continued to grow with the growth of our business. Our headcount is expected to increase in 2013 as we continue to grow our business.

Cost of revenue primarily consists of employee-related costs of our customer support teams and data center employees, as well as the costs to operate our data centers. The majority of our data center costs vary with the volume of services sold and include power, bandwidth, rent, and costs related to maintenance and the replacement of IT equipment components. Our contracts with network operators for bandwidth capacity generally commit us to pay a monthly fee based on usage. Our data centers rely on local and regional utility companies as their primary source of power. We have fixed-price power arrangements with the electricity providers of our Grapevine, Texas and Slough, U.K. data centers that expire in September 2013. Another significant component of cost of revenue is costs associated with software licenses. We enter into contracts with software providers that allow us to provide third-party software to our customers. Our arrangements with these software vendors are typically one to three years in length, and we generally pay a fixed fee per license.

Sales and marketing activities are directed toward both the acquisition of new customers and increasing our business with existing customers. We pay commissions to our sales representatives generally upon execution of a service agreement. Sales and marketing expense also includes compensation to our channel partners. Marketing expenditures are used to communicate the advantages of our services and to generate customer demand. The majority of our marketing expenditures relate to lead generation through pay-per-click placements on major Internet search engines. Sales and marketing expenses are expected to increase slightly as a percentage of revenue because we intend to launch an initiative in 2013 to reinforce our brand as the open cloud company.

General and administrative activities are comprised of employee-related costs, professional fees, general corporate costs and overhead. While we continue to invest in our administrative infrastructure and personnel to support our growth, our focus has been and continues to be on scaling these administrative costs. Also included in general and administrative activities are expenses related to research and development activities. As we invest more in our product portfolio, research and development expenses have increased over the last several years both in total and as a percentage of revenue. We expect this trend to continue in 2013.

Depreciation and amortization expense includes amortization of leasehold improvements associated with our data centers and corporate facilities, as well as depreciation of our data center infrastructure and equipment. Amortization expense is also comprised of the amortization of our customer-based intangible assets related to acquisitions, internally developed technology, and software licenses purchased from third-party vendors.

Our operating expenses are denominated in U.S. dollars as well as other foreign currencies, including the pound sterling, the euro, and Hong Kong dollar. Changes in related currency exchange rates may affect our operating results. The decrease in operating expenses due to foreign currency fluctuations was approximately $2 million, or less than 1%, in 2012.

Capital Expenditures

Our capital expenditures relate to customer gear, data center infrastructure, corporate office build-outs, and internally developed software and other projects. Each category is defined below:

Customer gear - Includes servers, firewalls, load balancers, cabinets, switches, backup libraries, storage arrays and drives and network cabling.

Data center infrastructure - Includes generators, uninterruptible power supplies (or UPS), power distribution units, mechanical and electrical plants, chillers, raised floor and other data center building improvements.

Corporate office build-outs - Includes raised floor, furniture and general building improvements.

Internally developed software and other - Includes salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects and other projects that meet the criteria for capitalization.

In 2012, we expended cash or entered into lease arrangements for the purchase of customer gear of $218 million and incurred data center infrastructure costs of $26 million, corporate office build-out costs of $14 million and $79 million of costs related to internally developed software and other capitalized projects.

Our data center infrastructure is built to accommodate future revenue growth. While we try to match the amount of capacity to customer demand, we consider appropriate lead times for these build-outs, which requires us to build capacity ahead of actual revenue growth. 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 excluding portions of the data center that have not been placed on line. 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.

While many factors may influence our margins, in periods when we make large investments, margins may decrease. Such investments may be made in connection with data center and office expansion, as well as significant product and market development initiatives.

During 2012, we continued to add to our existing data center footprint both in the U.S. and internationally to support our growth, adding approximately 13 megawatts of data center power capacity. In April 2012, we entered into an operating lease agreement to lease data center space with a maximum critical load power of 9.75 megawatts in Ashburn, Virginia. During the year we also entered into operating lease agreements for our first data center in Australia and an additional data center in London. This strategy of entering into operating lease agreements for data center space reduces the capital investments required to increase our data center capacity.

