10-K 1 rax1231201110-k.htm FORM 10-K RAX 12.31.2011 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10-K
 
(Mark one)
R
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2011.

OR 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______ to ______.
 
Commission file number 001-34143

 RACKSPACE HOSTING, INC.
(Exact Name of registrant as specified in its charter)
 
Delaware
 
74-3016523
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)

5000 Walzem Rd.
San Antonio, Texas 78218
(Address of principal executive offices, including zip code)

(210) 312-4000
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange of which registered
Common Stock, par value $0.001 per share
 
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:
None
(Title of Class)

 Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes o    No R  

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes o    No R  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   R    No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   R    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer R
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No R  
 
As of June 30, 2011, the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale price of such shares on the New York Stock Exchange on June 30, 2011) was $3,274,366,449.

On February 14, 2012, 131,960,849 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.


DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant's 2012 Annual Meeting of Stockholders to be filed within 120 days of the Registrant's fiscal year ended December 31, 2011 are incorporated by reference into Part III of this Form 10-K.


RACKSPACE HOSTING, INC.
 
TABLE OF CONTENTS
 
Page
 
 
 
Item 1.
 4
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
 
 
 
 
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
 
 
 
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
 
 
 
 
Item 15.
 
 
 
 


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

We have made forward-looking statements in this Annual Report on Form 10-K that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, are subject to the “safe harbor” created by those sections. The forward-looking statements in this report are based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “aspires,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this document in greater detail under the heading “Risk Factors.” We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The risks described in “Risk Factors” included in this report, as well as any other cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of the events described in “Risk Factors” and elsewhere in this report could harm our business.

Given these risks, uncertainties and other factors, you should not place undue reliance on these forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this filing. You should read this document completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

TRADEMARKS AND SERVICE MARKS

Rackspace® and Fanatical Support® are our registered service marks. Net Promoter® is a registered trademark of Bain & Company, Fred Reichheld and Satmetrix Systems, Inc.; NPS is a service mark of Bain & Company, Inc. EVA® is a registered trademark of Stern Stewart & Co. and EVAdimensions. Other trademarks and tradenames appearing in this report are the property of their respective holders. We do not intend our use or display of other companies’ tradenames, trademarks, or service marks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.



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PART I

ITEM 1 - BUSINESS

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the related Notes for additional information regarding the business and our operating results.

Overview

Rackspace is the service leader in cloud computing, an industry best described as delivering computing, storage, and applications as a service over the Internet. We and other cloud computing companies free our business customers from much of the expense and hassle of owning and managing their own computer hardware and software. What distinguishes Rackspace from its competitors is our unique blend of user-friendly technology and high-touch human support, which makes cloud computing simple for businesses of all sizes. Our rapid growth over the last 13 years has been fueled by our commitment to provide customers with a unique customer experience known as Fanatical Support®.

We were incorporated in Delaware on March 7, 2000 under the name Rackspace.com, Inc., but our operations began in 1998 as a limited partnership, which became our subsidiary through a corporate reorganization completed on August 21, 2001. Our principal executive offices are located at 5000 Walzem Rd., San Antonio, Texas 78218. Our telephone number is (210) 312-4000. Our website address is www.rackspace.com.

Our mission is to be recognized as one of the world’s great service companies.

Our Industry

The cloud computing industry is a fast-growing and crowded industry, and Rackspace has earned a well-defined leadership role within it. We are a cloud computing specialist and the industry's service leader. Our employees, who are called Rackers, are focused on providing cloud computing services for our business customers.

Unlike some of our rivals who essentially rent access to computer hardware and software, Rackspace specializes in offering a set of support and managed services on top of raw computing services. Our approach positions Rackspace as a mission-critical extension of our business customers' IT departments.

Today, there are three ways that businesses can fulfill their IT requirements:

1.
The first approach is commonly referred to as “do it yourself,” or DIY. This is the legacy approach to managing IT services, in which a business retains complete ownership and responsibility for ongoing maintenance and management of servers, software, networking equipment, IT staff, etc. Companies may choose to house this equipment in their own data centers or server closets, or may rent data center space from a colocation provider.

2.
The second approach is outsourcing, where businesses transfer full responsibility for their IT systems, operations, and employees to a third party.

3.
The third approach is cloud computing, which is the delivery of IT services on demand, usually over the Internet.

We believe that cloud computing delivers better quality and a more cost-competitive solution than do the outsourcing approach or the do-it-yourself approach. We believe demand for cloud computing will continue to grow for four reasons:

1.
Lack of In-House IT Expertise and Equipment. Most smaller companies do not have the IT staff needed to manage complicated, mission-critical websites or other IT applications, and they do not want to purchase expensive hardware with their available capital. Yet they must have an increasingly robust, reliable online presence in order to succeed in today’s market.

2.
Strategic Resource Utilization. Larger companies that do have specialized, dedicated IT resources would rather deploy these resources to more strategic areas of their business rather than managing servers or running a website.

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3.
Market Acceptance. As companies have experienced the benefits of using cloud computing providers to manage some of their IT workloads, they have become more comfortable having those providers manage additional IT services. As time goes by, they will move more and more of their IT workloads to the Cloud.

4.
Accelerated Business Creation. Cloud computing removes many of the traditional barriers to new business formation, through its low cost, its high speed and nimbleness, and the way it lowers upfront capital requirements. Cloud computing is driving innovation and new business formation at a rapid rate, in much the way that the iPhone has driven a fast-growing market for applications. The rising supply of cloud computing is, to a large extent, creating new demand.

Cloud computing is at the center of a multi-year shift that is changing the way businesses buy computing power and IT services. New virtualization technologies, which deliver greater agility and cost savings to businesses, make cloud computing even more compelling for a broader market.

Our Business

We are a global company. Our corporate headquarters is located in San Antonio, with operations located in eight other cities in the United States, along with London, Amsterdam, Hong Kong, and Sydney. Our services are sold to businesses in more than 120 countries. In 2011 we had net revenue of $1,025.1 million, and as of December 31, 2011, we served more than 172,000 business customers, and we managed more than 79,000 servers and 2,700,000 email accounts. No single customer accounted for more than 2% of our net revenue in any of the past three years.

We began our business by providing customers with dedicated hosting services in which our customers were provided access to an entire server that was not shared with anyone. As technology advanced, we were also able to offer hosting and other services that utilized pooled infrastructure in order to more efficiently utilize our infrastructure while providing customers with benefits such as more flexibility in accessing their computing needs and lower pricing points than dedicated hosting provides. We have historically referred to the pooled infrastructure service offering as our “Cloud” business and the dedicated hosting services as “Managed Hosting.” However, the meaning of the terms “cloud” and “cloud computing” have evolved to the point where they are now thought to mean the delivery of both pooled and dedicated computing as a service, over a network (typically the Internet). Because all of our services fit under this new definition, we have decided that our nomenclature for our services should change to be more effectively described and understood. Therefore, we intend to refer to the former Cloud services as “Public Cloud” hosting and our Managed Hosting services as “Dedicated Cloud" hosting. "Managed" will refer to a service level available to all customers, whether they are using Public Cloud or Dedicated Cloud resources.

We are focused on the segment of the cloud computing market that demands, and is willing to pay for, strong support and management services on top of raw computing services. Our services are productized and repeatable, which enables us to operate IT systems for our customers with high levels of up-time, rapid deployment of new systems and significant cost savings, which in turn allows our customers' IT departments to focus on their core business. Our service offering combines hosting on dedicated hardware and on multi-tenant pools of virtualized hardware in a way that best suits each customer’s requirements. We have adopted a portfolio approach to our services, which allows customers the flexibility to choose the best combination of support level, Dedicated Cloud hosting and Public Cloud hosting to meet their unique IT needs. The major components of our products and services are described in greater detail below:

Our Service

Customer Experience. This is where we differentiate. Fanatical Support, our unique brand of customer experience, is backed by a complex business process that we have built and refined over the past 13 years, and it distinguishes our company in the market. We incorporate Fanatical Support into all aspects of our hosting services. Fanatical Support is designed to generate an extraordinary customer experience. It involves everything from the way we recruit, interview and test prospective employees; to the way we continuously train new and veteran Rackers alike; to the way we make expert U.S. and U.K. based technicians available to customers 24/7 by phone or email or chat; to the way we empower those Rackers to spend time and money on customers without asking permission; to the way we measure customer satisfaction and churn on a daily basis, team by team; to the way we incentivize our teams and managers; to the way we design and implement hardware and software solutions and processes to make our services highly reliable and easy for the customer to use and navigate.


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When we first launched Fanatical Support®, it was mainly about answering the phone and providing extraordinary support when things went wrong with a customer's computing. Since then, our conception of Fanatical Support® has expanded to include technological improvements that make our services more reliable and easier to use, in line with our company's purpose statement: to make cloud computing simple for business.

We have built our business around an understanding that things go wrong in computing and always will in a field so complex and fast-changing. We believe that many business customers want a trusted partner who is available 24/7 to help them safely and reliably take advantage of the enhanced capabilities and cost savings available through cloud computing.

Our Product Categories

Everything that we do at Rackspace falls under the umbrella of cloud computing, defined as the delivery of computing, storage, and applications over the Internet. All of our computer hardware is located in our secure, business-class data centers in the U.S., the U.K. and Hong Kong. Our services are defined by particular form factors, as follows:

Dedicated Cloud, sometimes known as "managed hosting," refers to IT services that we provide on a server or servers reserved for a specific customer. Our customers have full administrator privileges and are responsible for most administrative functions. We provide a customer management portal and other management tools. This service frees the customer from the burden of managing the data center, network, hardware devices, and operating system software. Dedicated Cloud hosting is largely a recurring, subscription-based business and is a core service offering of Rackspace. Included in Dedicated Cloud hosting is private cloud, which refers to a pool of computing resources that is virtualized for greater efficiency and nimbleness, but that is dedicated to one particular customer, rather than being used by multiple customers. This approach is especially popular with some of our larger corporate customers.

Public Cloud refers to pooled computing resources delivered on-demand over the Internet. Virtualization and other cloud technologies allow us to effectively provision and manage a pool of computing resources across a larger base of customers and deliver more computing resources to businesses when they need them. At the same time, pooled cloud computing substantially lowers the cost of IT services. There are multiple varieties of pooled cloud hosting services that are priced on a pay-per-use basis and that can be quickly and easily scaled up or down on-demand. Today we offer Cloud Servers for computing, Cloud Files for storage, and Cloud Applications, which includes email, collaboration and file back-ups. Public Cloud services are emerging technologies and are core elements of our service offering.

Our Integrated Approach

Hybrid Hosting - we are pioneering this emerging category, which allows a customer to easily and seamlessly utilize the benefits of both Dedicated Cloud hosting and Public Cloud hosting. A customer is able to use any combination of dedicated and pooled resources and to manage them seamlessly through our RackConnect service. Each form factor has specific and unique customer benefits, and through Hybrid Hosting the two can be combined and adjusted to address each customer's changing and diverse needs. Furthermore, Rackspace’s set of managed support services and Fanatical Support are critical in this new world of computing as customers increasingly need help to make the transition and utilize these new services.

Competition

Given the significant market potential of cloud computing, we operate in a rapidly evolving and highly competitive environment.

Our principal areas of competition include:

Do-it-Yourself Solutions. Businesses may choose to house and maintain their own IT systems or use a colocation provider to house IT hardware and provide connectivity. Companies that provide colocation services include AT&T, Equinix, CenturyLink, and other telecommunications companies. We believe that over time it will be difficult for the vast majority of businesses to replicate the capabilities and low costs of specialized service providers, making the do-it-yourself option less attractive.

IT Outsourcing Providers. Businesses may choose to outsource their entire IT systems and staff to a provider such as CSC, HP or IBM. Outsourcing has long been an option for only the largest companies because of the cost, complexity and duration of outsourcing contracts. Rarely is this a viable option for small and medium-sized businesses with rapidly changing needs. Even some large corporations are questioning the cost-benefit ratio and the slow response times associated with the outsourcing approach.

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Cloud Computing Providers. Businesses may choose to use a cloud computing provider other than Rackspace to provide services and support for their IT systems. Competitors include AT&T, British Telecom, CenturyLink, Softlayer, Verizon and others. We also face competition from large, diversified technology companies such as Amazon, Microsoft, Google, IBM and Dell, who are making substantial investments in cloud computing.

Our Approach and Sources of Competitive Advantage

We are focused on creating sustainable competitive advantage in four key areas. First, our vision is to be recognized as one of the world’s great service companies. Because companies must trust their cloud computing provider with their mission-critical IT assets, service reputation is a key selection criterion. Second, our singular focus is to provide cloud computing services, which enables us to operate with a financial discipline that keeps costs low, thereby generating returns that exceed our cost of capital. Third, our portfolio approach to services allows customers to select the solution that best fits their requirements. Fourth, we are committed to open technology standards, which address one of the main barriers to adoption of cloud computing: the customer's fear of being locked in to a particular vendor who then wields great power to raise prices and stifle innovation. These key principles form the foundation of our business model, which is described in more detail below.

Fanatical Support - We believe that excellent customer service creates customer loyalty, which in turn leads to higher profits and growth. We call our unique, industry-leading customer service model “Fanatical Support.” Our entire company is focused on going above and beyond expectations to delight the customer. Fanatical Support builds customer loyalty, which in turn delivers three key benefits:

•
Loyal customers buy more, both as they grow and as they hand a larger proportion of their total IT workload over to us.

•
Loyal customers stay with us longer and refer other customers to us. Both factors help reduce customer acquisition costs and other sales and marketing costs.

•
Loyal customers can be served more cost effectively. The average cost of serving a customer is reduced after initial provisioning and our ability to provide additional service levels that are not capital intensive both lead to higher average profits and profit margins over time.

As a measure of customer loyalty, we make extensive use of the Net Promoter Score® (NPS), developed by Bain & Company, Inc., Fred Reichheld, and Satmetrix Systems, Inc. to track the likelihood that customers will refer us to friends or colleagues. Surveys are conducted on an ongoing basis, and broken down by support team, with results summarized monthly and analyzed to determine areas for improvement. We work with our customers to understand what they consider “must haves” and what they would like to see in terms of incremental improvements to our service offerings.

Fanatical Support is a result of our unique culture. Employees are called Rackers and are rewarded for going above and beyond to serve customers. The highest form of recognition is the Straightjacket Award, which is given to the employee who best demonstrates Fanatical Support in action. We are also very selective in our hiring process. Our philosophy is that technical and functional skills can be taught, but attitude and temperament are ingrained. We strive to hire employees with the personality traits that fit well within our culture and our teams. Periodically, we conduct employee engagement surveys as a measure of cultural health and reward those managers who create an engaging and high-performance environment. For the last two years, Fortune magazine has ranked us in its list of “100 Best Companies to Work For.” We firmly believe that our unique culture is a point of sustained differentiation because our corporate culture, and the complex business process that sustains it, cannot be easily or quickly replicated by competitors.

Singular Focus - We specialize exclusively in providing computing power over the Internet using dedicated and pooled technologies. Modern computing infrastructure is complex and ever-changing, so this specialist focus has allowed us to build a productized set of services that are repeatable, efficient, high-quality and valuable to customers. Our employees, systems, management practices and organizational processes are constantly tuned to improve our high-volume cloud computing offerings. Many of our competitors have to balance their cloud computing lines of business with other areas of focus. These other products and services vie internally for the resources and talent needed to make cloud computing successful. Our exclusive focus on cloud computing enables us to concentrate our capital and our Rackers' talents on a single mission and purpose. We can more rapidly and accurately deploy, upgrade and scale our systems and services. This focus has generated industry-leading revenue growth, profitability and customer satisfaction.


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Seamless Portfolio - Many hosting providers offer a limited set of services or rely on third-party reselling relationships to complete their hosting portfolio. Our portfolio of services allows us to deliver the right offering at the right budget for the customer. Because of the breadth of our portfolio, customers can host their entire environment with us, allowing them to benefit from the simplicity of working with one hosting specialist, rather than managing multiple providers. Our Hybrid Hosting approach allows customers the flexibility to combine both traditional and emerging services for a solution that best addresses their unique IT requirements, and our RackConnect product allows the customer to employ all of our services in a seamless, easy-to-use manner.

Open Standards at Cloud Scale - When we partnered with NASA in July 2010 to launch OpenStack, an open-source cloud computing platform, our goal was to provide an alternative to the proprietary software that then powered all of the major cloud-computing environments. We wanted to help overcome one of the major barriers to adoption of cloud computing: business customers' fear of vendor lock-in and rising prices. Over the past year, OpenStack has attracted significant support, with the addition of approximately 100 new companies, two successful Design Summits with participants from six continents, and the successful release of two new versions of the software.
 
Research and Development

For the years ended December 31, 2009, 2010 and 2011, we recognized $12.6 million, $18.8 million and $25.0 million of research and development expense, respectively. Our research and development efforts are focused on developing new services including:

•
Deployment of new technologies to address emerging trends, such as Public Cloud, private cloud and OpenStack;

•
Development and enhancement of proprietary tools;

•
Development and enhancement of processes for sales and support; and

•
Development and enhancement of data center operations.

We believe cloud computing is a paradigm shift in IT, and we are investing heavily to take advantage of these new technologies. In addition to the research and development expenses incurred, we have capitalized internal software development and other project costs in the amount of $25.0 million, $32.3 million and $63.1 million in the years ended December 31, 2009, 2010 and 2011, respectively.

Intellectual Property Rights

We rely on a combination of patent, copyright, trademark, service mark and trade secret laws in the U.S., the European Union, and various countries in Asia, South America, and elsewhere and contractual restrictions to establish and protect certain proprietary rights in our data, applications, and services. We have rights to patents on a wide range of technologies, and we have patents pending. We have trademarks registered or pending in the U.S., the European Union, and various countries in Asia, South America, and elsewhere for our name and certain words and phrases that we use in our business. We rely on copyright laws and licenses to use and protect software and certain other elements of our proprietary technologies. We also enter into confidentiality and invention assignment agreements with our employees and consultants and confidentiality agreements with other third parties, and we actively monitor access to our proprietary technologies.

In addition, we license third-party software, open source software and other technologies that are used in the provision of or incorporated into some elements of our services.

Employees

As of December 31, 2011, we employed 4,040 Rackers, a net increase of 778, or 23.9%, compared to December 31, 2010. None of our employees are represented by a collective bargaining agreement, nor have we experienced any work stoppages. We believe that our relations with our employees are good.


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Sales and Marketing

Our service suite is sold via direct sales teams, through third-party channel partners and via online ordering. Our direct sales model is based on centralized sales teams with leads generated primarily from customer referrals and corporate marketing efforts. This model also includes a centralized enterprise field sales force, which targets select businesses in that segment. Our channel partners include management and technical consultancies, technology integrators, software application providers, and web developers. Online sales occur via online stores located in the relevant sections of our website.

Our marketing efforts generate interest and market demand by communicating the advantages of our services and unique support model. Our marketing activities include web-based paid and natural search, participation in technology trade shows, conferences and customer events, advertisements in traditional and electronic (web and email-based) media, and targeted regional public relations activities.

Our Support Team Structure

Our support teams are specifically structured based on our customer’s product and service choices. Service teams are comprised of personnel that can address a wide range of business and technical issues for a customer and are available 24/7/365.

Financial Information About Geographic Areas

See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 16 – Segment Information” for financial information related to our geographic areas. For information regarding certain risks relating to our foreign operations, please see the risk titled, “Our ability to operate and expand our business is susceptible to risks associated with international sales and operations” in Item 1A, “Risk Factors.”

Available Information

We file annual, quarterly, and special reports, proxy statements and other information with the Securities and Exchange Commission ("SEC"). You may read and copy any materials that we have filed with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public at the SEC’s website at http://www.sec.gov. In addition, we make available free of charge on or through our Internet website, http://www.rackspace.com under “Investors,” all of the annual, quarterly and special reports, proxy statements, Section 16 insider reports on Form 3, Form 4 and Form 5 and amendments to these reports and other information we file with the SEC. Additionally, our board committee charters and code of ethics are available on our website and in print to any stockholder who requests them. The information contained on our website is not incorporated herein by reference and does not comprise a part of this Annual Report on Form 10-K.



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ITEM 1A – RISK FACTORS
 
Risks Related to Our Business and Industry
 
Our physical infrastructure is concentrated in a few facilities, and any failure in our physical infrastructure or services could lead to significant costs and disruptions and could reduce our revenue, harm our business reputation and have a material adverse effect on our financial results.
 
Our network, power supplies and data centers are subject to various points of failure.  Problems with our cooling equipment, generators, uninterruptible power supply, or UPS, routers, switches, or other equipment, whether or not within our control, could result in service interruptions for our customers as well as equipment damage.  Because our hosting services do not require geographic proximity of our data centers to our customers, our infrastructure is consolidated into a few large facilities. While data backup services and disaster recovery services are available as a part of our hosting services offerings, the majority of our customers do not elect to pay the additional fees required to have disaster recovery services store their backup data offsite in a separate facility, which could substantially mitigate the adverse effect to a customer from a single data center failure. Accordingly, any failure or downtime in one of our data center facilities could affect a significant percentage of our customers. The total destruction or severe impairment of any of our data center facilities could result in significant downtime of our services and the loss of customer data. Since our ability to attract and retain customers depends on our ability to provide customers with highly reliable service, even minor interruptions in our service could harm our reputation. The services we provide are subject to failure resulting from numerous factors, including:
 
▪
Power loss;
▪
Equipment failure;
▪
Human error or accidents;
▪
Sabotage and vandalism;
▪
Failure by us or our vendors to provide adequate service or maintenance to our equipment;
▪
Network connectivity downtime;
▪
Improper building maintenance by the landlords of the buildings in which our facilities are located;
▪
Physical or electronic security breaches;
▪
Fire, earthquake, hurricane, tornado, flood, and other natural disasters;
▪
Water damage; and
▪
Terrorism. 
Additionally, in connection with the expansion or consolidation of our existing data center facilities from time to time, there is an increased risk that service interruptions may occur as a result of server relocation or other unforeseen construction-related issues.
 
We have experienced interruptions in service in the past due to such things as power outages, power equipment failures, cooling equipment failures, routing problems, hard drive failures, database corruption, system failures, software failures, and other computer failures. While we have not experienced a material increase in customer attrition following these events, the extent to which our reputation suffers is difficult to assess. We have taken and continue to take steps to improve our infrastructure to prevent service interruptions, including upgrading our electrical and mechanical infrastructure. However, service interruptions continue to be a significant risk for us and could materially impact our business.
 
Any future service interruptions could:
 
▪
Cause our customers to seek damages for losses incurred;
▪
Require us to replace existing equipment or add redundant facilities;
▪
Affect our reputation as a reliable provider of hosting services;

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▪
Cause existing customers to cancel or elect to not review their contracts; or
▪
Make it more difficult for us to attract new customers.
Any of these events could materially increase our expenses or reduce our revenue, which would have a material adverse effect on our operating results.

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.
 
Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way hosting services are marketed and delivered. The adoption of new technologies, a change in industry standards or introduction of more attractive products or services could make some or all of our offerings less desirable or even obsolete. These potential changes are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by continually improving the performance, features, and reliability of our services and modifying our business strategies accordingly. We cannot guarantee that we will be able to identify the emergence of all of these new service alternatives successfully, modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes. Our failure to provide products and services to compete with new technologies or the obsolescence of our services would likely lead us to lose current and potential customers or cause us to incur substantial costs by attempting to catch our offerings up to the changed environment.
 
We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. For example, our data center infrastructure could require improvements due to (i) the development of new systems to deliver power to or eliminate heat from the servers we house, (ii) the development of new server technologies that require levels of critical load and heat removal that our facilities are not designed to provide, or (iii) a fundamental change in the way in which we deliver services. We may not be able to timely adapt to changing technologies, if at all. Our ability to sustain and grow our business would suffer if we fail to respond to these changes in a timely and cost-effective manner.

Our ability to introduce new products into the market in a timely manner is reliant on how well we can forecast customer demands, develop new products and services and bring the services and products to market. In addition, our ability to develop new products and services is reliant on how accurately we can balance our need to replace our older legacy systems in order to provide scalability with our continued utilization of available resources. If we continue to push our older systems beyond their functional limits, those systems could fail. Such failure could cause us to breach our service level obligations, take resources form ongoing projects to supplement for the non-functionality and distract our management. Alternatively, trying to replace legacy systems on too large of a scale and too quickly could result in material disruption in normal business operations.

Finally, even if we succeed in adapting to a new technology or the changing industry standard and developing attractive products and services and successfully bringing them to market, there is no assurance that our use of the new technology or standard or our introduction of the new products or services would have a positive impact on our financial performance and could even result in lower revenue, lower margins and/or higher costs and therefore could negatively impact our financial performance.

We may not be able to compete successfully against current and future competitors.
 
The market for cloud computing is highly competitive. We expect to face intense competition from our existing competitors as well as additional competition from new market entrants in the future as the actual and potential market for hosting and cloud computing continues to grow.
 
Our current and potential competitors vary by size, service offerings and geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:
 
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Do-it-yourself solutions with a colocation partner such as AT&T, Equinix, CenturyLink and other telecommunications companies;
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IT outsourcing providers such as CSC, HP, and IBM;
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Hosting providers such as AT&T, British Telecom, CenturyLink, Softlayer, Verio and other telecommunications companies; and

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Large technology companies such as Amazon, Microsoft, Google, IBM, Hewlett-Packard and Dell, who have made substantial investments in cloud computing offerings and initiatives.
 
The primary competitive factors in our market are: customer service and technical expertise, security reliability and functionality, reputation and brand recognition, financial strength, breadth of services offered, and price.
 
Many of our current and potential competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater brand recognition, and more established relationships in the industry than we do. As a result, some of these competitors may be able to:
 
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Develop superior products or services, gain greater market acceptance, and expand their service offerings more efficiently or more rapidly;
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Adapt to new or emerging technologies and changes in customer requirements more quickly;
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Bundle hosting services with other services they provide at reduced prices;
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Take advantage of acquisition and other opportunities more readily;
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Adopt more aggressive pricing policies and devote greater resources to the promotion, marketing, and sales of their services; and
▪
Devote greater resources to the research and development of their products and services.
If we do not prevent security breaches and other interruptions to our infrastructure, we may be exposed to lawsuits, lose customers, suffer harm to our reputation, and incur additional costs.
 
The services we offer involve the transmission of large amounts of sensitive and proprietary information over public communications networks, as well as the processing and storage of confidential customer information. Unauthorized access, remnant data exposure, computer viruses, denial of service attacks, accidents, employee error or malfeasance, intentional misconduct by computer “hackers,” and other disruptions can occur, and infrastructure gaps, hardware and software vulnerabilities, inadequate or missing security controls and exposed or unprotected customer data can exist that (i) interfere with the delivery of services to our customers, (ii) impede our customers' ability to do business, or (iii) compromise the security of systems and data, which exposes information to unauthorized third parties.

Techniques used to obtain unauthorized access to, or to sabotage, systems change frequently and generally are not recognized until launched against a target. We may be unable to implement security measures in a timely manner, or, if and when implemented, these measures could be circumvented as a result of accidental or intentional actions by parties within or outside of our organization. Any breaches that occur could expose us to increased risk of lawsuits, loss of existing or potential customers, harm to our reputation and increases in our security costs. Although we typically require our customers to sign agreements that contain provisions attempting to limit our liability for security breaches, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a security breach that they may ascribe to us. Additionally, we may decide to negotiate settlements with affected customers regardless of such contractual limitations. The outcome of any such lawsuit would depend on the specific facts of the case and legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may significantly exceed our liability insurance coverage by unknown but significant amounts, which could seriously impair our financial condition. The laws of some states and countries may also require us to inform any person whose data was accessed or stolen, which could harm our reputation and business. Complying with the applicable notice requirements in the event of a security breach could result in significant costs. We may also be subject to investigation and penalties by regulatory authorities and potential claims by persons whose information was disclosed, even if such person was not actually a customer.


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If we fail to hire and retain qualified employees and management personnel, our growth strategy and our operating results could be harmed.

Our growth strategy depends on our ability to identify, hire, train, and retain executives, IT professionals, technical engineers, software developers, operations employees, and sales and senior management personnel who maintain relationships with our customers and who can provide the technical, strategic, and marketing skills required for our company to grow. There is a shortage of qualified personnel in these fields, specifically in the San Antonio, Texas area, where we are headquartered and a majority of our employees are located. We compete with other companies for this limited pool of potential employees. In addition, as our industry becomes more competitive, it could become especially difficult to retain personnel with unique in-demand skills and knowledge, who we would expect to become recruiting targets for our competitors. There is no assurance that we will be able to recruit or retain qualified personnel, and this failure could cause a dilution of our service-oriented culture and our inability to develop and deliver new products and services, which could cause our operations and financial results to be negatively impacted.

Our success and future growth also depends to a significant degree on the skills and continued services of our management team, especially Graham Weston, our Chairman; A. Lanham Napier, our Chief Executive Officer; and Lew Moorman, our President. We do not have long-term employment agreements with any members of our management team, including Messrs. Weston, Napier and Moorman. Mr. Napier is the only member of our management team on whom we maintain key man insurance.

Failure to maintain adequate internal systems could cause us to be unable to properly provide service to our customers, causing us to lose customers, suffer harm to our reputation, and incur additional costs.

Some of our enterprise systems have been designed to support individual products, resulting in a fragmentation among various internal systems, making it difficult to serve customers who use multiple services offerings. This causes us to implement manual processes to overcome the fragmentation, which results in increased expense and unnecessary manual errors. Some of these systems are also on aging or undersized infrastructure and are at risk of reaching capacity limits in the near future. If we fail to upgrade, replace or increase capabilities on these systems, we may be unable to meet our customers' requests for certain types of service.

We have systems initiatives underway that span infrastructure, products and business transformation. These initiatives are likely to drive significant change in both infrastructure and business processes and contain overlaps and dependencies among the programs. Our inability to manage competing priorities, execute multiple parallel program tracks, plan effectively, manage resources effectively and meet deadlines and budgets, could result in us not being able to implement the systems needed to deliver our services in a compelling manner to our customers.

We provide service level commitments to our customers, which could require us to issue credits for future services if the stated service levels are not met for a given period and could significantly decrease our revenue and harm our reputation.
 
Our customer agreements provide that we maintain certain service level commitments to our customers relating primarily to network uptime, critical infrastructure availability, and hardware replacement. If we are unable to meet the stated service level commitments, we may be contractually obligated to provide these customers with credits for future services. As a result, a failure to deliver services for a relatively short duration could cause us to issue these credits to a large number of affected customers. In addition, we cannot be assured that our customers will accept these credits in lieu of other legal remedies that may be available to them. Our failure to meet our commitments could also result in substantial customer dissatisfaction or loss. Because of the loss of future revenue through these credits, potential customer loss and other potential liabilities, our revenue could be significantly impacted if we cannot meet our service level commitments to our customers.

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.
 
We believe that our success depends on our ability to provide customers with quality service that not only meets our stated commitments, but meets and then exceeds customer service expectations. We refer to this high quality of customer service as Fanatical Support®. If we are unable to provide customers with quality customer support in a variety of areas, we could face customer dissatisfaction, dilution of our brand, weakening of our main market differentiator, decreased overall demand for our services, and loss of revenue. In addition, our inability to meet customer service expectations may damage our reputation and could consequently limit our ability to retain existing customers and attract new customers, which would adversely affect our ability to generate revenue and negatively impact our operating results.
 

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Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.
 
Customer contracts for our dedicated cloud hosting services typically have initial terms of one to two years which, unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire on these contracts. In addition, many of our other services and products, including most of our pooled cloud computing products and services, are generally provided on a month-to-month basis and do not have an extended initial term at all. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.
 
Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.
 
Because our hosting services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may exceed our liability insurance coverage by unknown but significant amounts, which could materially impair our financial condition.

We have been accused of infringing the proprietary rights of others and may be accused of infringing on the proprietary rights of others in the future, which could subject us to costly and time consuming litigation and require us to discontinue services that infringe the rights of others.
 
There may be intellectual property rights held by others, including issued or pending patents, trademarks, and service marks that cover significant aspects of our technologies, branding or business methods, including technologies and intellectual property we have licensed from third parties. Companies in the technology industry, and other patent and trademark holders seeking to profit from royalties in connection with grants of licenses, own large numbers of patents, copyrights, trademarks, service marks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. These or other parties could claim that we have misappropriated or misused intellectual property rights. Any such current or future intellectual property claim against us, regardless of merit, could be time consuming and expensive to settle or litigate and could divert the attention of our technical and management personnel. An adverse determination also could prevent us from offering our services to our customers and may require that we procure or develop substitute services that do not infringe. For any intellectual property rights claim against us or our customers, we may also have to pay damages, indemnify our customers against damages or stop using technology or intellectual property found to be in violation of a third party’s rights. We may be unable to replace those technologies with technologies that have the same features or functionality and that are of equal quality and performance standards on commercially reasonable terms or at all. Licensing replacement technologies and intellectual property may significantly increase our operating expenses or may require us to restrict our business activities in one or more respects. We may also be required to develop alternative non-infringing technology and intellectual property, which could require significant effort, time, and expense.
 

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Our use of open source software and contributions to open source projects could impose limitations on our ability to provide our services, expose us to litigation, and cause us to impair some assets which could adversely affect our financial condition and operating results.
 
We utilize open source software, including Linux-based software, in providing a substantial portion of our services. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to offer our services. Additionally, the use and distribution of open source software can lead to greater risks than the use of third-party commercial software, as open source software does not come with warranties or other contractual protections regarding infringement claims or the quality of the code. From time to time parties have asserted claims against companies that distribute or use open source software in their products and services, asserting that open source software infringes their intellectual property rights. We have been subject to suits, and could be subject to suits in the future, by parties claiming infringement of intellectual property rights with respect to what we believe to be open source software. In such event, we could be required to seek licenses from third parties in order to continue using such software or offering certain of our services or to discontinue the use of such software or the sale of our affected services in the event we could not obtain such licenses, any of which could adversely affect our business, operating results and financial condition. In addition, if we combine our proprietary software with open source software in a certain manner, we could, under some of the open source licenses, be required to release the source code of our proprietary software.
 
We have also sponsored an open source project called OpenStack, which is designed to foster the emergence of cloud computing technology standards and cloud interoperability. Our participation in the project includes the release of our previously proprietary core cloud storage code, and we expect to release additional core cloud code in the future and contribute to the ongoing development of all of the OpenStack projects. In addition, we also participate in other open source projects and plan to continue to do so in the future. Our participation in and support for these projects could cause us to change our current software development and data center strategies. Our utilization of open source software and open data center design projects like the Facebook Open Compute project, which may replace our current capitalized design and development projects, could result in an impairment of those design and development assets.

In addition, our activities with these open source projects could subject us to additional risks of litigation including indirect infringement claims based on third-party contributors because of our sponsorship of this project.
 
We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.
 
We rely primarily on patent, copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies. We cannot assure you that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We currently have one patent issued and 23 patent applications filed in the U.S. Our patent applications may be challenged and/or ultimately rejected, and our issued patent may be contested, circumvented, found unenforceable or invalidated.
 
We endeavor to enter into agreements with our employees, contractors, and parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. We may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed.
 
In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the U.S. Despite the measures taken by us, it may be possible for a third party to copy or otherwise obtain and use our technology and information without authorization. Policing unauthorized use of our proprietary technologies and other intellectual property and our services is difficult, and litigation could become necessary in the future to enforce our intellectual property rights. Any litigation could be time consuming and expensive to prosecute or resolve, result in substantial diversion of management attention and resources, and harm our business, financial condition, and results of operations.

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Our corporate culture has contributed to our success, and if we cannot maintain this culture, we could lose the innovation, creativity, and teamwork fostered by our culture, and our operating results may be harmed.
 
We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity, and teamwork. If we implement more complex organizational management structures because of growth or other structural changes, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future operating results. In addition, being a publicly traded company may create disparities in personal wealth among our employees, which may adversely impact our corporate culture and employee relations.
 
If we are unable to manage our growth effectively, our financial results could suffer.
 
The growth of our business and our service offerings can strain our operating and financial resources. Further, we intend to continue expanding our overall business, customer base, headcount, and operations.  Creating a global organization and managing a geographically dispersed workforce requires substantial management effort and significant additional investment in our operating and financial system capabilities and controls. If our information systems are unable to support the demands placed on them by our growth, we may be forced to implement new systems, which would be disruptive to our business. We may be unable to manage our expenses effectively in the future due to the expenses associated with these expansions, which may negatively impact our gross margins or operating expenses. If we fail to improve our operational systems or to expand our customer service capabilities to keep pace with the growth of our business, we could experience customer dissatisfaction, cost inefficiencies, and lost revenue opportunities, which may materially and adversely affect our operating results.
 
We may not be able to continue to add new customers and increase sales to our existing customers, which could adversely affect our operating results.
 
Our growth is dependent on our ability to continue to attract new customers while retaining and expanding our service offerings to existing customers. Growth in the demand for our services may be inhibited, and we may be unable to sustain growth in our customer base for a number of reasons, such as:
 
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A reduction in the demand for our services due to economic factors;
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Our inability to market our services in a cost-effective manner to new customers;
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The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;
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Our inability to successfully communicate the benefits of our services to businesses;
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The decision of businesses to host their Internet sites and web infrastructure internally or in colocation facilities as an alternative to the use of our hosting services;
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Our inability to penetrate international markets;
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Our inability to provide compelling services or effectively market them to existing customers;
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Our inability to strengthen awareness of our brand; and
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Reliability, quality or compatibility problems with our services.
A substantial amount of our past revenue growth was derived from purchases of service upgrades and additional services by existing customers. Our costs associated with increasing revenue from existing customers are generally lower than costs associated with generating revenue from new customers. Therefore, a reduction in the rate of revenue increase or a rate of revenue decrease from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins.

Any failure by us to continue attracting new customers or grow our revenue from existing customers for a prolonged period of time could have a material adverse effect on our operating results.
 

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If we overestimate or underestimate our data center capacity requirements, our operating margins and profitability could be adversely affected.

The costs of construction, leasing, and maintenance of our data centers constitute a significant portion of our capital and operating expenses. In order to manage growth and ensure adequate capacity for new and existing customers while minimizing unnecessary excess capacity costs, we continuously evaluate our short and long-term data center capacity requirements.

If we overestimate the demand for our services and therefore secure excess data center capacity, our operating margins could be materially reduced, which would materially impair our profitability. If we underestimate our data center capacity requirements, we may not be able to service the expanding needs of our existing customers and may be required to limit new customer acquisition, which may materially impair our revenue growth.

In the past, we have leased data center facilities and built or maintained the facilities ourselves. Due to the lead time in expanding existing data centers or building new data centers, if we build or expand data centers ourselves, we are required to estimate demand for our services as far as two years into the future. This requirement to make customer demand estimates so far in advance makes it difficult to accurately estimate our data center space needs. Building and maintaining data center facilities is also quite expensive. Early on in our operating history, we acquired most of our data center facilities relatively inexpensively as distressed assets of third parties. However, any such endeavor to build our own facilities would now likely require us to pay full market rates, which would make the penalty for inaccurate forecasting of our space needs even more detrimental.

More recently, we have leased data centers from data center operators who have built or maintained the facilities for us. If there are facilities available for lease that suit our needs, our lead time to make capacity decisions is decreased. However, there is still substantial lead time necessary in making sure that available space is adequate for our needs and maximizes our investment return. If we inaccurately forecast our space needs, we may be forced to enter into a lease that is not ideal for our needs and may potentially be required to pay more to secure the space if the current customer demand were to require immediate space expansion.

We currently intend to continue to lease from data center operators, but we could be forced to re-evaluate those plans depending on the availability and cost of data center facilities, the ability to impact and control certain design aspects of the data center and economic conditions affecting the data center operator's ability to add additional facilities.
 
We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.
 
We do not own the facilities occupied by our current data centers but occupy them pursuant to commercial leasing arrangements. The initial terms of our main existing data center leases expire over a period ranging from 2012 to 2030, with each having at least one renewal period of no less than three years.  Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required or choose to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.
 
Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.


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We rely on a number of third-party providers for data center space, equipment, maintenance and other services, and the loss of, or problems with, one or more of these providers may impede our growth or cause us to lose customers.
 
We rely on third-party providers to supply data center space, equipment and maintenance.  For example, we lease data center space from third-party landlords, lease or purchase equipment from equipment providers, and source equipment maintenance through third parties. While we have entered into various agreements for these products and services, any failure to obtain additional capacity or space, equipment, or maintenance, if required, would impede the growth of our business and cause our financial results to suffer. For example, if a data center landlord does not adequately maintain its facilities or provide services for which it is responsible, we may not be able to deliver services to our customers according to our standards or at all.  Further, the equipment that we purchase could be deficient in some way, thereby affecting our products and services. If, for any reason, these providers fail to provide the required services, fail to deliver their equipment, or suffer other failures, we may incur financial losses. Additionally, our customers may lose confidence in our company, and we may not be able to retain these customers.
 
We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.
 
We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software or inadequate or delayed support by the third party could result in errors or a failure of our service, which could harm our operating results by adversely affecting our revenue or operating costs.
 
We engage and rely on third-party consultants who may fail to provide effective guidance or solutions, which could result in increased costs and loss of business opportunity.
 
We engage third-party consultants who provide us with guidance and solutions relating to everything from overall corporate strategy to data center design to employee engagement. We engage these parties based on our perception of their expertise and ability to provide valuable insight or solutions in the areas that we believe need to be addressed in our business. However, these consultants may provide us with ineffective or even harmful guidance or solutions, which, if followed or implemented, could result in a loss of resources, operational failures or a loss of critical business opportunities.
 
Increased energy costs, power outages, and limited availability of electrical resources may adversely affect our operating results.
 
Our data centers are susceptible to increased regional, national or international costs of power and to electrical power outages. Our customer contracts do not allow us to pass on any increased costs of energy to our customers, which could affect our operating margins. Further, power requirements at our data centers are increasing as a result of the increasing power demands of today’s servers. Increases in our power costs could impact our operating results and financial condition. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.
 
Increased Internet bandwidth costs and network failures may adversely affect our operating results.
 
Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.
 

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As our customer base grows and their usage of telecommunications capacity increases, we will be required to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.
 
Our operating results may fluctuate significantly, which could make our future results difficult to predict and could cause our operating results to fall below investor or analyst expectations.
 
Our operating results may fluctuate due to a variety of factors, including many of the risks described in this section, which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our operating results for any prior periods as an indication of our future operating performance. Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our budgeted expense levels depend in part on our expectations of long-term future revenue. Given relatively fixed operating costs related to our personnel and facilities, any substantial adjustment to our expenses to account for lower than expected levels of revenue will be difficult and time consuming. Consequently, if our revenue does not meet projected levels, our operating expenses would be high relative to our revenue, which would negatively affect our operating performance.
 
If our revenue or operating results do not meet or exceed the expectations of investors or securities analysts, the price of our common stock may decline.

We could be required to repay substantial amounts of money to certain state and local governments if we lose tax exemptions or grants previously awarded to us, which could adversely affect our operating results.
 
In August 2007, we entered into an agreement with the State of Texas (Texas Enterprise Fund Grant) under which we may receive up to $22.0 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest.  In September 2007, we received the initial installment of $5.0 million from the State of Texas, which was recorded as a non-current liability. On July 27, 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements. Under the amendment, the grant has been divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a Job Target of 1,225 new jobs by December 2012 (in addition to the 1,436 jobs in place as of August 1, 2007, for a total of 2,661 jobs in Texas). We already have drawn $5.0 million of this grant and, since we have achieved the Job Target as of December 31, 2011, we intend to request the additional $3.5 million that is available to us.  The remaining three tranches are at our option. We can draw an additional $13.5 million, based on the following amounts and milestones: $5.5 million if we create a total of 2,100 new jobs in Texas, another $5.25 million if we create a total of 3,000 new jobs in Texas, and $2.75 million more if we create a total of 4,000 new jobs in Texas. We are responsible for maintaining the jobs through January 2022. If we eliminate jobs for which we have drawn funds, we are subject to a clawback on the amounts we have drawn plus 3.4% interest on such amounts per year. 

On August 3, 2007, we entered into a lease for approximately 67 acres of land and a 1.2 million square foot facility in Windcrest, Texas, which is in the San Antonio, Texas area, to house our corporate headquarters. In connection with this lease, we also entered into a Master Economic Incentives Agreement (“MEIA”) with the Cities of Windcrest and San Antonio, Texas; Bexar County; and certain other parties, pursuant to which we agreed to locate existing and future employees at the new facility location. The agreement requires that we meet certain employment levels each year, with an ultimate job requirement of 4,500 jobs by December 31, 2012, provided that if the job requirement in any grant agreement with the State of Texas is lower, then the job requirement under the MEIA is automatically adjusted downward. Consequently, because the Texas Enterprise Fund Grant agreement has been amended to reduce the state job requirement, we believe the job requirement under the MEIA has been reduced to 1,774.  In addition, the MEIA requires that the median compensation of those employees be no less than $51,000 per year. In exchange for meeting these employment obligations, the parties agreed to enter into the lease structure, pursuant to which, as a lessee of the Windcrest Economic Development Corporation, we will not be subject to most of the property taxes associated with the property for a 14-year period. If we fail to meet these job creation requirements, we could lose a portion or all of the tax benefit being provided during the 14-year period by having to make payments in lieu of taxes (PILOT) to the City of Windcrest. The amount of the PILOT payment would be calculated based on the amount of taxes that would have been owed for that period if the property were not exempt, and then such amount would be adjusted pursuant to certain factors, such as the percentage of employment achieved compared to the stated requirements.


- 19 -

We have debt obligations that include restrictive covenants limiting our flexibility to manage our business; failure to comply with these covenants could trigger an acceleration of our outstanding indebtedness and adversely affect our financial position and operating results.
 
