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RAX > SEC Filings for RAX > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for RACKSPACE HOSTING, INC.

Form 10-K for RACKSPACE HOSTING, INC.


3-Mar-2014

Annual Report


ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

Rackspace is one of the world's leading providers of hybrid computing. We serve hundreds of thousands of business customers from our data centers on four continents. We help them find the IT infrastructure that best fits their unique needs, and we enable them to achieve their business goals through superior performance and cost efficiency. Leveraging our product portfolio, Rackspace helps businesses run each of their IT workloads where it performs best and most efficiently - whether on the public cloud, a private cloud, dedicated cloud, or a combination of these platforms.

We sell our services to small and medium-sized businesses, as well as large enterprises. During 2013, more than 25% of our net revenue was generated by our operations outside of the U.S., primarily from the U.K. Additionally, we have operations in Hong Kong and 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

Our dedicated cloud (also referred to as managed hosting) IT services are based upon a subscription-based business model and generate the majority of our revenue. Our customers pay us a recurring fee based on the capacity 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.

Company Highlights and Developments

Growth of Our Business

We believe that the segment of the cloud computing market on which we are focused is a large market that represents a significant opportunity. We see a high level of interest building from companies who are considering a hybrid portfolio of services as they gradually move more workloads to the cloud. These companies choose not to do everything on their own so that they can focus on their core business and what they do best. Therefore, they seek a partner who can deliver Fanatical Support every step of the way, and they want specialist expertise in running the ever-expanding set of open technologies that are at the heart of cloud scale applications.

While we believe that we are continuing to put the company in a position to take advantage of this large opportunity, net revenue growth in 2013 of 17.2% was a decrease from prior years. The deceleration in revenue growth was due to a number of factors including, without limitation, our public cloud platform transition, competition, and foreign exchange.

In 2013, we continued our hybrid cloud product and platform transition, which 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, and then continued through the actual roll-out of the new platform.

Competition also impacted our growth rate in 2013. Our industry includes 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. In some cases, we have adopted new pricing strategies that included 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

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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. The exchange rate between the U.S. dollar and pound sterling has the greatest impact on our revenue. In 2013, the weakening of the pound sterling against the U.S. dollar had an unfavorable impact on revenue of approximately $5 million.

Consistent with our goal to re-accelerate revenue growth and in order to take advantage of the long-term continued growth opportunities in the market, 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. In 2014, we expect to continue making these investments in research and development, data centers, corporate facilities, information technology infrastructure, and employees.

Based on these factors, we have provided the guidance below. These forward-looking statements reflect our current expectations and are subject to uncertainty.

         Net revenue - Sequential net revenue growth in the first quarter of
          2014 is expected to be between 2% and 3.5%. Net revenue growth from
          2013 to 2014 is expected to be between 15% and 18%.



         Adjusted EBITDA margin - We expect Adjusted EBITDA margin in the first
          quarter 2014 to be between 31% and 33%, while for the full year 2014,
          we expect it to be between 32% and 35%.



         Depreciation and amortization - We expect depreciation and amortization
          expense as a percentage of revenue to be approximately 21.5% of net
          revenue.

Share-based compensation expense - We expect share-based compensation expense to approach approximately 5% of net revenue during the year.

Other Developments

In February 2013 we acquired ObjectRocket, a MongoDB database as a service provider, and in March 2013 we acquired Exceptional Cloud Services, a cloud computing service company with products geared toward developers. Additionally, in October 2013 we acquired LiteStack, a company that specializes in an open source hypervisor built to run cloud applications called ZeroVM. While the acquisitions did not have a material impact on our financial results, the acquisitions further enhance our portfolio of products and services and our expertise in modern cloud-based applications. If appropriate opportunities present themselves, we may make additional acquisitions in the future in order to increase our service capabilities, product offerings and talent base.

In June 2013 we launched the Rackspace Open Cloud in our new Sydney data center, completing our hybrid cloud portfolio in the Australia and New Zealand market. This allows our customers to achieve higher performance at a lower total cost by providing them the infrastructure that best fits their specific needs. We believe this new hybrid cloud option could increase our ability to generate revenue in these markets.

In October 2013, we launched our hybrid cloud in our Hong Kong data center, completing our hybrid cloud portfolio in the East Asia market.