Disciplined Use of Capital and Management of Profitability

We have achieved net income profitability since the first quarter of 2004 through focused management of capital and profitability. We use the Economic Value Added model (EVA), which was developed by Stern Stewart & Co., as a tool to help ensure our growth and capital investments create stockholder value. Virtually all capital expenditures are evaluated against this metric using a standard cost of capital. EVA is calculated for our product offerings to evaluate our profitability.

We are also very careful with our facility and data center expansion practices. Currently, we sell to businesses in more than 120 countries. Unlike a colocation provider, we do not need to be located near our customers, allowing us to build or lease centralized, cost-optimized facilities with teams of highly-trained staff. We strive to locate our regional facilities and data centers in lower-cost locations, which reduces rent, power and labor costs. We also focus on either leasing or building sections of data centers in increments so that capital expenditures are more closely matched to revenue growth.

We have achieved a critical mass that generates long-term cost advantages. Like any service that moves from distributed to centralized production, scale is a factor in ensuring costs are low enough to drive mass adoption. We are able to generate significant cost advantages based on our large installed customer base and growth profile. We purchase large quantities of computing and data center assets, which allows us to negotiate higher volume pricing savings.

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 Annual Report on Form 10-K.

                                                              Year Ended December 31,
(Dollar amounts in thousands, except average
monthly revenue per server)                           2010             2011             2012
Growth
Dedicated Cloud, net revenue                      $  679,888      $   835,877      $ 1,005,165
Public Cloud, net revenue                         $  100,667      $   189,187      $   304,074
Net revenue                                       $  780,555      $ 1,025,064      $ 1,309,239
Revenue growth (year over year)                         24.1  %          31.3  %          27.7  %
Net upgrades (monthly average)                           1.5  %           1.9  %           1.5  %
Churn (monthly average)                                 -1.0  %          -0.9  %          -0.8  %
Growth in installed base (monthly average) (2)           0.5  %           1.0  %           0.8  %
Number of customers at period end (3)                130,291          172,510          205,538
Number of employees (Rackers) at period end            3,262            4,040            4,852
Number of servers deployed at period end              66,015           79,805           90,524
Average monthly revenue per server                $    1,054      $     1,157      $     1,278
Profitability
Income from operations                            $   79,602      $   123,471      $   172,741
Depreciation and amortization                     $  155,895      $   195,412      $   249,845
Share-based compensation expense
Cost of revenue                                   $    4,660      $     4,220      $     5,130
Sales and marketing                               $    4,241      $     2,313      $     6,097
General and administrative                        $   17,723      $    22,240      $    30,319
Total share-based compensation expense            $   26,624      $    28,773      $    41,546
Adjusted EBITDA (1)                               $  262,121      $   347,656      $   464,132
Adjusted EBITDA margin                                  33.6  %          33.9  %          35.5  %
Operating income margin                                 10.2  %          12.0  %          13.2  %
Income from operations                            $   79,602      $   123,471      $   172,741
Effective tax rate                                      35.1  %          34.4  %          37.3  %
Net operating profit after tax (NOPAT) (1)        $   51,662      $    80,997      $   108,309
NOPAT margin                                             6.6  %           7.9  %           8.3  %
Capital efficiency and returns
Interest bearing debt                             $  131,727      $   139,126      $   125,372
Stockholders' equity                              $  438,863      $   599,423      $   843,647
Less: Excess cash                                 $  (79,174 )    $  (125,865 )    $  (249,712 )
Capital base                                      $  491,416      $   612,684      $   719,307
Average capital base                              $  445,179      $   552,328      $   679,125
Capital turnover                                        1.75             1.86             1.93
Return on capital (1)                                   11.6  %          14.7  %          15.9  %
Capital expenditures
Purchases of property and equipment               $  140,591      $   251,214      $   270,374
Non-cash purchases of property and equipment      $   75,550      $    93,680      $    67,308
Total capital expenditures                        $  216,141      $   344,894      $   337,682
Customer gear                                     $  136,348      $   196,096      $   217,870
Data center build outs                            $   38,515      $    49,947      $    26,293
Office build outs                                 $    8,942      $    35,752      $    14,382
Capitalized software and other projects           $   32,336      $    63,099      $    79,137
Total capital expenditures                        $  216,141      $   344,894      $   337,682
Infrastructure capacity and utilization
Megawatts under contract at period end                  32.7             48.1             61.1
Megawatts available for use at period end               23.2             30.7             36.9
Megawatts utilized at period end                        16.7             20.9             24.0
Annual net revenue per average Megawatt of
power utilized                                    $   52,037      $    54,065      $    58,188

(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 is 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.