As of December 31, 2011, there was no outstanding indebtedness under our credit facility other than an outstanding letter of credit in the amount of $0.4 million. Our credit facility requires compliance with a set of financial and non-financial covenants. Those covenants include financial leverage limitations and interest rate coverage requirements, as well as limitations on our ability to incur additional debt or liens, make restricted payments, sell assets, enter into affiliate transactions, merge or consolidate with other companies, make certain acquisitions and take other actions.  If we default on our credit agreement due to non-compliance with such covenants or any other contractual requirement of the agreement, we may be required to repay all amounts owed under this credit facility.
 
We also have substantial equipment lease obligations, the principal balance of which totaled approximately $138.2 million as of December 31, 2011. The payment obligations under these equipment leases are secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

If we are unable to generate sufficient cash to repay our debt obligations when they become due and payable, either when they mature or in the event of a default, we may not be able to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to continue as a going concern.
 
We may require additional capital and may not be able to secure additional financing on favorable terms to meet our future capital needs, which could adversely affect our financial position and result in stockholder dilution.
 
In order to fund future growth, we will be dependent on significant capital expenditures. We may need to raise additional funds through equity or debt financings in the future in order to meet our operating and capital needs. We may not be able to secure additional debt or equity financing on favorable terms, or at all, at the time when we need such funding. If we are unable to raise additional funds, we may not be able to pursue our growth strategy, and our business could suffer. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our common stock. In addition, any debt financing that we may obtain in the future could have restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions.

We are exposed to commodity and market price risks that have the potential to substantially influence our profitability and liquidity.
 
We are a large consumer of power. During 2011, we expensed approximately $22.4 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations and changes in energy prices. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically tracked the general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. We periodically evaluate the advisability of entering into fixed-price utilities contracts and have entered into certain fixed-price utilities contracts for some of our power consumption.  If we choose not to enter into a fixed-price contract, we expose our cost structure to this commodity price risk. If we do choose to enter into a fixed-price contract, we lose the opportunity to reduce our power costs if the price for power falls below the fixed cost.
 
Our main credit facility is a revolving line of credit with a base rate determined by variable market rates, including the Prime Rate and the London Interbank Offered Rate (LIBOR). These market rates of interest are fluctuating and expose our interest expense to risk. At this point, our credit agreement does not obligate us to hedge any interest rate risk with any instruments, such as interest rate swaps or interest rate options, and we do not have any such instruments in place. As we borrow more, we may enter into swaps to continuously control our interest rate risk.  As a result, we are exposed to interest rate risk on our borrowings.  As an example of the impact of this interest rate risk, a 100 basis point increase in LIBOR would increase the interest expense on $10 million of borrowings that are not hedged by $0.1 million annually.  As of December 31, 2011, we did not have exposure to interest rate risk as there was no amount outstanding on our revolving credit facility.
 

- 20 -

The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. However, some of our customers are currently invoiced in currencies other than the applicable functional currency. As a result, we may incur foreign currency losses based on changes in exchange rates between the date of the invoice and the date of collection. In addition, large changes in foreign exchange rates relative to our functional currencies could increase the costs of our services to non-U.S. customers relative to local competitors, thereby causing us to lose existing or potential customers to these local competitors. Thus, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Further, as we grow our international operations, our exposure to foreign currency risk could become more significant. To date, we have not entered into any foreign currency hedging contracts, although we may do so in the future.
 
We may be liable for the material that content providers distribute over our network, and we may have to terminate customers that provide content that is determined to be illegal, which could adversely affect our operating results.
 
The law relating to the liability of private network operators for information carried on, stored on, or disseminated through their networks is still unsettled in many jurisdictions. We have been and expect to continue to be subject to legal claims relating to the content disseminated on our network, including claims under the Digital Millennium Copyright Act, other similar legislation and common law. In addition, there are other potential customer activities, such as online gambling and pornography, where we, in our role as a hosting provider, may be held liable as an aider or abettor of our customers. If we need to take costly measures to reduce our exposure to these risks, terminate customer relationships and the associated revenue or defend ourselves against such claims, our financial results could be negatively affected.
 
Government regulation is continuously evolving and, depending on its evolution, may adversely affect our operating results.
 
We are subject to varying degrees of regulation in each of the jurisdictions in which we provide services. Local laws and regulations, and their interpretation and enforcement, differ significantly among those jurisdictions. These regulations and laws may cover taxation, privacy, data protection, pricing, content, copyrights, distribution, mobile communications, electronic device certification, electronic waste, electronic contracts and other communications, consumer protection, web services, the provision of online payment services, unencumbered Internet access to our services, the design and operation of websites, and the characteristics and quality of products and services. These laws can be costly to comply with, can be a significant diversion to management’s time and effort, and can subject us to claims or other remedies, as well as negative publicity. Many of these laws were adopted prior to the advent of the Internet and related technologies and, as a result, do not contemplate or address the unique issues that the Internet and related technologies produce. Some of the laws that do reference the Internet and related technologies have been and continue to be interpreted by the courts, but their applicability and scope remain largely uncertain.
 
In addition, future regulatory, judicial, and legislative changes may have a material adverse effect on our ability to deliver services within various jurisdictions. National regulatory frameworks have only recently been, or are still being, put in place in many countries. Accordingly, many countries are still in the early stages of providing for and adapting to a liberalized telecommunications market. As a result, in these markets we may encounter more protracted and difficult procedures to obtain any necessary licenses or negotiate interconnection agreements, which could negatively impact our ability to expand in these markets or increase our operating costs in these markets.

Privacy concerns relating to our technology could damage our reputation and deter current and potential users from using our products and services.
 
Since our products and services are web-based, we store substantial amounts of data for our customers on our servers (including personal information). Any systems failure or compromise of our security that results in the release of our customers’ data could (i) subject us to substantial damage claims from our customers, (ii) expose us to costly regulatory remediation and (iii) harm our reputation and brand. We may also need to expend significant resources to protect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand our hosting footprint.
 
Regulatory authorities around the world are considering a number of legislative proposals concerning data protection. In addition, the interpretation and application of data protection laws in Europe and elsewhere are still uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines, this could result in an order requiring that we change our data practices, which could have an adverse effect on our business. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business.
 

- 21 -

Our ability to operate and expand our business is susceptible to risks associated with international sales and operations.
 
We anticipate that, for the foreseeable future, a significant portion of our revenue will continue to be derived from sources outside of the U.S. A key element of our growth strategy is to further expand our customer base internationally and successfully operate data centers in foreign markets. We have limited experience operating in foreign jurisdictions other than the U.K. and Hong Kong and expect to continue to grow our international operations. Managing a global organization is difficult, time consuming, and expensive. Our inexperience in operating our business globally increases the risk that international expansion efforts that we may undertake will not be successful. In addition, conducting international operations subjects us to new risks that we have not generally faced. These risks include:
 
▪
Localization of our services, including translation into foreign languages and adaptation for local practices and regulatory requirements;
▪
Lack of familiarity with and unexpected changes in foreign regulatory requirements;
▪
Longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
▪
Difficulties in managing and staffing international operations;
▪
Fluctuations in currency exchange rates;
▪
Potentially adverse tax consequences, including the complexities of transfer pricing, foreign value added tax systems, and restrictions on the repatriation of earnings;
▪
Dependence on certain third parties, including channel partners with whom we do not have extensive experience;
▪
The burdens of complying with a wide variety of foreign laws and legal standards;
▪
Increased financial accounting and reporting burdens and complexities;
▪
Political, social, and economic instability abroad, terrorist attacks and security concerns in general; and
▪
Reduced or varied protection for intellectual property rights in some countries.
Operating in international markets also requires significant management attention and financial resources. The investment and additional resources required to establish operations and manage growth in other countries may not produce desired levels of revenue or profitability.

We rely on our Channel Partner Program members for a significant portion of our revenues, and we benefit from our association with them. The loss of these members could adversely affect our business.
 
Our Channel Partner Program drives a significant amount of revenue to our business through referral and reseller arrangements. Most of our member partners offer services that are complementary to our services; however, some of the participants may actually compete with us in one or more of our product or service offerings. These network partners may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own services rather than ours, which could cause our revenue to decline.
 
Also, we derive tangible and intangible benefits from our association with some of our network partners, particularly high profile partners that reach a large number of companies through the Internet. If a substantial number of these partners terminate their relationship with us, our business could be adversely affected.
 
Our acquisitions may divert our management’s attention, result in dilution to our stockholders and consume resources that are necessary to sustain our business.
 
We have made acquisitions, and, if appropriate opportunities present themselves, we may make additional acquisitions or investments or enter into joint ventures or strategic alliances with other companies. Risks commonly encountered in such transactions include:
 
▪
The difficulty of assimilating the operations and personnel of the combined companies;
▪
The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;

- 22 -

▪
The potential disruption of our ongoing business;
▪
The diversion of management attention from our existing business;
▪
The inability of management to maximize our financial and strategic position through the successful integration of the acquired businesses;
▪
Difficulty in maintaining controls, procedures, and policies;
▪
The impairment of relationships with employees, suppliers, and customers as a result of any integration;
▪
The loss of an acquired base of customers and accompanying revenue; and
▪
The assumption of leased facilities, other long-term commitments or liabilities that could have a material adverse impact on our profitability and cash flow.
As a result of these potential problems and risks, businesses that we may acquire or invest in may not produce the revenue, earnings, or business synergies that we anticipated. In addition, there can be no assurance that any potential transaction will be successfully identified and completed or that, if completed, the acquired business or investment will generate sufficient revenue to offset the associated costs or other potential harmful effects on our business.

Concerns about greenhouse gas emissions and the global climate change may result in environmental taxes, charges, assessments or penalties.
 
The effects of human activity on the global climate change have attracted considerable public and scientific attention, as well as the attention of the United States government. Efforts are being made to reduce greenhouse emissions, particularly those from coal combustion by power plants, some of which we may rely upon for power. The added cost of any environmental taxes, charges, assessments or penalties levied on these power plants could be passed on to us, increasing the cost to run our data centers. Additionally, environmental taxes, charges, assessments or penalties could be levied directly on us in proportion to our carbon footprint. Any enactment of laws or passage of regulations regarding greenhouse gas emissions by the United States, or any domestic or foreign jurisdiction we perform business in, could adversely affect our operations and financial results.
 

- 23 -

Risks Related to the Ownership of Our Common Stock
 
The trading price of our common stock may be volatile.
 
The market price of our common stock has been highly volatile and could be subject to wide fluctuations in response to, among other things, the risk factors described in this periodic report and other factors beyond our control, such as stock market volatility and fluctuations in the valuation of companies perceived by investors to be comparable to us.
 
Further, the stock markets have experienced price and volume fluctuations that have affected our stock price and the market prices of equity securities of many other companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock. We may experience additional volatility as a result of the limited number of our shares available for trading in the market.
 
In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.
 
Our common stock has only been publicly traded since our initial public offering on August 7, 2008, and the price of our common stock has fluctuated substantially since then and may fluctuate substantially in the future.
 
Our common stock has only been publicly traded since our initial public offering on August 7, 2008. The trading price of our common stock has fluctuated significantly since then. For example, between December 31, 2010 and December 31, 2011, the closing trading price of our common stock was very volatile, ranging between $29.78 and $46.19 per share, including single-day increases of up to 12.4% and declines up to 12.4%. Our trading price could fluctuate substantially in the future due to the factors discussed in this Risk Factors section and elsewhere in this Annual Report on Form 10-K.
 
We do not intend to pay dividends on our common stock.

We have never declared or paid any cash dividend on our capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.

The issuance of additional stock in connection with acquisitions, our equity incentive and stock purchase plans, or otherwise will dilute all other stockholdings.
 
We have a large number of shares of common stock authorized but unissued and not reserved for issuance under our stock option plans or otherwise. We may issue all of these shares without any action or approval by our stockholders. We intend to continue to actively pursue strategic acquisitions. We may pay for such acquisitions, partly or in full, through the issuance of additional equity. In addition, our Amended and Restated 2007 Long-Term Incentive Plan and our Employee Stock Purchase Plan contain evergreen provisions, which annually increase the number of shares issuable under the applicable plan. Any issuance of shares in connection with our acquisitions, our Amended and Restated 2007 Long-Term Incentive Plan or otherwise would dilute the percentage ownership held by our then-existing stockholders.
 
Your ability to influence corporate matters may be limited because a small number of stockholders beneficially own a substantial amount of our common stock.
 
Our directors and executive officers and their affiliates beneficially own a significant portion of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. Although our directors and executive officers are not currently party to any agreements or understandings to act together on matters submitted for stockholder approval, this concentration of ownership could limit your ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.
 

- 24 -

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change of control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.
 
Our restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors deemed undesirable by our board of directors that our stockholders might consider favorable. Some of these provisions:
 
•
Authorize the issuance of blank check preferred stock which can be created and issued by our board of directors without prior stockholder approval, with voting, liquidation, dividend, and other rights senior to those of our common stock;
•
Provide for a classified board of directors, with each director serving a staggered three-year term;
•
Prohibit our stockholders from filling board vacancies or increasing the size of our board, calling special stockholder meetings or taking action by written consent;
•
Provide for the removal of a director only with cause and by the affirmative vote of the holders of a majority of the shares then entitled to vote at an election of our directors; and
•
Require advance written notice of stockholder proposals and director nominations.
In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

ITEM 1B - UNRESOLVED STAFF COMMENTS

None.

ITEM 2 - PROPERTIES

Office Space

Our corporate headquarter facility is located in San Antonio, Texas and consists of a 1.2 million square foot facility located on approximately 67 acres of land. We have remodeled and are currently using approximately 574,000 square feet of office space and will continue to remodel the formerly vacant facility as needed to facilitate our future growth and office requirements. Besides our corporate headquarters, we have additional U.S. office locations in Texas, Virginia, Missouri, Illinois, California and Georgia and additional office space located in the U.K., the Netherlands, Hong Kong and Australia. As of December 31, 2011, we utilized approximately 913,000 square feet of our leased office space and used it for customer service, operations, sales, corporate and administrative functions.

Data Centers

As of December 31, 2011, we leased eight main data centers located in the U.S., the U.K., and in Hong Kong with approximately 262,000 available technical square feet, of which 233,000 were utilized. At December 31, 2011, we were utilizing 20.9 Megawatts of power at our data centers. The five data centers in the U.S. are located in Texas, Virginia and Illinois.

We are continuously looking for additional data center space to accommodate future growth or that would present an attractive business opportunity for us. However, we believe that our existing office space and data center facilities are adequate for our current needs and that suitable additional or alternative space will be available in the future to meet our anticipated needs.


- 25 -

ITEM 3 – LEGAL PROCEEDINGS
 
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, on October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston was filed in the 37th District Court in Bexar County, Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We do not expect the results of this claim or any other current proceeding to have a material adverse effect on our business, results of operations or financial condition.

ITEM 4 – RESERVED
 

- 26 -

PART II

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information for Common Stock

Our common stock began trading on the New York Stock Exchange under the symbol "RAX" beginning on August 8, 2008. Prior to that time, there was no public market for our common stock.

The following table sets forth for the indicated periods the high and low closing prices for our common stock for the periods indicated, as reported by the New York Stock Exchange.

Fiscal Year 2011 Quarters:
 
High
 
Low
First Quarter
 
$
43.01

 
$
29.78

Second Quarter
 
46.19

 
38.24

Third Quarter
 
45.78

 
31.49

Fourth Quarter
 
45.16

 
31.49


Fiscal Year 2010 Quarters:
 
High
 
Low
First Quarter
 
$
23.09

 
$
17.11

Second Quarter
 
20.80

 
15.51

Third Quarter
 
26.11

 
16.46

Fourth Quarter
 
31.74

 
22.45


The last reported sale price for our common stock on the New York Stock Exchange was $31.41, $43.01 and $55.45 per share on December 31, 2010, December 31, 2011, and February 14, 2012, respectively.

Dividend Policy

We have never paid any cash dividends on our common stock. Our board of directors currently intends to retain any future earnings to support operations and to finance the growth and development of our business and does not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination related to our dividend policy will be made at the discretion of our board.

Stockholders

As of February 14, 2012, there were 226 registered stockholders of record of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these stockholders of record.

Securities Authorized for Issuance Under Equity Compensation Plans

For information regarding securities authorized for issuance under equity compensation plans, see Part III "Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."

- 27 -

Stock Performance Graph

The graph set forth below compares the cumulative total stockholder return on our common stock between August 7, 2008 (the date of our initial public offering, or IPO) and December 31, 2011, with the cumulative total return of (i) the Russell 2000 Index, (ii) the Russell 1000 Index, and (iii) the Nasdaq Internet Total Return Index over the same period. This graph assumes the investment of $100 on August 7, 2008 in our common stock at our IPO offering price of $12.50 per share, the Russell 2000 Index, the Russell 1000 Index and the Nasdaq Internet Total Return Index, and assumes the reinvestment of dividends, if any. The Russell 2000 Index measures the performance of the small-cap segment of U.S. equities. As our revenue and total market capitalization have both increased over the last year, we will no longer use the Russell 2000 Index and will instead use the Russell 1000 Index, which measures the performance of the large-cap segment of U.S. equities. We are currently included in the Russell 1000 Index. The Nasdaq Internet Total Return Index consists of U.S. listed companies engaged in Internet-related businesses.

The comparisons shown in the graph below are based upon historical data. We caution that the stock price performance shown in the graph below is not necessarily indicative of, nor is it intended to forecast, the potential future performance of our common stock.


Recent Sales of Unregistered Securities

None

- 28 -

ITEM 6 - SELECTED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes to those statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this document. The selected consolidated financial data in this section are not intended to replace the financial statements and are qualified in their entirety by the consolidated financial statements and related notes thereto, included elsewhere in this document.

The statements of income data for the fiscal years ended December 31, 2009, 2010 and 2011 and the balance sheet data as of December 31, 2010 and 2011 have been derived from our audited consolidated financial statements, which have been audited by KPMG LLP, independent registered public accounting firm, and included elsewhere in this document. The statements of income data for the years ended December 31, 2007 and 2008 and the balance sheet data as of December 31, 2007, 2008 and 2009 have been derived from our audited consolidated financial statements, which have been audited by KPMG LLP, independent registered public accounting firm, but are not included in this document. Historical results are not necessarily indicative of future results. See Note 2 to the financial statements for an explanation of the method used to determine the number of shares used in computing basic and diluted net income per common share.

 
Year Ended December 31,
(In thousands, except per share data)
2007
 
2008
 
2009
 
2010
 
2011
Net revenue
$
362,017

 
$
531,933

 
$
628,987

 
$
780,555

 
$
1,025,064

Costs and expenses:
 
 
 
 
 
 
 
 
 
Cost of revenue
118,225

 
172,583

 
200,943

 
249,840

 
309,095

Sales and marketing
53,930

 
80,323

 
79,458

 
96,207

 
126,505

General and administrative
102,777

 
148,706

 
168,116

 
199,011

 
270,581

Depreciation and amortization
56,476

 
90,172

 
125,229

 
155,895

 
195,412

Total costs and expenses
331,408

 
491,784

 
573,746

 
700,953

 
901,593

Income from operations
30,609

 
40,149

 
55,241

 
79,602

 
123,471

Other income (expense):
 
 
 
 
 
 
 
 
 
Interest expense
(3,643
)
 
(8,229
)
 
(8,950
)
 
(7,984
)
 
(5,848
)
Interest and other income (expense)
828

 
768

 
255

 
(207
)
 
(1,194
)
Total other income (expense)
(2,815
)
 
(7,461
)
 
(8,695
)
 
(8,191
)
 
(7,042
)
Income before income taxes
27,794

 
32,688

 
46,546

 
71,411

 
116,429

Income taxes
9,965

 
10,985

 
16,328

 
25,053

 
40,018

Net income
$
17,829

 
$
21,703

 
$
30,218

 
$
46,358

 
$
76,411

 
 
 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
 
 
Basic
$
0.18

 
$
0.20

 
$
0.25

 
$
0.37

 
$
0.59

Diluted
$
0.17

 
$
0.19

 
$
0.24

 
$
0.35

 
$
0.55

 
 
 
 
 
 
 
 
 
 
Balance sheet data
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
24,937

 
$
238,407

 
$
125,425

 
$
104,941

 
$
159,856

Total assets
301,813

 
685,261

 
668,645

 
761,577

 
1,026,482

Long-term obligations
96,213

 
283,053

 
161,024

 
133,572

 
189,310

Total stockholders’ equity
96,873

 
269,684

 
349,427

 
438,863

 
599,423



- 29 -

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

The following discussion should be read in conjunction with our consolidated financial statements and the related notes contained elsewhere in this document.
 
Overview of our Business

We are the service leader in cloud computing. Our growth is the result of our commitment to serving our customers, known as Fanatical Support, and our exclusive focus on 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 hosted computing on dedicated hardware and on pools of shared resources. We are committed to maintaining our service-centric focus, and we will follow our vision to be considered one of the world’s great service companies.

We offer a portfolio of cloud computing services, including Dedicated Cloud hosting and Public Cloud hosting. The equipment required (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) to deliver services is typically purchased and managed by us.

We sell our services to small and medium-sized businesses as well as large enterprises. During 2011, 25% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, we operate a Hong Kong data center and sales office. Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. During 2011, no individual customer accounted for more than 2% of our net revenue.

How We Earn Revenue and Measure Growth

Our subscription-based business model generates approximately 98% 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 interruptions, and also includes revenue related to customers who have canceled their service. Net revenue for the years ended December 31, 2009, 2010 and 2011 was $629.0 million, $780.6 million and $1,025.1 million, respectively, representing year-over-year increases of 24.1% in 2010 and 31.3% in 2011.

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. “Installed base growth” is a metric we use to measure the growth of revenue 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. The increase in net revenue due to foreign currency fluctuations was approximately $8.6 million, or 0.8%, in 2011.


- 30 -

Nature of Our Operating Expenses

Our operating expense categories include 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, vacation, benefits, and share-based compensation. Employee non-equity incentive compensation through our current non-equity incentive plan, in effect since January 1, 2009, is dependent upon the financial results of the company in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense. If company achievement of the pre-set target results in a 10.0% increase in the non-equity incentive compensation percentage payout in a quarter, this would increase total non-equity incentive compensation by approximately $0.6 million on an after-tax basis and increase net income by $0.6 million in that quarter. Company achievement resulting in a 10.0% decrease in the non-equity incentive compensation percentage payout in a quarter would decrease total non-equity incentive compensation by approximately $0.6 million on an after-tax basis and decrease net income by $0.6 million in that quarter. 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.

We had 3,262 and 4,040 employees as of December 31, 2010 and 2011, respectively. The year-over-year increase was primarily attributable to increases in our customer and data center support teams, as well as increases in general and administrative positions. 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 2012 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, and rent; costs associated with licenses; 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. We enter into contracts with software providers that allow us to provide licenses 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 intended 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.

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.

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 increase in operating expenses, due to foreign currency fluctuations, was approximately $6.4 million, or less than 1%, in 2011.


- 31 -

Capital Expenditures

Our capital expenditures primarily 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 building improvements.