In November 2013, we launched our Performance Flavors for Cloud Servers in our U.S. and U.K. data centers. These Performance Flavors deliver performance several times faster than that of our standard cloud servers. We plan to extend those Performance Flavors to our Hong Kong and Sydney data centers in 2014.

Nature of Our Operating Expenses

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

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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 net revenue growth 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 modify 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. Previously, the metric by which we determined a payout under the bonus plan was net income, which was oriented towards cost management and profit.

We had 4,852 and 5,651 employees as of December 31, 2012 and 2013, 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 product development positions involved in the development of internal-use software. Our headcount is expected to increase in 2014 as our business continues to grow.

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. To maintain our service focus, our support teams have continued to grow with the growth of our business. 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. Another significant component of cost of revenue is costs associated with software licenses. We enter into contracts with software providers that allow our customers to utilize third-party software on our IT infrastructure. Our arrangements with these software vendors are typically one to three years in length, and we generally pay a fixed fee per license.

Research and development activities are focused on the deployment of new technologies to address emerging trends such as public cloud, private cloud, hybrid cloud and OpenStack; the development and enhancement of proprietary tools; and the development and enhancement of data center operations. We expense costs related to preliminary project assessment, research and development, re-engineering, training, and application maintenance as incurred. These costs primarily include compensation costs for employees and consultants. Research and development expenses have increased as a percentage of revenue as we increase headcount related to R&D activities. We expect this trend to continue into 2014 as we invest in our products and services.

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. Sales and marketing expenses are expected to increase slightly as a percentage of revenue as we focus on re-accelerating revenue growth.

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 general and administrative headcount additions. However in 2013 we made strategic hires of executives and incurred higher general and administrative costs related to developing and implementing new systems infrastructure to support the business.

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 the 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 $3 million, or 1%, in 2013.

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:

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Customer gear - Includes servers, firewalls, load balancers, cabinets, backup libraries, storage arrays and drives, and network cabling used in customers' infrastructure environments.

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

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

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 2013, we purchased $298 million of customer gear, and incurred data center infrastructure costs of $58 million, corporate office build-out costs of $31 million and $85 million of costs related to internally developed software and other capitalized projects. Our capital expenditures in 2013 were higher than our original estimate primarily due to the equipment and data center costs associated with the global launch of our Performance Cloud Servers. Additionally, in the fourth quarter, we completed the purchase of land for future expansion of our London U.K. data center.

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. Our strategy of entering into operating lease agreements for data center space reduces the capital investments required to increase our data center capacity.

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.

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.

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                                                              Year Ended December 31,
(Dollar amounts in thousands, except average
monthly revenue per server)                            2011             2012             2013
Growth
Dedicated cloud, net revenue                      $   835,877      $ 1,005,165      $ 1,119,636
Public cloud, net revenue                         $   189,187      $   304,074      $   415,150
Net revenue                                       $ 1,025,064      $ 1,309,239      $ 1,534,786
Revenue growth (year over year)                          31.3  %          27.7  %          17.2  %
Net upgrades (monthly average)                            1.9  %           1.5  %           1.3  %
Churn (monthly average)                                  -0.9  %          -0.8  %          -0.8  %
Growth in installed base (monthly average) (2)            1.0  %           0.8  %           0.5  %
Number of employees (Rackers) at period end             4,040            4,852            5,651
Number of servers deployed at period end               79,805           90,524          103,886
Average monthly revenue per server                $     1,157      $     1,278      $     1,307
Profitability
Income from operations                            $   123,471      $   172,741      $   133,136
Depreciation and amortization                     $   195,412      $   249,845      $   313,007
Share-based compensation expense:
Cost of revenue                                   $     7,482      $     9,592      $    12,584
Research and development                          $     2,975      $     4,856      $     8,168
Sales and marketing                               $     2,408      $     6,379      $     7,317
General and administrative                        $    15,908      $    20,719      $    31,576
Total share-based compensation expense            $    28,773      $    41,546      $    59,645
Adjusted EBITDA (1)                               $   347,656      $   464,132      $   505,788
Adjusted EBITDA margin                                   33.9  %          35.5  %          33.0  %
Operating income margin                                  12.0  %          13.2  %           8.7  %
Income from operations                            $   123,471      $   172,741      $   133,136
Effective tax rate                                       34.4  %          37.3  %          33.7  %
Net operating profit after tax (NOPAT) (1)        $    80,997      $   108,309      $    88,269
NOPAT margin                                              7.9  %           8.3  %           5.8  %
Capital efficiency and returns
Interest bearing debt                             $   139,126      $   125,372      $    64,918
Stockholders' equity                              $   599,423      $   843,647      $ 1,055,412
Less: Excess cash                                 $  (125,865 )    $  (249,712 )    $  (210,761 )
Capital base                                      $   612,684      $   719,307      $   909,569
Average capital base                              $   552,328      $   679,125      $   804,173
Capital turnover                                         1.86             1.93             1.91
Return on capital (1)                                    14.7  %          15.9  %          11.0  %
Capital expenditures
Cash purchases of property and equipment          $   251,214      $   270,374      $   452,596
Non-cash purchases of property and equipment
(3)                                               $    93,680      $    67,308      $    19,493
Total capital expenditures                        $   344,894      $   337,682      $   472,089
Customer gear                                     $   196,096      $   217,870      $   297,787
Data center build outs                            $    49,947      $    26,293      $    58,278
Office build outs                                 $    35,752      $    14,382      $    31,103
Capitalized software and other projects           $    63,099      $    79,137      $    84,921
Total capital expenditures                        $   344,894      $   337,682      $   472,089
Infrastructure capacity and utilization
Megawatts under contract at period end                   48.1             61.1             60.0
Megawatts available for use at period end                30.7             36.9             46.9
Megawatts utilized at period end                         20.9             24.0             27.4
Net revenue per average Megawatt of power
utilized                                          $    54,065      $    58,188      $    59,442