Company Highlights and Developments

Growth of Our Business

Our business grew in 2012 with 27.7% net revenue growth year over year, bringing total net revenue to $1.3 billion. Our 2012 performance was the result of a combination of continued market demand for our services as well as our focused execution on our growth strategy. As of December 31, 2012, we served over 205,000 customers running on over 90,000 servers within our data centers across the world, which represented incremental increases in each category as compared to 2011.

Our revenue growth has moved us into a new competitive landscape where our direct competitors are much larger and stronger financially. We continue to compete more directly with Amazon, Microsoft, IBM and Google as cloud computing services become increasingly more virtualized. Accordingly, we have been making increased infrastructure investments to complement and leverage Fanatical Support, our principal differentiation from our competitors across our multiple service offerings. Our cloud computing services provide customers with a mission-critical service and world class support, and we believe this provides us with substantial growth opportunities. We believe that by offering a higher service level agreement and extending our support to new open-source technology platforms, our business becomes more capital efficient and our competitive advantage widens as our service capability increases.

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 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.

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 2012 we introduced the Rackspace open cloud, which marks the first time any company has deployed a large-scale open source public cloud powered by OpenStack. The Rackspace open cloud platform launch featured the release of several key products, including Cloud Servers, Cloud Databases, Cloud Monitoring, Cloud Backup, Cloud Block Storage, and Cloud Networks, along with a powerful new Control Panel. With the complete suite of OpenStack-based cloud solutions in full production, Rackspace offers an open, fast and simple cloud experience by providing customers with true choice and control without the fear of being locked into proprietary technologies. These solutions, backed by Fanatical Support, further expand our portfolio and are also available under a managed service level that makes our expertise available to design, plan, deploy, optimize and maintain the environments our customers rely on for business-critical applications.

We also introduced the industry's first certification for OpenStack and announced the release of Rackspace Private Cloud, powered by OpenStack, making it simple and easy for companies to install, test and run an OpenStack-based Private Cloud environment. 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.

The public cloud product and platform transition is a lengthy and complex process that began with a strategic decision to adopt an open source solution to power our public cloud. This involved deploying significant resources to develop and implement the cloud products that comprise the key elements of the OpenStack platform, then continued through the actual roll-out of the new platform, and continues today with infrastructure and support changes, new marketing and sales strategies, corporate-wide knowledge development and training, and reorganization of business units as necessary for the success of the platform and products. In the section titled, "Risk Factors," see the risk factor, "If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer."

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 and Rackspace Private 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."

Other Developments

In February 2012 we acquired SharePoint911, an industry leader in SharePoint consulting, training, and "JumpStart" services within SharePoint, and in August 2012 we acquired Mailgun, an email services company. While the acquisitions did not have a material impact on our financial results, the acquisitions further enhance our portfolio of products and services. We expect to make additional, similar acquisitions in the future in order to increase our service capabilities and product offerings.

In August 2012 we announced the opening of a data center in Australia, which enables us to offer local Dedicated Cloud solutions to Australian customers who prefer to keep their data onshore. The data center will also provide the infrastructure to launch an OpenStack-based open cloud platform in the future.

Results of Operations

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

Consolidated Statements of Income:

                                                Year Ended December 31,
(In thousands)                           2010           2011            2012
Net revenue                           $ 780,555     $ 1,025,064     $ 1,309,239
Costs and expenses:
Cost of revenue                         249,840         309,095         367,479
Sales and marketing                      96,207         126,505         158,108
General and administrative              199,011         270,581         361,066
Depreciation and amortization           155,895         195,412         249,845
Total costs and expenses                700,953         901,593       1,136,498
Income from operations                   79,602         123,471         172,741
Other income (expense):
Interest expense                         (7,984 )        (5,848 )        (4,749 )
Interest and other income (expense)        (207 )        (1,194 )            15
Total other income (expense)             (8,191 )        (7,042 )        (4,734 )
Income before income taxes               71,411         116,429         168,007
Income taxes                             25,053          40,018          62,589
Net income                            $  46,358     $    76,411     $   105,418

Consolidated Statements of Income, as a Percentage of Net Revenue:
. . .