Corporate office build-outs - Includes demolition, 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 2011, we expended cash or entered into lease arrangements for the purchase of customer gear of $196.1 million and incurred data center infrastructure costs of $49.9 million, corporate office build-out costs of $35.8 million and $63.1 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 minimize the amount of excess capacity, 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 2011, we continued to add to our existing data center footprint both in the U.S. and internationally to support our growth. We added more than 100 thousand technical square feet of data center space. In February and August 2011, we modified our operating lease agreement with a subsidiary of DuPont Fabros Technology to lease additional space at our Chicago area data center. In December 2011, we entered into an operating lease agreement with Digital Realty Trust to lease approximately 58,200 technical square feet of data center space in Richardson, Texas. This current strategy of entering into operating lease agreements for data center space reduces the capital investments required to increase our data center square footage.


- 32 -

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 made significant investments in cloud computing. Over the last several years, we have made acquisitions that have expanded our product set into new areas of cloud computing, including private cloud, OpenStack and Rackspace Cloud Builders. We will continue to identify and pursue strategic investments that have the potential to generate savings, enhance our competitive advantage, and increase our capabilities to serve customers.

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.

- 33 -

 
 
Year Ended December 31,
(Dollar amounts in thousands, except average monthly revenue per server and annualized net revenue per average technical square foot)
 
2009
 
2010
 
2011
 
 
 
Growth
 
 
 
 
 
 
Dedicated Cloud, net revenue
 
$
572,606

 
$
679,888

 
$
835,877

Public Cloud, net revenue
 
$
56,381

 
$
100,667

 
$
189,187

Net revenue
 
$
628,987

 
$
780,555

 
$
1,025,064

Revenue growth (year over year)
 
18.2
 %
 
24.1
 %
 
31.3
 %
Net upgrades (monthly average)
 
1.2
 %
 
1.5
 %
 
1.9
 %
Churn (monthly average)
 
-1.0
 %
 
-1.0
 %
 
-0.9
 %
Growth in installed base (monthly average) (2)
 
0.2
 %
 
0.5
 %
 
1.0
 %
Number of customers at period end (3)
 
90,925

 
130,291

 
172,510

Number of employees (Rackers) at period end
 
2,774

 
3,262

 
4,040

Number of servers deployed at period end
 
56,671

 
66,015

 
79,805

Average monthly revenue per server
 
$
1,004

 
$
1,054

 
$
1,157

Profitability
 
 
 
 
 
 
Income from operations
 
$
55,241

 
$
79,602

 
$
123,471

Depreciation and amortization
 
$
125,229

 
$
155,895

 
$
195,412

Share-based compensation expense
 
 
 
 
 
 
Cost of revenue
 
$
2,850

 
$
4,660

 
$
4,220

Sales and marketing
 
$
2,884

 
$
4,241

 
$
2,313

General and administrative
 
$
14,390

 
$
17,723

 
$
22,240

Total share-based compensation expense
 
$
20,124

 
$
26,624

 
$
28,773

Adjusted EBITDA (1)
 
$
200,594

 
$
262,121

 
$
347,656

Adjusted EBITDA margin
 
31.9
 %
 
33.6
 %
 
33.9
 %
Operating income margin
 
8.8
 %
 
10.2
 %
 
12.0
 %
Income from operations
 
$
55,241

 
$
79,602

 
$
123,471

Effective tax rate
 
35.1
 %
 
35.1
 %
 
34.4
 %
Net operating profit after tax (NOPAT) (1)
 
$
35,851

 
$
51,662

 
$
80,997

NOPAT margin
 
5.7
 %
 
6.6
 %
 
7.9
 %
Capital efficiency and returns
 
 
 
 
 
 
Interest bearing debt
 
$
167,386

 
$
131,727

 
$
139,126

Stockholders' equity
 
$
349,427

 
$
438,863

 
$
599,423

Less: Excess cash
 
$
(105,083
)
 
$
(79,174
)
 
$
(125,865
)
Capital base
 
$
411,730

 
$
491,416

 
$
612,684

Average capital base
 
$
390,472

 
$
445,179

 
$
552,328

Capital turnover
 
1.61

 
1.75

 
1.86

Return on capital (1)
 
9.2
 %
 
11.6
 %
 
14.7
 %
Capital expenditures
 
 
 
 
 
 
Purchases of property and equipment, net
 
$
117,292

 
$
144,778

 
$
269,804

Vendor-financed equipment purchases
 
$
68,382

 
$
71,363

 
$
75,090

Total capital expenditures
 
$
185,674

 
$
216,141

 
$
344,894

Customer gear
 
$
108,829

 
$
136,348

 
$
196,096

Data center build outs
 
$
37,208

 
$
38,515

 
$
49,947

Office build outs
 
$
14,672

 
$
8,942

 
$
35,752

Capitalized software and other projects
 
$
24,965

 
$
32,336

 
$
63,099

Total capital expenditures
 
$
185,674

 
$
216,141

 
$
344,894

Infrastructure capacity and utilization
 
 
 
 
 
 
Technical square feet of data center space at period end (4)
 
162,848

 
180,173

 
233,960

Annualized net revenue per average technical square foot
 
$
3,929

 
$
4,477

 
$
4,866

Utilization rate at period end
 
65.3
 %
 
72.0
 %
 
68.1
 %

- 34 -

(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.
(4)
Technical square footage as of December 31, 2011 excludes 28,460 square feet for unused portions of our data center facilities.

We have historically defined technical square feet of data center space as space that can be utilized to support IT equipment. With respect to square footage and utilization, for data centers that are not yet fully utilized, we include square footage and power capacity based on the agreed upon schedule in the lease agreement. For example, if the agreement has ten phases and we are in phase five, we include 50% of the total square footage and power capacity called for in the lease agreement.

As a result of our strategy to continue leasing data centers, beginning in the first quarter of 2012, we will begin disclosing our total Megawatts under contract, Megawatts available for use and Megawatts utilized as of period-end. We will no longer provide technical square footage as we believe that power is a better metric for evaluating our capacity. The table below shows how the new disclosure would have appeared in the Key Metrics table.

 
 
Year Ended December 31,
(Dollar amounts in thousands)
 
2009
 
2010
 
2011
Megawatts under contract at period end
 
28.4

 
32.7

 
48.1

Megawatts available for use at period end
 
20.8

 
23.2

 
30.7

Megawatts utilized at period end
 
13.3

 
16.7

 
20.9

Net revenue per average Megawatt of power utilized
 
$
53,304

 
$
52,037

 
$
54,065


Executive Overview

To aid in understanding our operating results for the periods covered by this report, we have provided an executive overview and a summary of the significant events that affected the most recent fiscal year. These sections should be read in conjunction with the more detailed discussion and analysis of our financial condition and results of operations in Item 7, our “Risk Factors” section included in Item 1A of Part I, and our audited consolidated financial statements and notes included in Item 8 of Part II of this report.

In 2011 we focused on accelerating the growth of our business while maintaining our profits and returns and focusing on the minimal use of cash to achieve our growth.

Growth of Our Business. Our business grew in 2011 with net revenue growth year over year of $244.5 million, or 31.3%, to $1,025.1 million compared to $780.6 million in 2010. Our increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of new customers and incremental services rendered to existing customers. Year-over-year revenue increases were 22.9% for our Dedicated Cloud hosting service and 87.9% for our Public Cloud hosting service. Also contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the pound sterling. Net revenue in 2011 would have been approximately $8.6 million lower had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.

Our 2011 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, 2011, we served over 172,000 customers running on over 79,000 servers within our data centers in the U.S., the U.K., and Hong Kong, which represented incremental increases in each category as compared to 2010. During 2011, our monthly average churn rate was 0.9%, compared to 1.0% in 2010. Overall, our installed base continued to provide a portion of our growth in 2011, growing at a monthly average rate of 1.0% in 2011, compared to 0.5% in 2010 and 0.2% in 2009, respectively. In the fourth quarter of 2011, our churn rate was 0.8% and installed base growth was 1.2%. The increase in net upgrades is primarily due to an increasing number of larger customers within our customer base, as well as increasing spend by these customers. These larger customers generally have higher net upgrades.


- 35 -

Our revenue growth has moved us into a new competitive landscape where our direct competitors are much larger and stronger financially. We will 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 technology platforms, our business becomes more capital efficient and our competitive advantage widens as our service capability increases.

Scaling Profits and Returns. While accelerating our revenue growth rate in 2011, profit margins increased as well, particularly during the second half of the year.

Income from operations increased $43.9 million, or 55.2%, to $123.5 million in 2011, compared to $79.6 million in 2010. Operating income margin was 12.0% in 2011 as compared to 10.2% in 2010. Adjusted EBITDA increased $85.6 million, or 32.7%, to $347.7 million in 2011, compared to $262.1 million in 2010. In addition, Adjusted EBITDA as a percentage of revenue was 33.9% in 2011 compared to 33.6% in 2010. See the following section on non-GAAP financial measures for a discussion of Adjusted EBITDA. Net income was $76.4 million or $0.55 per share on a diluted basis in 2011, compared to net income of $46.4 million, or $0.35 per share on a diluted basis in 2010. Net income margin was 7.5% in 2011 as compared to 5.9% in 2010.

Use of Cash. For the year ended December 31, 2011, we had negative adjusted free cash flow of $7.4 million. See below for our discussion of non-GAAP financial measures.

During 2011, we were able to maintain a consistent level of cash and cash equivalents while growing our business by maintaining our disciplined use of capital. Our capital expenditures for 2011 were $344.9 million, of which $75.1 million was vendor-financed, while our cash provided by operating activities was $343.0 million. In 2011, we deployed an additional 13,790 servers, bringing our total servers to 79,805, an increase of 20.9%. As of December 31, 2011, we had $119.1 million in cash deposits and $40.7 million in money market funds.

Company Highlights and Developments

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. It enables them to match costs directly to revenue and to scale up and down on a real-time basis as necessary. We do not believe that Public Cloud will replace traditional Dedicated Cloud hosting offerings. We believe the two complement one another, allowing customers to choose from a portfolio of offerings to meet their business needs.

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 creating new technologies to help businesses leverage the benefits of Public Cloud hosting. Hosted virtual desktop, our managed Cloud service, the U.K. Cloud, and Cloud Load Balancers are a few of the recent examples of new capabilities we have developed that are available in the market today that make us more competitive, drive revenue growth, and improve returns.

Our product road-map includes a variety of new capabilities and features including Cloud Block Storage, enhancements to RackConnect, and building a support business around the OpenStack cloud computing platform. Based on our experience working with customers running OpenStack, we are ready to move into the next phase of our OpenStack strategy with the introduction of a new service we call Rackspace Cloud: Private Edition. This new offering will enable 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. While this initiative is still in its early stages of development, Rackspace Cloud: Private Edition is an opportunity to drive incremental demand.


- 36 -

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)
 
2009
 
2010
 
2011
Net revenue
 
$
628,987

 
$
780,555

 
$
1,025,064

Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
200,943

 
249,840

 
309,095

Sales and marketing
 
79,458

 
96,207

 
126,505

General and administrative
 
168,116

 
199,011

 
270,581

Depreciation and amortization
 
125,229

 
155,895

 
195,412

Total costs and expenses
 
573,746

 
700,953

 
901,593

Income from operations
 
55,241

 
79,602

 
123,471

Other income (expense):
 
 
 
 
 
 
Interest expense
 
(8,950
)
 
(7,984
)
 
(5,848
)
Interest and other income (expense)
 
255

 
(207
)
 
(1,194
)
Total other income (expense)
 
(8,695
)
 
(8,191
)
 
(7,042
)
Income before income taxes
 
46,546

 
71,411

 
116,429

Income taxes
 
16,328

 
25,053

 
40,018

Net income
 
$
30,218

 
$
46,358

 
$
76,411

 
 
Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
 
Year Ended December 31,
(Percent of net revenue)
 
2009
 
2010
 
2011
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
31.9
 %
 
32.0
 %
 
30.2
 %
Sales and marketing
 
12.6
 %
 
12.3
 %
 
12.3
 %
General and administrative
 
26.7
 %
 
25.5
 %
 
26.4
 %
Depreciation and amortization
 
19.9
 %
 
20.0
 %
 
19.1
 %
Total costs and expenses
 
91.2
 %
 
89.8
 %
 
88.0
 %
Income from operations
 
8.8
 %
 
10.2
 %
 
12.0
 %
Other income (expense):
 
 
 
 
 
 
Interest expense
 
-1.4
 %
 
-1.0
 %
 
-0.6
 %
Interest and other income (expense)
 
0.0
 %
 
0.0
 %
 
-0.1
 %
Total other income (expense)
 
-1.4
 %
 
-1.0
 %
 
-0.7
 %
Income before income taxes
 
7.4
 %
 
9.1
 %
 
11.4
 %
Income taxes
 
2.6
 %
 
3.2
 %
 
3.9
 %
Net income
 
4.8
 %
 
5.9
 %
 
7.5
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 37 -

Years ended December 31, 2010 and December 31, 2011

Net Revenue

Our net revenue was $780.6 million during 2010 and $1,025.1 million during 2011, an increase of $244.5 million, or 31.3%. The increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of new customers and incremental services rendered to existing customers. Also contributing to the the revenue increase was the positive impact of a weaker U.S. dollar relative to the pound sterling in 2011 compared to 2010. Net revenue for 2011 would have been approximately $8.6 million lower had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year, with a minimal impact to our margins as the majority of these customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively.

Cost of Revenue

Our cost of revenue was $249.8 million during 2010 and $309.1 million during 2011, an increase of $59.3 million, or 23.7%. Of this increase, $31.1 million was attributable to an increase in employee-related expenses due to increases in salaries and benefits of $27.1 million and non-equity incentive compensation of $4.4 million, partially offset by a $0.4 million decrease in share-based compensation expense. These increases were the result of the hiring of data center and support personnel to support our growth and higher percentage attainment against the preset target for non-equity incentive compensation. The cost increase was further attributable to an increase in data center costs of $13.5 million related to bandwidth, power and rent, and an increase in license costs of $11.9 million. The remaining increase was due to small variances in other cost of revenue expenses.

Sales and Marketing Expenses

Our sales and marketing expenses were $96.2 million during 2010 and $126.5 million during 2011, an increase of $30.3 million, or 31.5%. Of this increase, $17.5 million was attributable to an increase in employee-related expenses due to increases in salaries and benefits of $16.1 million and commissions of $3.3 million, partially offset by a $1.9 million decrease in share-based compensation expense. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. Additionally, advertising and Internet-related marketing expenditures increased $11.5 million. The remaining increase was due to small variances in other sales and marketing expenses.

General and Administrative Expenses

Our general and administrative expenses were $199.0 million during 2010 and $270.6 million during 2011, an increase of $71.6 million, or 36.0%. Of this increase, $48.8 million was attributable to employee-related expenses due to increases in salaries and benefits of $36.9 million, non-equity incentive compensation of $7.4 million, and share-based compensation expense of $4.5 million. These increases are primarily due to additional headcount, higher percentage attainment against the preset target for non-equity incentive compensation and equity awards granted in 2011. Professional fees and legal expenses increased $11.4 million primarily as a result of increased consulting expenses related to accounting and tax services, corporate strategy and internal system maintenance and improvements and various infrastructure projects that were not capitalized. Travel and other employee related expenses such as recruiting fees and relocation increased $4.7 million primarily due to a general increase in hiring during 2011. Additionally, office expenses including rent and maintenance increased $2.0 million, and merchant credit card fees and bad debt increased $2.7 million and $0.6 million, respectively, due to a higher volume of sales. The remaining variance was due to small changes in other general and administrative expenses.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $155.9 million during 2010 and $195.4 million during 2011, an increase of $39.5 million, or 25.3%. This increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, including increases in data center equipment and leasehold improvements due to data center build-outs and internally developed and purchased software.


- 38 -

Other Income (Expense)

Our interest expense was $8.0 million during 2010 and $5.8 million during 2011, a decrease of $2.2 million, or 27.5%. This decrease was primarily due to the decreased level of indebtedness. Interest expense was partially offset by capitalized interest of $0.6 million during 2010. There was no interest capitalized in 2011.

Interest and other income (expense) was $(0.2) million during 2010 and $(1.2) million during 2011. 2010 included foreign currency losses of $0.7 million compared to foreign currency losses of $0.3 million in 2011 and accretion expense of acquisition-related liabilities of $1.3 million.

Income Taxes

Our effective tax rate was 35.1% and 34.4% in 2010 and 2011, respectively. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, research and development credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States.

For a full reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Item 8 of Part II, “Financial Statements and Supplementary Data – Note 14 – Taxes.”

Years ended December 31, 2009 and 2010

Net Revenue

Our net revenue was $629.0 million during 2009 and $780.6 million during 2010, an increase of $151.6 million, or 24.1%. The increase in net revenue was primarily due to increased volume of services provided, due to both an increasing number of new customers and incremental services rendered to existing customers. Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the pound sterling in 2010 compared to 2009. Net revenue for 2010 would have been approximately $2.7 million higher had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year, with a minimal impact to our margins as the majority of these customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. Net revenue in 2009 was negatively impacted by two service interruptions, which resulted in a total of $3.7 million in service credits. There were no significant service interruptions in 2010.

Cost of Revenue

Our cost of revenue was $200.9 million during 2009 and $249.8 million during 2010, an increase of $48.9 million, or 24.3%. Of this increase, $24.0 million was attributable to an increase in employee-related expenses due to increases in salaries and benefits of $20.9 million, share-based compensation expense of $1.8 million and non-equity incentive compensation of $1.3 million. These increases were the result of the hiring of data center and support personnel to support our growth, equity awards granted in 2010 and higher percentage attainment against the preset target for non-equity incentive compensation. The cost increase was further attributable to an increase in data center costs of $6.2 million related to bandwidth, power and rent, an increase in license costs of approximately $8.3 million and an increase in consulting fees related to data center assessments and improvements of $10.0 million. Impacting the $8.3 million increase in license costs was a $2.1 million reduction in 2009 related to the reversal of a previously recorded obligation relating to an unresolved contractual issue with a vendor. During the fourth quarter of 2009, we concluded that the obligation was no longer probable, and accordingly, we reversed the liability, which reduced cost of revenue. The remaining increase was due to small increase in other cost of revenue expenses.

Sales and Marketing Expenses

Our sales and marketing expenses were $79.5 million during 2009 and $96.2 million during 2010, an increase of $16.7 million, or 21.0%. Of this increase, $11.4 million was attributable to an increase in employee-related expenses due to increases in salaries and benefits of $5.3 million, commissions of $4.1 million, share-based compensation expense of $1.4 million and non-equity incentive compensation of $0.6 million. Total compensation increased as a result of the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. Additionally, advertising and Internet-related marketing expenditures increased $3.3 million, and travel and other employee-related expenses increased $2.0 million.


- 39 -

General and Administrative Expenses

Our general and administrative expenses were $168.1 million during 2009 and $199.0 million during 2010, an increase of $30.9 million, or 18.4%. Of this increase, $19.0 million was attributable to employee-related expenses due to increases in salaries and benefits of $13.4 million, non-equity incentive compensation of $2.3 million, and share-based compensation expense of $3.3 million. These increases are primarily due to additional headcount, higher percentage attainment against the preset target for non-equity incentive compensation and equity awards granted in 2010. Professional fees increased $3.6 million primarily as a result of increased consulting expenses related to accounting and tax services, corporate strategy and internal system maintenance and improvements, and incremental software and maintenance costs of $1.6 million. Travel and other employee-related expenses such as recruiting fees and relocation increased $5.4 million primarily due to the addition of several executive level positions and a general increase in hiring during 2010. Additionally, property tax increased $2.0 million due to the addition of data center facilities. We also experienced an increase in merchant credit card fees of $1.8 million due to higher volume of sales in 2010. The overall increase was partially offset by a decrease in bad debt expense of $2.0 million due to a positive change in customer payment patterns and increased cash collections. The remaining variance was due to small changes in other general and administrative expenses.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $125.2 million during 2009 and $155.9 million during 2010, an increase of $30.7 million, or 24.5%. This increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets, including increases in data center equipment and leasehold improvements due to data center build outs and internally developed and purchased software, as well as intangible assets acquired through acquisitions.

Income Taxes

Our effective tax rate remained constant with a rate of 35.1% for 2009 and 2010. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, research and development credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States.

Quarterly Key Metrics and Results of Operations

The following tables set forth our unaudited quarterly key metrics and condensed consolidated statement of operations data in dollars and as a percentage of revenue for each of our most recent five quarters as of the period ended December 31, 2011. The quarterly data presented below has been prepared on a basis consistent with the audited consolidated financial statements included elsewhere in this document and, in the opinion of management, reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information. You should read this information together with our consolidated financial statements and related notes included elsewhere in this document. Our quarterly results of operations may fluctuate in the future due to a variety of factors. As a result, comparing our operating results on a period-to-period basis may not be meaningful. Our results for these quarterly periods are not necessarily indicative of the results of operations for a full year or any period.