(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) Non-cash purchases of property and equipment represents changes in amounts accrued for purchases under vendor financing and other deferred payment arrangements.

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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.

The Company has made certain reclassifications to the prior year amounts below in order to conform to the current year's presentation. Refer to Note 1, "Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies," within Part II, Item 8 of this Form 10-K for more information about these reclassifications.

Consolidated Statements of Income:
                                                 Year Ended December 31,
(In thousands)                            2011            2012            2013
Net revenue                           $ 1,025,064     $ 1,309,239     $ 1,534,786
Costs and expenses:
Cost of revenue                           346,341         419,013         492,493
Research and development                   33,709          56,736          90,213
Sales and marketing                       131,174         166,172         208,417
General and administrative                194,957         244,732         297,520
Depreciation and amortization             195,412         249,845         313,007
Total costs and expenses                  901,593       1,136,498       1,401,650
Income from operations                    123,471         172,741         133,136
Other income (expense):
Interest expense                           (5,848 )        (4,749 )        (3,118 )
Interest and other income (expense)        (1,194 )            15             741
Total other income (expense)               (7,042 )        (4,734 )        (2,377 )
Income before income taxes                116,429         168,007         130,759
Income taxes                               40,018          62,589          44,022
Net income                            $    76,411     $   105,418     $    86,737

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

                                         Year Ended December 31,
(Percent of net revenue)                2011       2012       2013
Net revenue                           100.0  %   100.0  %   100.0  %
Costs and expenses:
Cost of revenue                        33.8  %    32.0  %    32.1  %
Research and development                3.3  %     4.3  %     5.9  %
Sales and marketing                    12.8  %    12.7  %    13.6  %
General and administrative             19.0  %    18.7  %    19.4  %
Depreciation and amortization          19.1  %    19.1  %    20.4  %
Total costs and expenses               88.0  %    86.8  %    91.3  %
Income from operations                 12.0  %    13.2  %     8.7  %
Other income (expense):
Interest expense                       (0.6 )%    (0.4 )%    (0.2 )%
Interest and other income (expense)    (0.1 )%     0.0  %     0.0  %
Total other income (expense)           (0.7 )%    (0.4 )%    (0.2 )%
Income before income taxes             11.4  %    12.8  %     8.5  %
Income taxes                            3.9  %     4.8  %     2.9  %
Net income                              7.5  %     8.1  %     5.7  %

Due to rounding, totals may not equal the sum of the line items in the table above.

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Years ended December 31, 2012 and 2013

Net Revenue

Our net revenue was $1.3 billion during 2012 and $1.5 billion during 2013, an increase of $226 million, or 17%. The increase in net revenue was primarily due to both 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. . . .

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