- 40 -

 
 
 
Three Months Ended
 
(Dollar amounts in thousands, except average monthly revenue per server and annualized net revenue per average technical square foot)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
 
Growth
 
 
 
 
 
 
 
 
 
 
 
Dedicated Cloud, net revenue
 
$
183,311

 
$
192,895

 
$
204,275

 
$
213,899

 
$
224,808

 
Public Cloud, net revenue
 
$
31,415

 
$
37,107

 
$
42,954

 
$
50,673

 
$
58,453

 
Net revenue
 
$
214,726

 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

 
Revenue growth (year over year)
 
26.7
 %
 
28.6
 %
 
32.0
 %
 
32.5
 %
 
31.9
 %
 
Net upgrades (monthly average)
 
1.6
 %
 
1.8
 %
 
1.8
 %
 
1.8
 %
 
2.0
 %
 
Churn (monthly average)
 
-1.0
 %
 
-0.9
 %
 
-0.9
 %
 
-0.9
 %
 
-0.8
 %
 
Growth in installed base (monthly average) (2)
 
0.6
 %
 
0.9
 %
 
0.9
 %
 
0.9
 %
 
1.2
 %
 
Number of customers at period end (3)
 
130,291

 
142,441

 
152,578

 
161,422

 
172,510

 
Number of employees (Rackers) at period end
 
3,262

 
3,492

 
3,712

 
3,799

 
4,040

 
Number of servers deployed at period end
 
66,015

 
70,473

 
74,028

 
78,717

 
79,805

 
Average monthly revenue per server
 
$
1,101

 
$
1,123

 
$
1,141

 
$
1,155

 
$
1,191

 
Profitability
 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
23,408

 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
Depreciation and amortization
 
$
41,529

 
$
44,098

 
$
46,952

 
$
49,518

 
$
54,844

 
Share-based compensation expense
 


 


 


 


 


 
Cost of revenue
 
$
1,223

 
$
1,412

 
$
756

 
$
1,005

 
$
1,047

 
Sales and marketing (4)
 
$
1,052

 
$
1

 
$
609

 
$
864

 
$
839

 
General and administrative
 
$
4,812

 
$
6,397

 
$
4,618

 
$
5,526

 
$
5,699

 
Total share-based compensation expense
 
$
7,087

 
$
7,810

 
$
5,983

 
$
7,395

 
$
7,585

 
Adjusted EBITDA (1)
 
$
72,024

 
$
75,891

 
$
81,588

 
$
87,983

 
$
102,194

 
Adjusted EBITDA margin
 
33.5
 %
 
33.0
 %
 
33.0
 %
 
33.3
 %
 
36.1
 %
 
Operating income margin
 
10.9
 %
 
10.4
 %
 
11.6
 %
 
11.7
 %
 
14.0
 %
 
Income from operations
 
$
23,408

 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
Effective tax rate
 
37.2
 %
 
38.3
 %
 
33.8
 %
 
31.7
 %
 
34.5
 %
 
Net operating profit after tax (NOPAT) (1)
 
$
14,700

 
$
14,798

 
$
18,968

 
$
21,221

 
$
26,046

 
NOPAT margin
 
6.8
 %
 
6.4
 %
 
7.7
 %
 
8.0
 %
 
9.2
 %
 
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
 
Interest bearing debt
 
$
131,727

 
$
134,905

 
$
138,841

 
$
144,152

 
$
139,126

 
Stockholders' equity
 
$
438,863

 
$
478,307

 
$
511,843

 
$
551,049

 
$
599,423

 
Less: Excess cash
 
$
(79,174
)
 
$
(106,268
)
 
$
(102,358
)
 
$
(92,931
)
 
$
(125,865
)
 
Capital base
 
$
491,416

 
$
506,944

 
$
548,326

 
$
602,270

 
$
612,684

 
Average capital base
 
$
471,119

 
$
499,180

 
$
527,635

 
$
575,298

 
$
607,477

 
Capital turnover (annualized)
 
1.82

 
1.84

 
1.87

 
1.84

 
1.87

 
Return on capital (annualized) (1)
 
12.5
 %
 
11.9
 %
 
14.4
 %
 
14.8
 %
 
17.2
 %
 
Capital expenditures
 
 
 
 
 
 
 
 
 
 
 
Purchases of property and equipment, net
 
$
46,884

 
$
57,651

 
$
74,754

 
$
70,379

 
$
67,020

 
Vendor-financed equipment purchases
 
$
16,596

 
$
19,009

 
$
20,567

 
$
23,179

 
$
12,335

 
Total capital expenditures
 
$
63,480

 
$
76,660

 
$
95,321

 
$
93,558

 
$
79,355

 
Customer gear
 
$
38,052

 
$
46,300

 
$
48,777

 
$
53,643

 
$
47,376

 
Data center build outs
 
$
9,754

 
$
9,173

 
$
17,491

 
$
16,715

 
$
6,568

 
Office build outs
 
$
5,145

 
$
2,957

 
$
14,074

 
$
8,806

 
$
9,915

 
Capitalized software and other projects
 
$
10,529

 
$
18,230

 
$
14,979

 
$
14,394

 
$
15,496

 
Total capital expenditures
 
$
63,480

 
$
76,660

 
$
95,321

 
$
93,558

 
$
79,355

 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
 
Technical square feet of data center space at period end (5)
 
180,173

 
181,848

 
198,868

 
227,988

 
233,960

 
Annualized net revenue per average technical square foot
 
$
4,807

 
$
5,083

 
$
5,195

 
$
4,959

 
$
4,906

 
Utilization rate at period end
 
72.0
 %
 
76.7
 %
 
72.9
 %
 
69.0
 %
 
68.1
 %

- 41 -

(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.
(4) During the three months ended March 31, 2011, share-based compensation expense within Sales and Marketing was positively impacted by the reversal of previously recorded expense related to terminated employees. The offset of the reversal was a true-up of the forfeiture rate across Cost of Revenue and General and Administrative expenses for options that fully vested within the quarter, negatively impacting these categories.
(5)
Technical square footage as of December 31, 2011 excludes 28,460 square feet for unused portions of our data center facilities.

As noted above in the annual Key Metrics table, beginning in the first quarter of 2012, we will begin disclosing our total Megawatts under contract, Megawatts available for use and Megawatts utilized as of period-end. We will no longer provide technical square footage as we believe that power is a better metric for evaluating our capacity. The table below shows how the new disclosure would have appeared in the quarterly Key Metrics table.

 
 
Three Months Ended
(Dollar amounts in thousands)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
Megawatts under contract at period end
 
32.7

 
35.7

 
38.0

 
41.9

 
48.1

Megawatts available for use at period end
 
23.2

 
24.7

 
27.0

 
29.7

 
30.7

Megawatts utilized at period end
 
16.7

 
18.0

 
19.0

 
20.2

 
20.9

Annualized net revenue per average Megawatt of power utilized
 
$
53,019

 
$
53,026

 
$
53,455

 
$
53,994

 
$
55,136



- 42 -

Consolidated Statements of Income by Quarter
 
 
Three Months Ended
(In thousands)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
 
(Unaudited)
Net revenue
 
$
214,726

 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
66,747

 
69,742

 
74,057

 
82,445

 
82,851

Sales and marketing
 
26,294

 
29,738

 
31,477

 
31,838

 
33,452

General and administrative
 
56,748

 
62,441

 
66,090

 
69,701

 
72,349

Depreciation and amortization
 
41,529

 
44,098

 
46,952

 
49,518

 
54,844

Total costs and expenses
 
191,318

 
206,019

 
218,576

 
233,502

 
243,496

Income from operations
 
23,408

 
23,983

 
28,653

 
31,070

 
39,765

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(1,897
)
 
(1,491
)
 
(1,522
)
 
(1,531
)
 
(1,304
)
Interest and other income (expense)
 
57

 
(78
)
 
(614
)
 
(276
)
 
(226
)
Total other income (expense)
 
(1,840
)
 
(1,569
)
 
(2,136
)
 
(1,807
)
 
(1,530
)
Income before income taxes
 
21,568

 
22,414

 
26,517

 
29,263

 
38,235

Income taxes
 
8,029

 
8,593

 
8,956

 
9,281

 
13,188

Net income
 
$
13,539

 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047


Consolidated Statements of Income by Quarter, as a Percentage of Net Revenue
 
 
Three Months Ended
(Percent of net revenue)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
 
(Unaudited)
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
31.1
 %
 
30.3
 %
 
30.0
 %
 
31.2
 %
 
29.2
 %
Sales and marketing
 
12.2
 %
 
12.9
 %
 
12.7
 %
 
12.0
 %
 
11.8
 %
General and administrative
 
26.4
 %
 
27.1
 %
 
26.7
 %
 
26.3
 %
 
25.5
 %
Depreciation and amortization
 
19.3
 %
 
19.2
 %
 
19.0
 %
 
18.7
 %
 
19.4
 %
Total costs and expenses
 
89.1
 %
 
89.6
 %
 
88.4
 %
 
88.3
 %
 
86.0
 %
Income from operations
 
10.9
 %
 
10.4
 %
 
11.6
 %
 
11.7
 %
 
14.0
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
-0.9
 %
 
-0.6
 %
 
-0.6
 %
 
-0.6
 %
 
-0.5
 %
Interest and other income (expense)
 
0.0
 %
 
0.0
 %
 
-0.2
 %
 
-0.1
 %
 
-0.1
 %
Total other income (expense)
 
-0.9
 %
 
-0.7
 %
 
-0.9
 %
 
-0.7
 %
 
-0.5
 %
Income before income taxes
 
10.0
 %
 
9.7
 %
 
10.7
 %
 
11.1
 %
 
13.5
 %
Income taxes
 
3.7
 %
 
3.7
 %
 
3.6
 %
 
3.5
 %
 
4.7
 %
Net income
 
6.3
 %
 
6.0
 %
 
7.1
 %
 
7.6
 %
 
8.8
 %
Due to rounding, totals may not equal the sum of the line items in the table above.


- 43 -

Liquidity and Capital Resources

At December 31, 2011, we held $159.9 million in cash and cash equivalents. We use our cash and cash equivalents, cash flow from operations, capital leases, and existing amounts available under our revolving credit facility as our primary sources of liquidity.  We currently believe that cash generated by operations, current cash and cash equivalents, and available borrowings through vendor-financing arrangements and our credit facility will be sufficient to meet our operating and capital needs in the foreseeable future.

We do not have a significant amount of cash holdings in foreign countries. If these funds are repatriated, we will need to accrue and pay taxes; however, we do not currently intend to repatriate these funds because we believe cash available in the U.S. is sufficient to meet our domestic operating and capital needs.

On September 26, 2011, we entered into a revolving credit facility with a syndicate of seven banks led by JPMorgan Chase. This facility replaces our previous credit facility, which was due to expire in August 2012. The new credit facility has a total commitment in the amount of $200 million and matures in September 2016.  The facility is unsecured and governed by customary financial and non-financial covenants, including a leverage ratio of not greater than 3.00 to 1.00, an interest coverage ratio of not less than 3.00 to 1.00 and a requirement to maintain a certain level of tangible assets in our U.S. entities. As of December 31, 2011, we were in compliance with all of the covenants under our facility.

We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), and our overall cost of capital. As of December 31, 2011 there was no amount outstanding under the new facility except for an outstanding letter of credit of $0.4 million, resulting in an additional $199.6 million being available for future borrowings.
 
We have vendor finance arrangements in the form of leases and notes payable with our major vendors that permit us to finance our purchases of data center equipment.  As of December 31, 2010 and 2011, we had $131.7 million and $139.1 million outstanding with respect to these arrangements.  We believe our borrowings from these arrangements will continue to be available, and as long as they are competitive, we expect to continue to finance at least some of our equipment purchases through these arrangements.
 
Capital Expenditure Requirements

In 2012, we expect to have capital expenditures between $335 million and $405 million in the aggregate, consisting of $210 million to $250 million for customer gear, $25 million to $35 million for data center infrastructure costs, $25 million to $35 million for office build-outs, and $75 million to $85 million for capitalized software and other projects.

Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. Our money market mutual funds invest exclusively in high-quality, short-term securities that are issued or guaranteed by the U.S. government or by U.S. government agencies. We actively monitor the third-party depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation or “FDIC” insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.
 
We currently believe that current cash and cash equivalents, cash generated by operations and available borrowings through vendor financing arrangements and our credit facility will be sufficient to meet our operating and capital needs in the foreseeable future. Our long-term future capital requirements will depend on many factors, most importantly our revenue growth and our investments in new technologies and services. Our ability to generate cash depends on our financial performance, general economic conditions, technology trends and developments, and other factors. As our business continues to grow, our need for data center capacity will also grow.  Most recently we have financed data center growth through leasing activities, and we will continue to evaluate all opportunities to secure further data center capacity in the future.  We could be required, or could elect, to seek additional funding in the form of debt or equity.
 

- 44 -

The following table sets forth a summary of our cash flows for the periods indicated: 
 
 
Year Ended December 31,
(In thousands)
 
2009
 
2010
 
2011
Cash provided by operating activities
 
$
196,868

 
$
244,235

 
$
342,985

Cash used in investing activities
 
$
(124,114
)
 
$
(175,197
)
 
$
(270,588
)
Cash used in financing activities
 
$
(187,287
)
 
$
(89,402
)
 
$
(17,190
)
Acquisition of property and equipment by capital leases and equipment notes payable
 
$
68,382

 
$
71,363

 
$
75,090


Operating Activities
 
Net cash provided by operating activities is primarily a function of our profitability, the amount of non-cash charges included in our profitability, and our working capital management.  Net cash provided by operating activities was $244.2 million in 2010 compared to $343.0 million in 2011, an increase of $98.8 million, or 40.5%.  Net income increased from $46.4 million in 2010 to $76.4 million in 2011.  A summary of the significant changes in non-cash adjustments affecting net income is as follows:

•
Depreciation and amortization expense was $155.9 million in 2010 compared to $195.4 million in 2011.  The increase in depreciation and amortization was due to purchases of servers, networking gear, computer software (internally developed technology), electrical equipment, and leasehold improvements primarily for data center expansion, as well as the amortization of intangibles related to acquisitions.
•
Our provision for bad debts and customer credits increased from $4.3 million in 2010 to $5.9 million in 2011 due to the increases in net revenue and accounts receivable.
•
The change in deferred income taxes created a $6.8 million increase to cash flow from operating activities in 2010 compared to a $14.0 million increase in 2011. The change in deferred income taxes is due to the utilization of existing net operating losses as part of the intellectual property transfer to an offshore subsidiary. See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 14 – Taxes.”
•
The change in deferred rent created a $7.1 million non-cash increase to cash flow from operating activities in 2010 compared to a $9.5 million increase in 2011.  The change resulted from data center lease arrangements that were entered into in 2009, 2010 and 2011 with terms that included escalating rental payments.  As total rent expense for each of these lease arrangements is recorded on a straight-line basis for the term of the lease, there is a difference between rent expense and cash paid for rent during the period.
•
Share-based compensation expense was $26.6 million in 2010 compared to $28.8 million in 2011.  The increase in expense was due to incremental stock options and restricted stock units granted in 2010 and 2011.
A summary of changes in assets and liabilities impacting operating cash flows is as follows:
•
The change in accounts receivable was a cash outflow of $12.9 million in 2010 compared to a cash outflow of $26.8 million in 2011. Accounts receivable increased due to the increase in sales.
•
The change in income taxes receivable was a cash inflow of $2.6 million in 2010 compared to a cash inflow of $4.4 million in 2011.  We received federal income tax refunds totaling $4.5 million in 2011 compared to federal income tax refunds of $8.4 million received in 2010 related to a carryback claim for our loss.
•
The change in prepaid expenses and other current assets was a cash outflow of $10.1 million in 2010 compared to a cash outflow of $2.6 million in 2011. The change in cash outflow is the result of making increased license prepayments beginning in 2010 that continued into 2011.
•
The change in accounts payable and accrued expenses created a $16.8 million cash inflow in 2010 compared to a $57.5 million cash inflow in 2011.  The changes resulted from the timing of payments for trade payables and payroll-related expenses.
Net cash provided by operating activities was $196.9 million in 2009 compared to $244.2 million in 2010, an increase of $47.3 million or 24.0%. Net income increased from $30.2 million in 2009 to $46.4 million in 2010.


- 45 -

During 2009 and 2010, we incurred depreciation and amortization charges in the amount of $125.2 million and $155.9 million, respectively. The increase in depreciation and amortization was due to the purchases of servers, networking gear and computer software (internally developed technology), electrical equipment, and leasehold improvements primarily for data center expansion, as well as amortization of intangibles related to acquisitions. We further incurred non-cash compensation expense in the amount of $20.1 million and $26.6 million in 2009 and 2010, respectively. The increase was due to stock options and restricted stock units granted in 2009 and 2010.

The changes in certain assets and liabilities in 2010 was a cash outflow of $1.2 million compared to a cash outflow of $3.8 million in 2009. The cash outflows in each year primarily consisted of increases in accounts receivable due to the increase in sales each year.

Investing Activities

Net cash used in investing activities was primarily capital expenditures to meet the demands of our growing customer base. Historically our main investing activities have consisted of purchases of IT equipment for our data center infrastructure, furniture, equipment and leasehold improvements to support our operations.
 
Our net cash used in investing activities was $175.2 million during 2010 compared to $270.6 million during 2011, an increase of $95.4 million, or 54.5%.  The increase was primarily due to an increase in the purchase of property and equipment of $125.0 million, partially offset by a $28.9 million decrease related to acquisitions.
 
The combined total of capital expenditures for property and equipment, net, increased from $216.1 million during 2010 to $344.9 million in 2011. Of the 2011 amount, $196.1 million was used to purchase dedicated customer equipment, $49.9 million for data center build-outs, $35.8 million related to build-out of office space and $63.1 million was invested in capitalized software, including internally developed software that is focused on improving our service offerings, and other purchases.

We purchase equipment through capital lease arrangements and other types of vendor financing that do not require an initial outlay of cash.  Purchases through these arrangements increased from $71.4 million during 2010 to $75.1 million during 2011.

Our net cash used in investing activities was $124.1 million during 2009 compared to $175.2 million during 2010, an increase of $51.1 million, or 41.2%. This increase was primarily due to an increase in the purchase of property and equipment of $27.5 million and a $29.9 million increase related to acquisitions.

The combined total of capital expenditures for property and equipment, net, increased from $185.7 million during 2009 to $216.1 million in 2010. Of the 2010 amount, $136.3 million was used to purchase dedicated customer equipment, $38.5 million for data center build-outs, $9.0 million related to build-out of office space and $32.3 million was invested in capitalized software, including internally developed software that is focused on improving our service offerings, and other purchases.

We purchase equipment through capital lease arrangements and other types of vendor financing that do not require an initial outlay of cash.  Purchases through these arrangements increased from $68.4 million during 2009 to $71.4 million during 2010.

 Financing Activities
 
Net cash used in financing activities was $89.4 million during 2010 compared to $17.2 million during 2011, a decrease of $72.2 million, or 80.8%. Principal payments on capital leases and notes payable were $57.0 million in 2010 compared to $67.7 million in 2011.  Cash proceeds from employee stock plans increased from $15.3 million in 2010 to $36.3 million in 2011 due to increased stock option exercise activity. Additionally, in 2011, there were cash outflows of $1.1 million for payments of debt issuance costs related to our new revolving credit agreement and $5.3 million for payments of earn-out provisions related to our December 2010 acquisition. Our net leverage as of December 31, 2011 was 0.1 times.  See below for our discussion of non-GAAP financial measures.

Net cash used in financing activities was $187.3 million during 2009 compared to $89.4 million during 2010, a change of $97.9 million, or 52.3%. This change was due primarily to a decrease in net payments to our revolving line of credit from $150 million in 2009 to $50 million in 2010.


- 46 -

Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of December 31, 2011: 
(In thousands)
 
Total
 
2012
 
2013-2014
 
2015-2016
 
2017 and Beyond
 
 
(Unaudited)
Capital leases (1)
 
$
144,284

 
$
69,840

 
$
71,907

 
$
2,537

 
$
—

Operating leases
 
742,722

 
35,426

 
89,395

 
98,505

 
519,396

Purchase obligations
 
52,927

 
47,574

 
5,295

 
58

 
—

Software and equipment notes (1)
 
885

 
885

 
—

 
—

 
—

Total contractual obligations
 
$
940,818

 
$
153,725

 
$
166,597

 
$
101,100

 
$
519,396

(1)
Represents principal and interest.

Leases
 
Capital leases are primarily related to expenditures for IT equipment. Our operating leases are primarily for data center facilities and office space.

In February 2011, we modified our Chicago area data center lease in order to lease additional space at the data center.  The additional leased space (accounted for as an operating lease) has a term of 15 years from the commencement date with a total estimated financial obligation of approximately $88 million over the 15-year term, inclusive of base lease payments and Rackspace’s pro-rata share of operating expenses.  Rackspace has a one-time option to terminate the lease after ten years subject to a penalty, as well as upon expiration of the lease, the option to renew the lease for two successive five year periods.

In August 2011, we further modified our Chicago area data center lease in order to lease additional space at the data center. This amendment provides for three separate commencement dates, each for approximately one-third of the total additional leased space. The additional leased space (accounted for as an operating lease) has a term of 15 years from each respective commencement date with a total estimated financial obligation of approximately $125 million to $130 million over the term, inclusive of base lease payments and Rackspace’s pro-rata share of operating expenses.  Upon the expiration of any of the 15-year terms, Rackspace has the option to renew the lease for the additional space for two successive five year periods. In addition, until December 1, 2012, Rackspace has an ongoing option and right of first refusal to lease additional space at the data center.

In December 2011, we entered into a lease for a new data center in Richardson, Texas for approximately 58,200 square feet of raised floor space. The lease provides for two separate commencement dates, anticipated as August 1, 2012 and August 1, 2015, with each commencement date applicable for one-half of the total leased space. The initial term is 15 years from the respective commencement date, and upon the expiration of each of these terms, Rackspace has the option to renew the lease for the applicable space for one additional 10-year period. At any time during the lease, Rackspace has the right to terminate the lease with respect to up to half of the total leased space, subject to a penalty. Rackspace's total estimated financial obligation for the leased space over the 15-year terms is approximately $134 million.
  
Purchase obligations
 
Our purchase obligations are primarily related to costs associated with our data centers including bandwidth, electricity, and consulting services, as well as commitments to purchase hardware and to prepay for certain software licenses.  

Software and Equipment Notes
 
We finance certain software and equipment from third-party vendors. The terms of these arrangements are generally one to five years. The interest rates on the arrangements range from 0.0% to 6.0%.
 
Uncertain Tax Positions
 
We have excluded $2.3 million of uncertain tax positions from the table above as we are uncertain as to if or when such amounts will be recognized.


- 47 -

Non-GAAP Financial Measures
 
Return on Capital (ROC) (Non-GAAP financial measure)
 
We define Return on Capital as follows: ROC = Net operating profit after tax (NOPAT) / Average capital base

NOPAT = Income from operations x (1 – Effective tax rate)

Average capital base = Average of (Interest bearing debt + stockholders’ equity – excess cash) = Average of (Total assets – excess cash – accounts payables and accrued expenses – deferred revenue – other non-current liabilities, deferred income taxes, and deferred rent); calculated on a quarterly basis.
 
Year-to-date average balances are based on an average calculated using the quarter end balances at the beginning of the period and all other quarter ending balances included in the period.

We define excess cash as the amount of cash and cash equivalents that exceeds our operating cash requirements, which is calculated as three percent of our annualized net revenue for the three months prior to the period end.  We will periodically review the calculation and adjust it to reflect our projected cash requirements for the upcoming year.

We believe that ROC is an important metric for investors in evaluating our company’s performance. ROC relates 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 increased from 9.2% in 2009 to 11.6% in 2010 and increased to 14.7% in 2011.  The increase in the current year is due to income from operations increasing at a faster pace than our average capital base over that time period. Return on assets increased from 4.7% in 2009 to 6.4% in 2010 and 8.5% in 2011. The increases are due to net income increasing at a faster pace than our average asset balance.
 

- 48 -

See our reconciliation of the calculation of annual return on assets to ROC in the following table: 
 
 
Year Ended December 31,
(In thousands)
 
2009
 
2010
 
2011
Income from operations
 
$
55,241

 
$
79,602

 
$
123,471

Effective tax rate
 
35.1
%
 
35.1
%
 
34.4
%
Net operating profit after tax (NOPAT)
 
$
35,851

 
$
51,662

 
$
80,997

 
 
 
 
 
 
 
Net income
 
$
30,218

 
$
46,358

 
$
76,411

 
 
 
 
 
 
 
Total assets at period end
 
$
668,645

 
$
761,577

 
$
1,026,482

Less: Excess cash
 
(105,083
)
 
(79,174
)
 
(125,865
)
Less: Accounts payable and accrued expenses
 
(89,773
)
 
(111,645
)
 
(156,004
)
Less: Deferred revenue (current and non-current)
 
(19,444
)
 
(18,749
)
 
(18,281
)
Less: Other non-current liabilities, deferred income taxes, and deferred rent
 
(42,615
)
 
(60,593
)
 
(113,648
)
Capital base
 
$
411,730

 
$
491,416

 
$
612,684

 
 
 
 
 
 
 
Average total assets
 
$
647,493

 
$
720,521

 
$
895,545

Average capital base
 
$
390,472

 
$
445,179

 
$
552,328

 
 
 
 
 
 
 
Return on assets (Net income/Average total assets)
 
4.7
%
 
6.4
%
 
8.5
%
Return on capital (NOPAT/Average capital base)
 
9.2
%
 
11.6
%
 
14.7
%

See our reconciliation of the calculation of quarterly return on assets to ROC in the following table:
 
 
Three Months Ended
(In thousands)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
Income from operations
 
$
23,408

 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

Effective tax rate
 
37.2
%
 
38.3
%
 
33.8
%
 
31.7
%
 
34.5
%
Net operating profit after tax (NOPAT)
 
$
14,700

 
$
14,798

 
$
18,968

 
$
21,221

 
$
26,046

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
13,539

 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
761,577

 
$
831,414

 
$
887,576

 
$
970,677

 
$
1,026,482

Less: Excess cash
 
(79,174
)
 
(106,268
)
 
(102,358
)
 
(92,931
)
 
(125,865
)
Less: Accounts payable and accrued expenses
 
(111,645
)
 
(132,308
)
 
(145,609
)
 
(148,464
)
 
(156,004
)
Less: Deferred revenue (current and non-current)
 
(18,749
)
 
(19,149
)
 
(18,687
)
 
(17,772
)
 
(18,281
)
Less: Other non-current liabilities, deferred income taxes, and deferred rent
 
(60,593
)
 
(66,745
)
 
(72,596
)
 
(109,240
)
 
(113,648
)
Capital base
 
$
491,416

 
$
506,944

 
$
548,326

 
$
602,270

 
$
612,684

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
760,888

 
$
796,496

 
$
859,495

 
$
929,127

 
$
998,580

Average capital base
 
$
471,119

 
$
499,180

 
$
527,635

 
$
575,298

 
$
607,477

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
7.1
%
 
6.9
%
 
8.2
%
 
8.6
%
 
10.0
%
Return on capital (annualized)
 
12.5
%
 
11.9
%
 
14.4
%
 
14.8
%
 
17.2
%


- 49 -

Adjusted EBITDA (Non-GAAP financial measure)
 
We use Adjusted EBITDA as a supplemental measure to review and assess our performance.  We define Adjusted EBITDA as Net income, plus income taxes, total other (income) expense, depreciation and amortization, and non-cash charges for share-based compensation.
 
Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.
 
Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation, or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP.  Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.
 
Adjusted EBITDA increased $85.6 million, or 32.7%, from $262.1 million in 2010 to $347.7 million in 2011.  Adjusted EBITDA as a percentage of revenue increased from 33.6% in 2010 to 33.9% in 2011.  The primary driver of the increase in Adjusted EBITDA percentage was a decrease in Cost of Revenue expenses as a percentage of revenue, partially offset by an increase in General and Administrative expenses as a percentage of revenue.  Also impacting our results were changes in non-cash deferred rent and non-equity incentive compensation. Non-cash rent increased from $7.1 million in 2010 to $9.5 million in 2011.  Overall, non-equity incentive compensation increased $11.8 million due to an increase in the payout percentage and increased headcount.

See our annual Adjusted EBITDA reconciliation below. 
 
 
Year Ended December 31,
(Dollars in thousands)
 
2009
 
2010
 
2011
 
 
 
 
 
 
 
Net revenue
 
$
628,987

 
$
780,555

 
$
1,025,064

 
 
 
 
 
 
 
Income from operations
 
$
55,241

 
$
79,602

 
$
123,471

 
 
 
 
 
 
 
Net income
 
$
30,218

 
$
46,358

 
$
76,411

   Plus: Income taxes
 
16,328

 
25,053

 
40,018

   Plus: Total other (income) expense
 
8,695

 
8,191

 
7,042

   Plus: Depreciation and amortization
 
125,229

 
155,895

 
195,412

   Plus: Share-based compensation expense
 
20,124

 
26,624

 
28,773

Adjusted EBITDA
 
$
200,594

 
$
262,121

 
$
347,656

 
 
 
 
 
 
 
Operating income margin
 
8.8
%
 
10.2
%
 
12.0
%
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
31.9
%
 
33.6
%
 
33.9
%


- 50 -

See our quarterly Adjusted EBITDA reconciliation below.
 
 
Three Months Ended
(Dollars in thousands)
 
December 31,
2010
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
214,726

 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
23,408

 
$
23,983

 
$
28,653

 
$
31,070

 
$
39,765

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
13,539

 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

   Plus: Income taxes
 
8,029

 
8,593

 
8,956

 
9,281

 
13,188

   Plus: Total other (income) expense
 
1,840

 
1,569

 
2,136

 
1,807

 
1,530

   Plus: Depreciation and amortization
 
41,529

 
44,098

 
46,952

 
49,518

 
54,844

   Plus: Share-based compensation expense
 
7,087

 
7,810

 
5,983

 
7,395

 
7,585

Adjusted EBITDA
 
$
72,024

 
$
75,891

 
$
81,588

 
$
87,983

 
$
102,194

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
10.9
%
 
10.4
%
 
11.6
%
 
11.7
%
 
14.0
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
33.5
%
 
33.0
%
 
33.0
%
 
33.3
%
 
36.1
%

Adjusted Free Cash Flow (Non-GAAP financial measure)
 
We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditures (including vendor-financed equipment purchases), cash payments for interest, net, and cash payments for income taxes, net.
 
We believe that Adjusted Free Cash Flow is an important metric for investors in evaluating how a company is currently using cash generated and may indicate its ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, payment of dividends, etc. Note that Adjusted Free Cash Flow is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.
 
See our Adjusted Free Cash Flow reconciliation to Adjusted EBITDA below, as well as our reconciliation of Net income to Adjusted EBITDA provided above. 
 
 
Year Ended
(In thousands)
 
December 31,
2011
Adjusted EBITDA
 
$
347,656

Non-cash deferred rent
 
9,471

Total capital expenditures
 
(344,894
)
Cash payments for interest, net
 
(5,445
)
Cash payments for income taxes, net
 
(14,192
)
Adjusted free cash flow
 
$
(7,404
)
 

- 51 -

Net Leverage (Non-GAAP financial measure)
 
We define Net Leverage as Net Debt divided by Adjusted EBITDA (trailing twelve months). We believe that Net Leverage is an important metric for investors in evaluating a company’s liquidity. Note that Net Leverage is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.
 
See our Net Leverage calculation below. 
(Dollars in thousands)
 
As of
 
 
 
December 31, 2011
 
Obligations under capital leases
 
$
138,247

 
Debt
 
879

 
Total debt
 
$
139,126

 
Less: Cash and cash equivalents
 
(159,856
)
 
Net debt
 
$
(20,730
)
 
Adjusted EBITDA (trailing twelve months)
 
$
347,656

 
Net leverage
 
(0.06
)
x

Off-Balance Sheet Arrangements
 
During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. These entities are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
 
We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us, our employees, agents or representatives. To date, there have been no claims against us or our customers pertaining to such indemnification provisions, and no amounts have been recorded.
 
These indemnification obligations are considered off-balance sheet arrangements. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements.


Critical Accounting Policies and Estimates
 
Our consolidated financial statements are prepared in accordance with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, significant judgment is required in making estimates and selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. These judgments and estimates affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We consider these policies requiring significant management judgment and estimates used in the preparation of our financial statements to be critical accounting policies.
 
We review our estimates and judgments on an ongoing basis, including those related to revenue recognition, service credits, allowance for doubtful accounts, property and equipment, goodwill and intangibles, contingencies, the fair valuation of stock related to share-based compensation, software development, and income taxes.

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to determine the carrying values of assets and liabilities. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.

- 52 -

  
Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, service has been provided to the customer, the amount of fees to be paid by the customer is fixed or determinable, and collectibility is reasonably assured. Because we provide our cloud computing services to our customers and do not sell individual hardware and software products, we generally recognize cloud computing revenue, including implementation and set-up fees, on a monthly basis, beginning on the date the customer commences use of our services. For services that are billed according to customer usage, revenue is recognized in the month in which the usage is provided. Implementation fees are amortized over the estimated average customer life. If a customer terminates its relationship with us before the expiration of the estimated average customer life, any unamortized installation fees are recognized as revenue at that time. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of prepaid service fees and set-up fees. Professional services are recognized in the period services are provided.

Our customers generally have the right to cancel their contracts by providing prior written notice to us of their intent to cancel the remainder of the contract term. In the event that a customer cancels their contract, they are not entitled to a refund for services already rendered.

Valuation of Accounts Receivable and Service Credits

Estimates that further impact revenue recognition relate primarily to the allowance for doubtful accounts and customer service credits. Both estimates are relatively predictable based on historical experience.

We make judgments as to our ability to collect outstanding receivables and provide allowances when collection becomes doubtful. Judgment is required to assess the likelihood of ultimate realization of recorded accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of either their ability or willingness to make payments, an increase in the allowance for doubtful accounts would be required. Similarly, a change in the payment behavior of customers generally may require an adjustment in the calculation of the appropriate allowance. Each month, management reviews customer payment patterns, historical data and anticipated customer default rates of the various aging categories of accounts receivables in order to determine the appropriate allowance for doubtful accounts. We write off customer accounts receivable balances to the allowance for doubtful accounts when it becomes likely that we will not collect from the customer.

All of our customer agreements provide that we will achieve certain service levels. To the extent that such service levels are not achieved, we record service credits, which are a reduction to revenue, and a corresponding increase in the allowance for customer credits to provide for estimated adjustments to receivables. We base these provisions on historical experience and evaluate the estimate of service credits on a regular basis and adjust the amount reserved accordingly.

Property, Equipment and Other Long-Lived Assets

In providing services to our customers, we utilize significant amounts of property and equipment, which we depreciate on a straight-line basis over their estimated useful lives. Changes in technology or changes in the intended use of property and equipment may cause the estimated useful life or the value of these assets to change, so we periodically review the appropriateness of the estimated economic useful lives for each category of property and equipment.

Periodically we assess potential impairment of our property and equipment. Whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable, we perform an impairment review by comparing the carrying amount of the asset or asset group to the net future undiscounted cash flows that the asset is expected to generate. If necessary, we recognize an impairment charge equal to the amount by which the carrying amount exceeds the fair market value of the asset. There were no impairment charges recorded in 2009, 2010 or 2011.


- 53 -

Goodwill

Goodwill, which consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired, is evaluated for impairment on an annual basis on October 1st, or whenever events or circumstances indicate that impairment may have occurred. The goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. We evaluate our reporting units annually and, if necessary, reassign goodwill using a relative fair value allocation approach. We estimate the fair value of our reporting units using a discounted cash flow methodology, which requires significant judgments, including estimation of future cash flows, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.

We did not identify any triggering events in 2011 that would require an update to our annual impairment test. Additionally, upon conclusion of our 2011 annual test, we noted that the fair value of each of our reporting units with goodwill was substantially in excess of the carrying value of the respective reporting unit’s net assets.

Contingencies

We accrue for contingent obligations, including estimated legal costs, when the obligation is probable and the amount is reasonably estimable. As facts concerning contingencies become known, we reassess our position and make appropriate adjustments to the financial statements. Estimates that are particularly sensitive to future changes include those related to tax, legal, and other regulatory matters, changes in the interpretation and enforcement of international laws, and the impact of local economic conditions and practices, which are all subject to change as events evolve and as additional information becomes available during the administrative and litigation process.

Share-Based Compensation

Share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, share-based compensation expense and our results of operations could be impacted.

Software Development

We capitalize the salaries and payroll-related costs of employees and consultants who devote time to the development of certain internal-use software projects. If a project constitutes an enhancement to previously developed software, we assess whether the enhancement is significant and creates additional functionality to the software, thus resulting in capitalization. All other software development costs are expensed as incurred. We generally amortize capitalized software development costs over periods ranging from 12 to 36 months, which represents the estimated useful lives of the software.

Income Taxes

We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.

Historically, our effective tax rates have not differed significantly from the statutory rate, and any differences are primarily due to the tax impact of foreign operations, research and development tax credits, state taxes, contingency reserves for uncertain tax positions and certain benefits realized related to stock option activity. Our effective tax rates were 35.1%, 35.1% and 34.4% for 2009, 2010 and 2011, respectively. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

- 54 -


Recent Accounting Pronouncements
 
See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies.”

ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Power Prices. We are a large consumer of power. During 2011, we expensed approximately $22.4 million that was paid to utility companies to power our data centers, representing 2.2% of our net revenue. Because we anticipate further revenue growth for the foreseeable future, we expect to consume more power in the future. Power costs vary by geography, the source of power generation, and seasonal fluctuations and are subject to certain proposed legislation that may increase our exposure to increased power costs. Our largest exposure to energy prices based on consumption currently exists at our Grapevine, Texas data center in the Dallas-Fort Worth area, a deregulated energy market. We currently have a fixed-price power contract with the provider of electricity for our Grapevine data center that expires in September 2013. The contract allows the company to periodically convert the price to a floating market price during the arrangement. We also have a power contract for our facility in Slough U.K. that allows us to procure power either on a fixed price or on a variable price basis, which also expires in September 2013. We have fixed the price of the majority of the load through September 2012. These contracts have been designated as meeting the normal purchases and normal sales exception and thus are not accounted for as derivatives.

In 2010, the U.K.’s carbon emission trading scheme (CRC Energy Efficiency Scheme) came into operation. Based on certain criteria, we are required to register under the CRC’s second phase, which begins in April 2012. Under the scheme’s second phase, the period commencing April 2012 to March 2013 is a qualification period during which we will be required to officially measure our carbon dioxide emissions. The period from April 2013 to March 2014 is then considered the footprint year under which participant companies are required to track and report their carbon dioxide emissions to the regulatory body. Beginning June 2014, participants will be required to purchase allowances to offset their carbon dioxide emissions. The purchase of these allowances will increase the cost of power; however, the full financial impact of this scheme will not be determined until April 2013 when we will need to register in the scheme's second phase. No legislation has been enacted to date that would impact our U.S. or Hong Kong data centers.

Interest Rates. Our main credit facility is a revolving line of credit with a base rate determined by variable market rates, including the Prime Rate and the London Interbank Offered Rate (LIBOR). These market rates of interest are fluctuating and expose our interest expense to risk. As of December 31, 2011, the outstanding balance of credit facility was $0, and therefore we have limited interest rate risk.

Leases. The majority of our purchases of customer gear are vendor-financed through capital leases with fixed payment terms generally over three to five years, coinciding with the depreciation period of the equipment. As of December 31, 2011, we have a principal liability for these leases of $138.2 million on our consolidated balance sheet, of which $66.0 million is classified as current. Although we believe our borrowings from these arrangements will continue to be available, we have exposure that vendor financing may no longer be available or the borrowing rates, which are fixed rates, may increase.

Foreign Currencies. The majority of our customers are invoiced, and substantially all of our expenses are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries, respectively. A relatively insignificant amount of customers are invoiced in currencies other than the applicable functional currency. Therefore, our results of operations and cash flows are subject to fluctuations in foreign currency exchange rates. We also have exposure to foreign currency transaction gains and losses as the result of certain receivables due from our foreign subsidiaries, which are denominated in both U.S. dollars and the pound sterling. During 2011, we recognized foreign currency losses of $0.3 million within other income (expense). We have not entered into any currency hedging contracts, although we may do so in the future. As we grow our international operations, our exposure to foreign currency risk could become more significant.


- 55 -

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

RACKSPACE HOSTING, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS




- 56 -

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
Rackspace Hosting, Inc.:

We have audited the accompanying consolidated balance sheets of Rackspace Hosting, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2011, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2011. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule II. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Rackspace Hosting, Inc. and subsidiaries as of December 31, 2010 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Rackspace Hosting, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 17, 2012 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP
San Antonio, Texas
February 17, 2012

- 57 -

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
Rackspace Hosting, Inc.:

We have audited Rackspace Hosting, Inc. and subsidiaries' (the Company) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Rackspace Hosting, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Rackspace Hosting, Inc. and subsidiaries as of December 31, 2010 and 2011, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2011, and our report dated February 17, 2012 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP
San Antonio, Texas
February 17, 2012



- 58 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 
December 31,
2010
 
December 31,
2011
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
104,941

 
$
159,856

Accounts receivable, net of allowance for doubtful accounts and customer credits of $2,846 as of December 31, 2010 and $3,420 as of December 31, 2011
 
47,734

 
68,709

Income taxes receivable
 
4,397

 
—

Deferred income taxes
 
6,416

 
9,841

Prepaid expenses
 
16,738

 
22,006

Other current assets
 
5,219

 
2,953

Total current assets
 
185,445

 
263,365

 
 
 
 
 
Property and equipment, net
 
495,228

 
627,490

Goodwill
 
57,147

 
59,993

Intangible assets, net
 
9,675

 
26,034

Other non-current assets
 
14,082

 
49,600

Total assets
 
$
761,577

 
$
1,026,482

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
111,645

 
$
156,004

Current portion of deferred revenue
 
15,822

 
14,835

Current portion of obligations under capital leases
 
59,763

 
66,031

Current portion of debt
 
1,912

 
879

Total current liabilities
 
189,142

 
237,749

 
 
 
 
 
Non-current deferred revenue
 
2,927

 
3,446

Non-current obligations under capital leases
 
69,173

 
72,216

Non-current debt
 
879

 
—

Non-current deferred income taxes
 
35,238

 
68,781

Non-current deferred rent
 
14,595

 
23,343

Other non-current liabilities
 
10,760

 
21,524

Total liabilities
 
322,714

 
427,059

 
 
 
 
 
COMMITMENTS AND CONTINGENCIES
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 126,950,468 shares issued and outstanding as of December 31, 2010; 131,912,829 shares issued and outstanding as of December 31, 2011
 
127

 
132

Additional paid-in capital
 
296,571

 
383,031

Accumulated other comprehensive loss
 
(12,416
)
 
(14,732
)
Retained earnings
 
154,581

 
230,992

Total stockholders’ equity
 
438,863

 
599,423

Total liabilities and stockholders’ equity
 
$
761,577

 
$
1,026,482


See accompanying notes to the consolidated financial statements.

- 59 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF INCOME
 
 
 
Year Ended December 31,
(In thousands, except per share data)
 
2009
 
2010
 
2011
 
 
 
 
 
 
 
Net revenue
 
$
628,987

 
$
780,555

 
$
1,025,064

Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
200,943

 
249,840

 
309,095

Sales and marketing
 
79,458

 
96,207

 
126,505

General and administrative
 
168,116

 
199,011

 
270,581

Depreciation and amortization
 
125,229

 
155,895

 
195,412

Total costs and expenses
 
573,746

 
700,953

 
901,593

Income from operations
 
55,241

 
79,602

 
123,471

Other income (expense):
 
 
 
 
 
 
Interest expense
 
(8,950
)
 
(7,984
)
 
(5,848
)
Interest and other income (expense)
 
255

 
(207
)
 
(1,194
)
Total other income (expense)
 
(8,695
)
 
(8,191
)
 
(7,042
)
Income before income taxes
 
46,546

 
71,411

 
116,429

Income taxes
 
16,328

 
25,053

 
40,018

Net income
 
$
30,218

 
$
46,358

 
$
76,411

 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
Basic
 
$
0.25

 
$
0.37

 
$
0.59

Diluted
 
$
0.24

 
$
0.35

 
$
0.55

 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
Basic
 
120,570

 
125,097

 
129,922

Diluted
 
127,420

 
133,429

 
138,064

 
See accompanying notes to the consolidated financial statements.

- 60 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
 
Year Ended December 31,
(In thousands)
 
2009
 
2010
 
2011
Cash Flows From Operating Activities
 
 
 
 
 
 
Net income
 
$
30,218

 
$
46,358

 
$
76,411

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 
 
 
 
Depreciation and amortization
 
125,229

 
155,895

 
195,412

Loss on disposal of equipment, net
 
1,027

 
758

 
247

Provision for bad debts and customer credits
 
10,347

 
4,330

 
5,913

Deferred income taxes
 
9,379

 
6,788

 
13,991

Deferred rent
 
4,378

 
7,064

 
9,471

Share-based compensation expense
 
20,124

 
26,624

 
28,773

Excess tax benefits from share-based compensation arrangements
 
—

 
(2,370
)
 
(20,627
)
Changes in certain assets and liabilities
 
 
 
 
 
 
Accounts receivable
 
(17,075
)
 
(12,864
)
 
(26,805
)
Income taxes receivable
 
4,809

 
2,606

 
4,397

Prepaid expenses and other current assets
 
(2,313
)
 
(10,125
)
 
(2,597
)
Accounts payable and accrued expenses
 
15,168

 
16,765

 
57,476

Deferred revenue
 
(1,163
)
 
(488
)
 
(482
)
All other operating activities
 
(3,260
)
 
2,894

 
1,405

Net cash provided by operating activities
 
196,868

 
244,235

 
342,985

 
 
 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
 
 
Purchases of property and equipment, net
 
(117,292
)
 
(144,778
)
 
(269,804
)
Acquisitions, net of cash acquired
 
—

 
(29,854
)
 
(952
)
Earn-out payments for acquisitions
 
(6,822
)
 
(490
)
 
—

All other investing activities
 
—

 
(75
)
 
168

Net cash used in investing activities
 
(124,114
)
 
(175,197
)
 
(270,588
)
 
 
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
 
 
Principal payments of capital leases
 
(44,680
)
 
(52,129
)
 
(65,778
)
Principal payments of notes payable
 
(6,729
)
 
(4,893
)
 
(1,913
)
Payments on line of credit
 
(150,000
)
 
(50,000
)
 
—

Payments for debt issuance costs
 
(367
)
 
—

 
(1,114
)
Payments of earn-out provisions for acquisitions
 
—

 
—

 
(5,299
)
Proceeds from employee stock plans
 
14,489

 
15,250

 
36,287

Excess tax benefits from share-based compensation arrangements
 
—

 
2,370

 
20,627

Net cash used in financing activities
 
(187,287
)
 
(89,402
)
 
(17,190
)
 
 
 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
1,551

 
(120
)
 
(292
)
 
 
 
 
 
 
 
Increase (decrease) in cash and cash equivalents
 
(112,982
)
 
(20,484
)
 
54,915

 
 
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
238,407

 
125,425

 
104,941

 
 
 
 
 
 
 
Cash and cash equivalents, end of period
 
$
125,425

 
$
104,941

 
$
159,856

 
 
 
 
 
 
 
Supplemental cash flow information:
 
 
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
64,692

 
$
71,363

 
$
75,090

Acquisition of property and equipment by notes payable
 
3,690

 
—

 
—

Vendor financed equipment purchases
 
$
68,382

 
$
71,363

 
$
75,090

 
 
 
 
 
 
 
Shares issued in business combinations
 
$
8,680

 
$
510

 
$
—

Cash payments for interest, net of amount capitalized
 
$
8,213

 
$
7,743

 
$
5,577

Cash payments for income taxes
 
$
8,651

 
$
20,112

 
$
19,088

See accompanying notes to the consolidated financial statements.

- 61 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
 
Years Ended December 31, 2009, 2010, and 2011
 
Common Stock
 
Additional Paid-In Capital
 
Accumulated other comprehensive income (loss)
 
Retained Earnings
 
Total stockholders' equity
(in thousands except share data)
Shares
 
Amount
 
 
 
 
Balance at December 31, 2008
117,154,094

 
$
117

 
$
207,589

 
$
(16,027
)
 
$
78,005

 
$
269,684

Issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options and release of stock awards (including excess tax benefit of $0)
5,723,772

 
6

 
14,023

 
 
 
 
 
14,029

Issuance of common stock to board of directors
50,376

 
—

 
462

 
 
 
 
 
462

Issuance of common stock (earn-out)
818,899

 
1

 
8,679

 
 
 
 
 
8,680

Issuance of shares from Employee Stock Purchase Plan
26,836

 
—

 
460

 
 
 
 
 
460

Total issuance of common stock
6,619,883

 
7

 
23,624

 
 
 
 
 
23,631

Share-based compensation expense
 
 
 
 
20,124

 
 
 
 
 
20,124

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
 
30,218

 
30,218

Unrealized gain on derivative instrument, net of tax effect
 
 
 
 
 
 
704

 
 
 
704

Cumulative translation adjustment
 
 
 
 
 
 
5,066

 
 
 
5,066

Total comprehensive income
 
 
 
 
 
 
 
 
 
 
35,988

Balance at December 31, 2009
123,773,977

 
$
124

 
$
251,337

 
$
(10,257
)
 
$
108,223

 
$
349,427

Issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options and release of stock awards (including excess tax benefit of $2,370)
3,101,687

 
3

 
17,017

 
 
 
 
 
17,020

Stock-based activity and issuance of common stock to board of directors
21,021

 
—

 
484

 
 
 
 
 
484

Issuance of common stock (earn-out)
27,080

 
—

 
510

 
 
 
 
 
510

Issuance of shares from Employee Stock Purchase Plan
26,703

 
—

 
599

 
 
 
 
 
599

Total issuance of common stock
3,176,491

 
3

 
18,610

 
 
 
 
 
18,613

Share-based compensation expense
 
 
 
 
26,624

 
 
 
 
 
26,624

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
 
46,358

 
46,358

Unrealized gain on derivative instrument, net of tax effect
 
 
 
 
 
 
1,182

 
 
 
1,182

Cumulative translation adjustment
 
 
 
 
 
 
(3,341
)
 
 
 
(3,341
)
Total comprehensive income
 
 
 
 
 
 
 
 
 
 
44,199

Balance at December 31, 2010
126,950,468

 
$
127

 
$
296,571

 
$
(12,416
)
 
$
154,581

 
$
438,863

Issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options and release of stock awards (including excess tax benefit of $20,627)
4,913,504

 
5

 
55,858

 
 
 
 
 
55,863

Stock-based activity and issuance of common stock to board of directors
23,102

 
—

 
779

 
 
 
 
 
779

Issuance of shares from Employee Stock Purchase Plan
25,755

 
—

 
1,050

 
 
 
 
 
1,050

Total issuance of common stock
4,962,361

 
5

 
57,687

 
 
 
 
 
57,692

Share-based compensation expense
 
 
 
 
28,773

 
 
 
 
 
28,773

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
 
76,411

 
76,411

Cumulative translation adjustment
 
 
 
 
 
 
(2,316
)
 
 
 
(2,316
)
Total comprehensive income
 
 
 
 
 
 
 
 
 
 
74,095

Balance at December 31, 2011
131,912,829

 
$
132

 
$
383,031

 
$
(14,732
)
 
$
230,992

 
$
599,423

See accompanying notes to the consolidated financial statements.

- 62 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies

Nature of Operations

As used in this report, the terms “Rackspace,” “Rackspace Hosting,” “we,” “our company,” “the company,” “us,” or “our” refer to Rackspace Hosting, Inc. and its subsidiaries.  Rackspace Hosting, Inc., through its operating subsidiaries, is a provider of cloud computing services, managing web-based IT systems for small and medium-sized businesses as well as large enterprises.  We focus on providing a service experience for our customers, which we call Fanatical Support®.

Rackspace Hosting, Inc. was incorporated in Delaware on March 7, 2000. However, our operations began in 1998 as a limited partnership which became our subsidiary through a corporate reorganization completed on August 21, 2001.

We operate consolidated subsidiaries which include, among others, Rackspace US, Inc., our domestic operating entity, and Rackspace Limited, our United Kingdom operating entity.

Basis of Consolidation

The consolidated financial statements include the accounts of Rackspace Hosting and our wholly-owned subsidiaries. Intercompany transactions and balances have been eliminated in consolidation.

Certain reclassifications have been made to prior year balances in order to conform to the current year's presentation.
 
Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and customer credits, property and equipment, fair values of intangible assets and goodwill, useful lives of intangible assets, fair value of stock options, contingencies, and income taxes, among others. We base our estimates on historical experience and on other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We engaged third-party valuation consultants to assist management in the purchase price allocation of significant acquisitions.

Concentrations of Risk

Our revenue is primarily derived from cloud computing, the market for which is highly competitive and rapidly changing. Significant changes in this industry or changes in customer buying behavior could adversely impact our operating results. See the Segment Information footnote for information concerning operations located outside of the U.S.

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of cash and cash equivalents and accounts receivable. We place our cash and cash equivalents in money market accounts with high credit quality financial institutions; however, the balance may exceed Federal Deposit Insurance Corporation “FDIC” insurance limits or may not be insured. While we monitor the balances in our accounts and adjust these balances as appropriate, they could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no material loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

We perform ongoing credit evaluations, and collateral is generally not required for trade receivables. At December 31, 2010 and 2011, no customer, reseller or strategic partner comprised more than 5% of total accounts receivable.

We rely on equipment and software purchased from third parties to provide our services. This equipment and software may not continue to be available on commercially reasonable terms, and equipment may not be available in quantities sufficient to meet our business needs. Any errors or defects in third-party equipment and software could result in errors or a failure of our service, which could harm our business. Indemnification from equipment and software providers, if any, would likely be insufficient to cover any damage to our business or our customers resulting from such failures.

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Significant Accounting Policies
 
The accompanying financial statements reflect the application of certain significant accounting policies. There have been no material changes to our significant accounting policies that are disclosed in our audited consolidated financial statements and notes thereof during 2011.

Cash and Cash Equivalents

For the purposes of the consolidated financial statements, we consider all highly liquid investments with original maturities of three months or less when acquired to be cash equivalents. Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. Gains and losses are included in interest and other income in our accompanying consolidated statements of income.

Accounts Receivable, Net

We classify as trade accounts receivable amounts due within twelve months, arising from the provision of services in the normal course of business. We assess collectability based on a number of factors, including customer payment history and creditworthiness. We generally do not request collateral from our customers, although in certain cases we may require the customer to prepay for services. When evaluating the adequacy of allowances, we analyze accounts receivable, current economic conditions and trends, historical bad debt write-offs, customer creditworthiness, and changes in customer payment terms. We write off customer accounts receivable balances to the allowance for doubtful accounts when it becomes likely that we will not collect from the customer.

In addition, at the end of a given period, we estimate customer service level credits based on historical data and known credits yet to be issued to our customers. Customer credits reduce revenue and accounts receivable in the period the estimate is recorded.

Prepaid Expenses and Other Assets

Prepaid expenses and other assets consist primarily of software and equipment maintenance contracts and prepaid operating expenses. Software maintenance contracts are amortized over the agreement period, generally one to three years. Prepaid operating expenses are expensed in the period in which services are received.

Property and Equipment, Net

Property and equipment is stated at cost, net of accumulated depreciation. Property and equipment is depreciated on a straight-line basis over the estimated useful life of the asset. Replacements and major improvements are capitalized, while maintenance and repairs are charged to expense as incurred. Upon retirement or sale, the cost of assets disposed of and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is credited or charged to operations.

Goodwill and Intangible Assets

Goodwill consists of the excess of the purchase price over the fair value of identifiable net assets of businesses acquired. Goodwill is evaluated for impairment at a reporting unit level on an annual basis at the beginning of the fourth quarter or whenever events or circumstances indicate that impairment may have occurred.

Intangible assets, including purchased technology, customer contracts and relationships, certain tradenames, license agreements, and non-compete agreements arising principally from acquisitions are recorded at cost less accumulated amortization, and the definite-lived intangibles are amortized using a method that reflects the pattern in which the economic benefits of the related intangible asset are consumed or utilized.


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Leases

We lease certain property and equipment under capital lease agreements. The assets held under capital lease and related obligations are recorded at the lesser of the present value of aggregate future minimum lease payments, including estimated bargain purchase options, or the fair value of the assets held under capital lease. Such assets and the related leasehold improvements are amortized over the shorter of the terms of the leases or the estimated useful lives of the assets, which typically range from three to five years for software and equipment and 30 years for property. For assets for which the lease agreement includes a bargain purchase option or transfer of ownership at the completion of the lease and the lease term is shorter than the estimated useful life of the asset, the asset is amortized over its estimated useful life.

We also lease property and equipment under operating lease agreements. The lease terms typically range from two to five years for equipment and one to twenty years for property, including office space and data center facilities. Rent increases, rent holidays, leasehold incentives or any other unusual provisions or conditions are considered with total rent payments and are expensed on a straight-line basis over the lease period.

Impairment of Long-Lived Assets

Long-lived assets, including property and equipment and intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount should be evaluated. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset in conjunction with its asset group compared to the estimated undiscounted future cash flows expected to be generated by the asset group. If the carrying amount of the asset group exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset group exceeds the fair value of the assets.

Revenue and Deferred Revenue

We provide cloud computing services to our customers and generally do not sell individual hardware and software products. Our customers pay us a monthly recurring charge based upon the size and complexity of the IT systems we manage, the type of technology used and the level of support we provide. Some customers also pay a non-refundable installation fee. We recognize revenue when persuasive evidence of an arrangement exists, service has been provided to the customer, the amount of fees to be paid by the customer is fixed or determinable, and collectibility is reasonably assured.

We recognize cloud computing revenue, including installation fees, on a monthly basis, beginning on the date the customer commences use of our services. Cloud computing revenue is recognized over the contractual term of the customer contract. For cloud computing services that are billed according to customer usage, revenue is recognized in the month in which the usage is recorded. Our customers generally continue to utilize our services beyond the initial contract term, which typically ranges from several months to three years. As a result, installation fees are recognized ratably over the estimated average life of a customer relationship. Amounts that have been invoiced are recorded in accounts receivable and either deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Therefore, deferred revenue primarily consists of amounts that have been prepaid or deferred installation fees. As of December 31, 2011, of the total $18.3 million in deferred revenue recorded on our balance sheet (the majority of which related to prepaid amounts), $14.8 million, $2.8 million, and $0.7 million will be amortized to revenue in 2012, 2013 and 2014, respectively.

Revenue is recorded net of sales and use tax.

Our hosting arrangements contain service level commitments with our customers. To the extent that such service levels are not achieved or are otherwise disputed due to third-party power or service issues, unfavorable weather, or other service interruptions or conditions, we are required to issue service credits for a portion of the hosting service fees paid by our customers. At each reporting period, we estimate the amount of credits to be issued and record a reduction to revenue. To estimate service credits, we utilize historical data and known credits yet to be issued to our customers.

Cost of Revenue

Cost of revenue consists primarily of expenses related to our data center facilities and personnel costs. These costs typically include uncapitalized infrastructure costs, including software licenses, rental fees, replacement components, bandwidth, and power costs. Personnel expenses include the salaries, share-based compensation and related expenses of our support teams and data center employees.


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Installation Costs

Setup and other direct installation activities are performed at the inception of a specific arrangement with each customer to enable us to perform under the terms of the arrangement. These setup or installation costs are expensed as incurred.

Advertising Costs

We charge advertising costs to expense in the period incurred. Advertising expenses for the years ended December 31, 2009, 2010 and 2011 were approximately $23.5 million, $26.3 million and $37.8 million, respectively.

Research and Development Costs

Our research and development efforts are focused on the deployment of new technologies to address emerging trends, development and evolution of proprietary tools, and enhancement of systems and processes for sales and support. We expense costs related to preliminary project assessment, research and development, re-engineering, training, and application maintenance as incurred in general and administrative expenses or cost of revenue. These costs primarily include compensation costs for employees and consultants dedicated to research and development efforts. Administrative and other infrastructure expenses attributable to research and development are reported in general and administrative expense. For the years ended December 31, 2009, 2010 and 2011, we recognized $12.6 million, $18.8 million and $25.0 million of research and development expense, respectively.

Internally Developed Software

We capitalize certain costs of computer software developed or obtained for internal use. Capitalized computer software costs consist of purchased software licenses, implementation costs, and salaries and related compensation costs of employees and consultants for certain projects that qualify for capitalization. The capitalized software costs are being amortized on a straight-line basis, which is generally over periods ranging from 12 to 60 months.

Share-Based Compensation

The Black-Scholes valuation model that we use to determine the fair value of share-based compensation requires us to make assumptions and judgments about variables related to our common stock and the related awards. These variables and assumptions include the fair value of our common stock, expected term, the expected volatility, the risk-free interest rate, expected dividends, and the estimated rate of forfeitures of unvested stock options.

We used the following assumptions when determining the fair value of our stock options:

•
Fair Value of our Common Stock—For valuations prior to our IPO on August 7, 2008, the fair value of our common stock was determined using both a market and discounted cash flow approach. The aggregate equity valuation was allocated between our various securities using the treasury stock method. Subsequent to the IPO, the end of day market price on the grant date was used to determine fair value.

•
Expected Term—The expected term represents the period that our share-based awards are expected to be outstanding. In order to compute the expected term, we have elected to use the simplified method because we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time our equity shares have been publicly traded. We have been a public company since August 2008 and our options generally vest over four years and expire seven to ten years from the grant date.

•
Expected Volatility—Management estimates volatility for option grants by evaluating the average historical volatility of a peer group, as well as the volatility of the company’s stock since the IPO. Management believes historical volatility of the identified peer group (while incorporating the company’s historical volatility) to be the best estimate of future volatility.

•
Risk-Free Interest Rate—The risk-free interest rate used in the Black-Scholes valuation model is based on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent expected term.

•
Expected Dividend—We have not issued dividends to date and do not anticipate issuing dividends.

- 66 -


•
Estimated Rate of Forfeitures—We estimate expected forfeitures based on our historical experience. If actual forfeitures differ from our estimates, we will record the difference as an adjustment in the period we revise our estimates.

We also grant restricted stock units (RSUs), a portion of which have vesting conditions dependent upon the performance of the company’s total shareholder return (TSR) on its common stock compared to certain market indices. Additionally, the company’s TSR must be positive for vesting to occur. We use a Monte Carlo simulation to estimate the fair value of these awards. For all other RSUs granted that vest ratably over the requisite service period, we measure fair value based on the closing fair market value of the company’s common stock on the date of grant, and we recognize expense straight-line over the vesting period.

Income Taxes

Income taxes are accounted for using the asset and liability method. Deferred income taxes are provided for temporary differences in recognizing certain income, expense, and credit items for financial reporting purposes and tax reporting purposes. Such deferred income taxes primarily relate to the difference between the tax bases of assets and liabilities and their financial reporting amounts. Deferred tax assets and liabilities are measured by applying enacted statutory tax rates applicable to the future years in which deferred tax assets or liabilities are expected to be settled or realized. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon projections of future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these deductible differences.

We are not currently under income tax audit in any jurisdiction in which we operate. However, due to the complexity involved with certain tax matters, there is the possibility that the various taxing authorities may disagree with certain tax positions filed on our income tax returns. We have considered all relevant facts and circumstances believe that we have made adequate provision for all income tax uncertainties. For a further discussion of the impact of uncertain tax positions, see Note 14, "Taxes."

We do not provide for a U.S. income tax liability on undistributed earnings of our foreign subsidiaries. The earnings of non-U.S. subsidiaries, which reflect full provision for non-U.S. income taxes, are currently indefinitely reinvested in non-U.S. operations or will be remitted substantially free of additional tax.
 
Derivative Financial Instruments

In order to limit our exposure to interest rate risk, we entered into an interest rate swap contract in 2007 that expired in 2010. We recognize derivative instruments as either assets or liabilities on the balance sheet at fair value. The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge is initially reported as a component of “other comprehensive income” and is then recorded in income in the period or periods during which the hedged forecasted transaction affects income. The ineffective portion of the gain or loss on the cash flow derivative instrument, if any, is recognized in income as incurred.

Fair Value of Financial Instruments

The fair values of certain financial instruments, including cash and cash equivalents, accounts receivables, accounts payable, and accrued expenses approximate fair value because of the short-term nature of these items. The fair value of our debt approximates the carrying value as of December 31, 2010 and 2011.


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Foreign Currency

We have assessed the functional currency of each of our international subsidiaries and have generally designated the local currency to be their respective functional currencies. The financial statements of these foreign subsidiaries are translated into the U.S. dollar. All assets and liabilities are translated to the U.S. dollar at the end-of-period exchange rates. Capital accounts are determined to be of a permanent nature and are therefore translated using historical exchange rates. Revenue and expenses are translated using average exchange rates. Foreign currency translation adjustments arising from differences in exchange rates from period to period are included in the foreign currency translation adjustment account in accumulated comprehensive income (loss) of stockholders’ equity. Transaction gains or losses in currencies other than the functional currency are included as a component of other income (expense) in the consolidated statements of income.

Recently Adopted Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (FASB) issued guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements.  The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). We had previously adopted the guidance in 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which became effective for us at the beginning of this year. This new guidance did not have a material impact on our consolidated financial statements.

In October 2009, the FASB issued guidance on revenue recognition that eliminates the requirement that all undelivered elements in a multiple-element revenue arrangement have vendor-specific objective evidence (VSOE) or third-party evidence (TPE) before an entity can recognize the portion of an overall arrangement fee that is attributable to items that already have been delivered.  In the absence of VSOE or TPE of the standalone selling price for one or more delivered or undelivered elements in a multiple-element arrangement, entities are required to estimate the selling prices of those elements.  The overall arrangement fee should be allocated to each element (both delivered and undelivered items) based on their relative selling prices, regardless of whether those selling prices are evidenced by VSOE or TPE or are based on the entity’s estimated selling price.  Application of the “residual method” of allocating an overall arrangement fee between delivered and undelivered elements is no longer be permitted.  The guidance became effective for us at the beginning of this year. The adoption of this new guidance did not have a material impact on our consolidated financial statements.

Recent Accounting Pronouncements Not Yet Adopted

In May 2011, the FASB issued guidance to amend the requirements related to fair value measurement that changes the wording used to describe many requirements in GAAP for measuring fair value and for disclosing information about fair value measurements. Additionally, the amendments clarify the FASB's intent about the application of existing fair value measurement requirements. The amended guidance is effective for interim and annual periods beginning after December 15, 2011, and is to be applied prospectively. The company will adopt this guidance at the beginning of its first quarter of 2012. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In June 2011, the FASB issued guidance that eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity.  Instead, an entity will be required to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements.  The guidance is effective for fiscal years, including interim periods, beginning after December 15, 2011.  We will adopt this standard in the first quarter of 2012.

In September 2011, the FASB issued guidance that is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a “qualitative” assessment to determine whether further impairment testing is necessary. Specifically, an entity has the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test.  If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. This standard is effective for annual and interim goodwill impairment tests performed for annual periods beginning after December 15, 2011, with early adoption permitted.  We will adopt this standard in the first quarter of 2012, and we do not expect adoption to have a material impact on our financial statements.

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2. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share:
 
 
Year Ended December 31,
(In thousands except per share data)
 
2009
 
2010
 
2011
Basic net income per share:
 
 
 
 
 
 
Net income
 
$
30,218

 
$
46,358

 
$
76,411

Weighted average shares outstanding:
 
 
 
 
 
 
Common stock
 
120,570

 
125,097

 
129,922

Number of shares used in per share computations
 
120,570

 
125,097

 
129,922

Earnings per share
 
$
0.25

 
$
0.37

 
$
0.59

 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
Net income
 
$
30,218

 
$
46,358

 
$
76,411

Weighted average shares outstanding:
 
 
 
 
 
 
Common stock
 
120,570

 
125,097

 
129,922

Stock options, awards and employee share purchase plan
 
6,850

 
8,332

 
8,142

Number of shares used in per share computations
 
127,420

 
133,429

 
138,064

Earnings per share
 
$
0.24

 
$
0.35

 
$
0.55


We excluded 3.8 million, 3.0 million and 1.2 million potential common shares from the computation of dilutive earnings per share for the periods ended December 31, 2009, 2010 and 2011, respectively, because the effect would have been anti-dilutive.

3. Cash and Cash Equivalents

Cash and cash equivalents consisted of:
(In thousands)
 
December 31,
2010
 
December 31,
2011
Cash deposits
 
$
64,201

 
$
119,115

Money market funds
 
40,740

 
40,741

Cash and cash equivalents
 
$
104,941

 
$
159,856


Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. We actively monitor the third-party depository institutions that hold our deposits. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds.

Our money market mutual funds invest exclusively in high-quality, short-term securities that are issued or guaranteed by the U.S. government or by U.S. government agencies.


- 69 -

4.  Fair Value Measurements
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:
 
Level 1 – Observable inputs such as quoted prices in active markets for identical assets or liabilities;
 
Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
 
Level 3 – Unobservable inputs that are supported by little or no market activity, which require management judgment or estimation.

We measure our financial instruments at fair value. Our money market funds are classified within Level 1 because these funds are valued using quoted market prices.

The carrying values of cash deposits and accounts receivable are reasonable estimates of their fair values due to the short maturity of these financial instruments.
 
Assets and liabilities measured at fair value on a recurring basis are summarized by level below.  The table does not include assets and liabilities that are measured at historical costs or any other basis other than fair value.
 
 
 
December 31, 2010
(In thousands)
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Assets/Liabilities at Fair Value
Assets:
 
 
 
 
 
 
 
 
Money market funds (1)
 
$
40,740

 
$
—

 
$
—

 
$
40,740

Rabbi trust (2)
 
795

 
—

 
—

 
795

     Total
 
$
41,535

 
$
—

 
$
—

 
$
41,535

 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 

Deferred compensation (3)
 
$
754

 
$
—

 
$
—

 
$
754

     Total
 
$
754

 
$
—

 
$
—

 
$
754

 
 
 
December 31, 2011
(In thousands)
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total Assets/Liabilities at Fair Value
Assets:
 
 
 
 
 
 
 
 
Money market funds (1)
 
$
40,741

 
$
—

 
$
—

 
$
40,741

Rabbi trust (2)
 
293

 
—

 
—

 
293

     Total
 
$
41,034

 
$
—

 
$
—

 
$
41,034

 
 
 
 
 
 
 
 
 

Liabilities:
 
 
 
 
 
 
 
 
Deferred compensation (3)
 
$
187

 
$
—

 
$
—

 
$
187

     Total
 
$
187

 
$
—

 
$
—

 
$
187


(1)
Money market funds are classified in cash and cash equivalents.
(2)
Investments in marketable securities held in a Rabbi Trust associated with a non-qualified deferred compensation plan are classified in other non-current assets.
(3)
Obligations to pay benefits under a non-qualified deferred compensation plan are classified in other non-current liabilities.

- 70 -


Our Rabbi Trust was established in 2009, and we elected the fair value option, which allows for the recognition of gains and losses to be recorded in the statement of income in the same period as the gains and losses are incurred as part of the non-qualified deferred compensation plan. During 2009, 2010, and 2011, we recognized minimal net gains as interest and other income.

5. Property and Equipment, net
 
Property and equipment consisted of: 
(In thousands)
 
Estimated Useful Lives
 
December 31,
2010
 
December 31,
2011
Computers, software and equipment
 
1
-
5
years
 
$
668,691

 
$
898,045

Furniture and fixtures
 
7
years
 
25,140

 
34,000

Buildings and leasehold improvements
 
2
-
30
years
 
141,506

 
201,639

Land
 
 
 
 
 
 
13,860

 
13,860

Property and equipment, at cost
 
 
 
 
 
 
849,197

 
1,147,544

Less accumulated depreciation and amortization
 
 
 
 
 
 
(422,716
)
 
(582,794
)
Work in process
 
 
 
 
 
 
68,747

 
62,740

Property and equipment, net
 
 
 
 
 
 
$
495,228

 
$
627,490

 
Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $118.8 million, $149.9 million and $189.8 million for the years ended December 31, 2009, 2010 and 2011, respectively.

At December 31, 2010, the work in process balance consisted of build-outs of $35.7 million for office facilities, $21.3 million for data centers (of which $13.3 million related to a vendor fee for data center design services), and $11.7 million for capitalized software and other projects.  At December 31, 2011, the work in process balance consisted of build-outs of $28.0 million for office facilities, $3.6 million for data centers, and $31.2 million for capitalized software and other projects.
 
Capitalized interest was $0.8 million and $0.6 million for the years ended December 31, 2009 and 2010, respectively. There has been no interest capitalized in 2011. 

The unamortized balance of computer software costs on our balance sheets was $31.7 million and $39.9 million as of December 31, 2010 and 2011, respectively. Amortization expense for capitalized computer software costs was $12.7 million, $17.9 million and $26.2 million for the years ended December 31, 2009, 2010 and 2011, respectively.


- 71 -

6. Business Combinations and Goodwill

In January 2011, we acquired a company to bolster our service delivery capabilities around OpenStack. The acquisition, which was accounted for using the acquisition method, included an initial cash payment, additional cash payments due on the first and second anniversaries of the closing date and cash or stock to be paid upon the achievement of certain earn-out provisions. The composition of the payment of the earn-out provisions between cash and stock is at our discretion. The purchase price was allocated based on the estimated fair values of the individual assets acquired and liabilities assumed at the date of acquisition, and after the completion of our final tax review during the three months ended September 30, 2011, we determined the allocation of the purchase price was final. The fair value of the contingent consideration of $2.1 million was recorded as a liability as of the date of acquisition. The first two earn-out provisions were met in 2011, resulting in a cash payment of $1.0 million. The fair value of the remaining contingent consideration as of December 31, 2011 was $1.2 million, all of which is classified as short-term within accounts payable and accrued expenses. The consolidated statements of income include the results of operations for the acquired company commencing on January 26, 2011.

In December 2010, we acquired a company and accounted for the transaction using the acquisition method. During the three months ended March 31, 2011, we recorded a measurement period adjustment to reflect changes in the estimated fair value of deferred tax assets related to the acquisition. This adjustment resulted from our final review of certain tax matters relating to the transaction and did not result from intervening events subsequent to the acquisition date. Upon the final completion of an independent appraisal and all other evaluations during the three months ended March 31, 2011, we determined the allocation of the purchase price was final. Beginning in the second quarter of 2011, the associated earn-out payments were no longer contingent upon achievement of certain provisions, and the full amount was scheduled to be paid in six equal installments, with the composition of the payout between cash and stock at our discretion. We made the the first three payments in cash totaling $5.0 million, in 2011. As of December 31, 2011, the amount of the liability recorded was $4.9 million.

In April 2010, the final $1.0 million earn-out in connection with an acquisition made in 2008 was paid in a combination of cash and stock. The earn-out was accounted for as additional goodwill.
 
The following table provides a roll forward of our goodwill balance.
(In thousands)
 
December 31, 2009
$
22,329

Earn-out payment for acquisition
1,000

Acquisition
33,818

December 31, 2010
$
57,147

Measurement period adjustments
149

Acquisition
2,697

December 31, 2011
$
59,993


The $2.7 million of goodwill recorded for the acquisition in January 2011 is deductible for tax purposes.

We test goodwill at the reporting unit level using a fair value approach. Our annual testing did not result in an impairment of goodwill for the year ended December 31, 2011 as the fair value of each reporting unit with goodwill was determined to be in excess of its carrying value. If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. There were no such changes during the year ended December 31, 2011, and as of December 31, 2011, there were no indicators that our goodwill was impaired.


- 72 -

7. Intangible Assets

The following tables provide information regarding our intangible assets, other than goodwill:

 
December 31, 2010
(In thousands)
Gross carrying amount
 
Accumulated amortization
 
Net carrying amount
Intangible assets:
 
 
 
 
 
Licenses
$
11,571

 
$
(10,356
)
 
$
1,215

Purchased technologies
7,145

 
(2,970
)
 
4,175

Domain name purchases
459

 
(440
)
 
19

Non-compete agreements
1,534

 
(382
)
 
1,152

Customer relationships
5,240

 
(2,389
)
 
2,851

Trademarks, tradenames and patents
887

 
(657
)
 
230

Other
631

 
(598
)
 
33

Total
$
27,467

 
$
(17,792
)
 
$
9,675


 
December 31, 2011
(In thousands)
Gross carrying amount
 
Accumulated amortization
 
Net carrying amount
Intangible assets:
 
 
 
 
 
Licenses
$
12,582

 
$
(11,676
)
 
$
906

Purchased technologies
7,145

 
(4,277
)
 
2,868

Domain name purchases
468

 
(453
)
 
15

Non-compete agreements
1,734

 
(786
)
 
948

Customer relationships
6,540

 
(3,561
)
 
2,979

Trademarks, tradenames and patents
2,789

 
(1,176
)
 
1,613

Other
18,108

 
(1,403
)
 
16,705

Total
$
49,366

 
$
(23,332
)
 
$
26,034


The increase in Other is primarily due to a transfer from work in process and represents a vendor fee for data center design services. The useful life of this asset is five years.

Amortization expense on intangibles was $6.5 million, $6.0 million and $5.6 million in 2009, 2010 and 2011, respectively. Intangible assets are recorded at cost and are amortized on a straight-line basis over their estimated useful lives, which range from one to six years. The only intangible assets amortized over six years are related to business acquisitions. As of December 31, 2011, amortization expense on intangible assets for the next five years was expected to be as follows:

(In thousands)
 
Year ending:
Amount
2012
$
6,744

2013
6,124

2014
4,995

2015
4,305

2016
3,331

Thereafter
535

Total
$
26,034


As of December 31, 2011, there were no indicators that our intangible assets were impaired.

- 73 -

8. Accounts Payable and Accrued Expenses
 
Accounts payable and accrued expenses consisted of: 
(In thousands)
 
December 31,
2010
 
December 31,
2011
Trade payables
 
$
30,603

 
$
51,097

Accrued compensation and benefits
 
26,855

 
41,767

Income and other taxes payable
 
19,814

 
16,778

Vendor accruals
 
22,503

 
32,458

Other liabilities
 
11,870

 
13,904

Accounts payable and accrued expenses
 
$
111,645

 
$
156,004

 

- 74 -

9. Debt
 
Debt outstanding consisted of:
(In thousands)
 
December 31,
2010
 
December 31,
2011
Notes payable
 
$
2,791

 
$
879

Total debt
 
2,791

 
879

Less current portion of debt
 
(1,912
)
 
(879
)
Total non-current debt
 
$
879

 
$
—

 
Revolving Credit Facility
 
On September 26, 2011, we entered into a revolving credit facility with a syndicate of seven banks led by JPMorgan Chase. This facility replaces our previous credit facility, which was due to expire in August 2012.  The new credit facility has a total commitment of $200 million and matures in September 2016.  The facility is governed by financial and non-financial covenants, including a leverage ratio of not greater than 3.00 to 1.00, an interest coverage ratio of not less than 3.00 to 1.00, and a requirement to maintain a certain level of tangible assets in our U.S. entities. Our marginal borrowing costs on this facility are based on a floating base rate (LIBOR) plus a spread, which ranges from 1.25% to 2.00%, depending on our degree of financial leverage. We also pay an unused fee on the committed, but unused amount of the facility, which ranges from 0.25% to 0.40%, also depending on our degree of financial leverage. The agreement further includes an accordion feature, which allows for an increase in the commitments to a total of $400 million under the same terms and conditions, subject to credit approval of the banking syndicate.

In entering into the new facility, we incurred loan origination fees of $1.1 million, which were included in other assets and will be amortized as a component of interest expense over the five-year term of the agreement.

In December 2010, we repaid the entire outstanding balance of our previous credit facility and have not had any borrowings under either the old or new facility since that time. Therefore, as of December 31, 2011, there was no amount outstanding under the facility except for an outstanding letter of credit of $0.4 million, resulting in $199.6 million being available for future borrowings. As of the same date, we were in compliance with all of the covenants under our facility.

Interest Rate Swap

Historically, we have used cash flow hedges to limit our exposure that may result from the variability of floating interest rates. Our previous interest rate swap, which had a notional amount of $50.0 million to hedge a portion of our outstanding floating-rate debt, expired in December 2010. Prior to its expiration, this swap converted floating-rate interest based on LIBOR into fixed-rate interest as part of the arrangement with our primary lender.

We were required to pay the counterparty a stream of fixed interest payments at a rate of 4.135%, and in turn, received variable interest payments based on 1-month LIBOR. The net receipts or payments from the swap were recorded as interest expense, and the swap was designated and qualified as a cash flow hedge. The swap was deemed to be highly effective, and there was no hedge ineffectiveness recognized in earnings during the years ended December 31, 2009 and 2010.

The following table presents the impact of the interest rate swap on the consolidated balance sheets:
 
Year Ended December 31,
(In thousands)
2009
 
2010
 
2011
Effective gain recognized in accumulated other comprehensive income, net of tax
$
704

 
$
1,182

 
$
—


Notes Payable

We have entered into various financing arrangements with multiple equipment and software vendors. As of December 31, 2011 the total amount financed under these relationships was $0.9 million with various terms extending to June 2012 and stated rates ranging from 0.0% to 6.0%. For arrangements with below market interest rates, we impute an interest charge based on our average borrowing rate. The weighted average effective interest rate of the various arrangements with third-party vendors was 3.91% and 4.03% as of December 31, 2010 and 2011, respectively.


- 75 -

10. Leases

Capital Leases

We have master lease agreements with our primary vendors that supply us with servers and computer equipment. Currently, we finance most equipment purchases through their respective finance companies. The terms vary with each vendor but typically include a term of two to four years and interest rates ranging from 1.7% to 6.0%. A majority of these agreements allow us to purchase the equipment at the end of the lease for a nominal amount.

Amounts in property and equipment under capital leases consisted of:
(In thousands)
December 31, 2010
 
December 31, 2011
Computers, software and equipment
$
253,687

 
$
330,256

Less: accumulated depreciation and amortization
(132,795
)
 
(201,109
)
 
$
120,892

 
$
129,147


Future capital lease payments under non-cancelable leases as of December 31, 2011 were as follows:

(In thousands)
 
Year ending:
Amount
2012
$
69,840

2013
48,638

2014
23,269

2015
2,537

Total minimum capital lease payments
144,284

Less amount representing interest
(6,037
)
Present value of net minimum lease payments
138,247

Less current portion of obligations under capital leases
(66,031
)
Non-current obligations under capital leases
$
72,216


Lease obligations for our foreign subsidiaries are denominated in foreign currencies, which have been converted to U.S. dollars at the exchange rate on December 31, 2011.

Operating Leases

We lease our data center facilities, certain office space and equipment under non-cancelable operating lease agreements. Facility leases generally include renewal options and may require us to pay a portion of the related operating expenses. Certain of these lease agreements have escalating rental payment provisions. We recognize rent expense for such arrangements on a straight-line basis.


Future operating lease payments under non-cancelable leases with an initial term in excess of one year as of December 31, 2011 were as follows:

(In thousands)
 
Year ending:
Amount
2012
$
35,426

2013
42,549

2014
46,846

2015
48,262

2016
50,243

Thereafter
519,396

Total minimum operating lease payments
$
742,722


- 76 -


Rent expense for the years ended December 31, 2009, 2010 and 2011 was $22.1 million, $26.6 million and $34.1 million, respectively.

11. Commitments and Contingencies
 
Purchase Commitments

Non-cancelable purchase commitments primarily relate to costs associated with our data centers, including bandwidth, electricity and consulting services, as well as commitments to purchase hardware and to prepay for certain software licenses. The agreements vary from one to three years and provide for either penalties for early termination or may require minimum commitments for the remaining term. The minimum commitments for all of these agreements as of December 31, 2011 approximated $47.6 million, $4.4 million, $0.9 million and $0.1 million for the years ended December 31, 2012, 2013, 2014 and 2015, respectively.

We also have purchase orders and construction contracts primarily related to data center equipment and facility build-outs. We generally have the right to cancel these open purchase orders prior to delivery or terminate the contracts without cause.

Legal Proceedings
 
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, on October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston was filed in the 37th District Court in Bexar County Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We do not expect the results of this claim or any other current proceeding to have a material adverse effect on our business, results of operations or financial condition.

We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business, and we defend ourselves vigorously against any such claims. Although the outcome of these matters is currently not determinable, management expects that any losses that are incurred as a result of these matters, which are in excess of amounts already accrued in its consolidated balance sheet, would not be material to the financial statements as a whole.

Contingent Liability

As of December 31, 2011, the fair value of the contingent consideration related to our January 2011 acquisition was $1.2 million. The earn-out can be paid in cash or our common stock at our discretion.


- 77 -

Guarantees

We have identified certain guarantees. When evaluating estimated losses for guarantees, we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such guarantees in our financial statements.

As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of the insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. We have no significant liabilities recorded for these agreements as of December 31, 2010 or 2011.

We have service level commitment obligations with most of our customers. As a result, service interruptions or significant equipment damage in our data centers, whether or not within our control, could result in us not achieving service level commitments to these customers, resulting in an obligation to pay a service level credit. Our liability insurance does not cover ordinary service interruptions. In addition, any loss of services, equipment damage or inability to meet our service level commitment obligations could reduce the confidence of our customers and could consequently impair our ability to obtain and retain customers, which would adversely affect both our ability to generate revenue and our operating results. We generally have the ability to determine such service level credits prior to the associated revenue being recognized and record an estimate for potential unrecorded amounts. The balance for credits resulting from our service level agreements within allowances for doubtful accounts and customer credits as of December 31, 2010 and 2011 was $0.5 million and $0.6 million, respectively.

Indemnifications

In the normal course of business, we indemnify certain parties, including customers, vendors and lessors, with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants or out of intellectual property infringement or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. We have no significant liabilities recorded for these agreements as of December 31, 2010 or 2011.


- 78 -

Incentive Arrangements

In August 2007, we entered into a lease for our corporate headquarters. In connection with this lease, we also entered into a Master Economic Incentives Agreement ("MEIA") with the Cities of Windcrest and San Antonio, Texas; Bexar County; and certain other parties, pursuant to which we agreed to locate existing and future employees at the new facility location. The agreement requires that we meet certain employment levels each year, with an ultimate employee base requirement of 4,500 jobs in Windcrest by December 31, 2012; however, if the job requirement in any grant agreement with the State of Texas is lower, then the job requirement under the MEIA is automatically adjusted downward. Consequently, because the Texas Enterprise Fund Grant agreement discussed below has been amended to reduce the state job requirement, we believe the job requirement under the MEIA has been reduced to 1,774. In addition, the agreement requires that the median payroll of those employees be no less than $51 thousand per year. In exchange for meeting these employment obligations, we will receive a 14-year exemption from most of the property taxes associated with the property. If we fail to meet these job creation requirements, we could lose a portion or all of the tax exemption provided during the 14-year period and would then be obligated to repay the exemption amount. We have met the requirements for the employment level and median payroll for the year ended December 31, 2011, and we believe that it is probable that we will meet the requirements throughout the exemption period. We elected to begin the exemption period in 2009.

Further, we entered into an agreement with the State of Texas, under which we received $5.0 million in 2007 and may receive up to an additional $17.0 million from the Texas Enterprise Fund in multiple installments, provided that we meet certain new job levels in the State of Texas paying an average of at least $56 thousand per year (subject to a 2.0% per year increase commencing in 2012), beginning December 31, 2008, and sustain these jobs through December 31, 2021. On July 27, 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements. Under the amendment, the grant has been divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a Job Target of 1,225 new jobs by December 2012 (in addition to the 1,436 jobs in place as of August 1, 2007 for a total of 2,661 jobs in Texas, two thirds of which must be located in Windcrest, Texas). We already have drawn $5.0 million of this grant and, since we have achieved the Job Target as of December 31, 2011, we intend to request the additional $3.5 million that is available to us. The remaining three tranches are at our option. We can draw an additional $13.5 million based on the following amounts and milestones: $5.5 million if we create a total of 2,100 new jobs in Texas, another $5.25 million if we create a total of 3,000 new jobs in Texas, and $2.75 million more if we create a total of 4,000 new jobs in Texas. We are responsible for maintaining the jobs until January 2022. If we eliminate jobs for which we have drawn funds, we are subject to a clawback on the amounts we have drawn plus 3.4% interest on such amounts per year. As of December 31, 2011, the $5.0 million received was deferred and recorded as other non-current liabilities. Amounts will be recognized into income upon the achievement of the performance criteria and the determination that the cash is no longer refundable to the State of Texas.


- 79 -

12. Stockholders' Equity

Common Stock

At December 31, 2010 and 2011, we had 126,950,468 and 131,912,829 shares of our common stock legally issued and outstanding, respectively.

We have one class of authorized common stock. The rights and privileges provided to our common stockholders are as follows:

•Dividend Rights—Subject to preferences that may apply to shares of preferred stock outstanding at the time, the holders of our common stock are entitled to receive dividends, at the discretion of our board of directors.

•Voting Rights—All holders of common stock are entitled to one vote per share on all matters to be voted on by Rackspace Hosting's stockholders.

•Right to Receive Liquidation Distributions—Upon liquidation, dissolution or winding-up, the holders of our common stock are entitled to share equally in all of our assets remaining after payment of all liabilities and the liquidation preferences of any outstanding preferred stock.

Common Stock Issuances

In 2009, per the terms of the merger agreements with Jungle Disk and Slicehost and product integration milestones, we issued 140,935 shares of our common stock at a price of $5.428 per share as the first earn-out for Jungle Disk in March 2009, resulting in an aggregate recorded amount of $765 thousand. In April 2009, we issued 200,000 shares of our common stock at a price of $5.574 per share as the first earn-out for Slicehost, resulting in an aggregate recorded amount of $1.1 million. In August 2009, we issued 477,964 shares of our common stock at a price of $14.227 per share as the second earn-out for Slicehost, resulting in an aggregate recorded amount of $6.8 million. In April 2010, we issued 27,080 shares of our common stock at a price of $18.833 per share as the second earn-out for Jungle Disk, resulting in an aggregate recorded amount of $510 thousand.

In each of the years 2009, 2010 and 2011, we had two employee stock purchases under the 2008 Employee Stock Purchase Plan (ESPP), under which we issued a total of 26,836, 26,703 and 25,755 shares of common stock, respectively. No expense associated with these shares issued was recorded, and the shares were fully vested and unrestricted as of year-end.

In 2009, 2010 and 2011, we issued 5,723,772, 3,101,687 and 4,913,504 shares, respectively, related to employee stock options and restricted stock units. See Note 13 for additional disclosures related to the share-based compensation.

In 2009, 2010 and 2011, each of our non-employee board of directors was compensated with shares of common stock. We granted a total of 50,376, 21,021 and 23,102 shares of common stock as a portion of director’s fees to non-employee members of our board of directors in 2009, 2010 and 2011, respectively. The shares are fully vested and unrestricted as of December 31, 2011. Additionally, in 2010, we issued restricted stock units (RSUs) to certain members of our board of directors. We recorded total expense of $462 thousand, $484 thousand, and $779 thousand related to these shares and RSUs in 2009, 2010 and 2011, respectively. These amounts have been recorded as a component of general and administrative expense.

Preferred Stock

As of December 31, 2010 and 2011, there were 50 million authorized shares of preferred stock, of which none was issued or outstanding.


- 80 -

13. Share-Based Compensation
 
In December 2007, we adopted our 2007 Long Term Incentive Plan, or the 2007 Stock Plan. Under the 2007 Stock Plan, incentive and non-qualified stock options or rights to purchase common stock may be granted to eligible participants. In addition to stock options, we may grant other equity awards such as stock appreciation rights, restricted stock awards, restricted stock units, performance awards, cash-based awards, and dividend equivalents. All awards, excluding incentive stock options, may be granted under the plan to employees, officers, directors, or any other non-employee service provider to the company. Incentive stock options may be granted only to employees of the company or a subsidiary. The exercise price of a stock option granted under the 2007 Stock Plan will be determined by the Compensation Committee at the time the option is granted and generally may not be less than 100% of the fair market value of a share of common stock as of the date of grant. The 2007 Stock Plan has an automatic share reserve increase effective the first day of each fiscal year beginning in 2009 with an amount equal to the lesser of (i) 10,000,000 shares, (ii) four percent of the number of shares on the last day of the immediately preceding fiscal year that are (a) outstanding and (b) issuable pursuant to outstanding awards and awards under prior plans, or (iii) such lesser number of shares determined by our board of directors. For fiscal years 2009, 2010 and 2011, this resulted in an increase of approximately 5.5 million, 5.7 million and 5.8 million shares, respectively, available under our Stock Plans.

In addition to the 2007 Stock Plan, we also maintain the 2003 Stock Plan, the 2005 Stock Plan and plans assumed through acquisitions, collectively referred to as the Stock Plans. Options are priced to be at least 100% of our common stock’s fair market value at the date of grant. Options have generally been granted for terms of either seven or ten years. Options granted under the Stock Plans generally vest ratably over a four-year period, or at the end of three years. Stock options assumed through acquisitions have had seven to ten-year terms and vest 25% the first year and ratably over the remaining periods.

As of December 31, 2011, the total number of shares authorized, outstanding and available for future grants under the Stock Plans was as follows:
Plan Name
 
Shares Authorized
 
Shares Outstanding
 
Shares
Available for Future Grants
2003 Stock Option Plan
 
2,511,255

 
154,856

 
—

Non-Qualified 2005 Stock Option Plan
 
11,639,580

 
3,651,475

 
—

Webmail.us, Inc. 2004 Stock Incentive Plan
 
101,180

 
5,734

 
—

Amended and Restated 2007 Long-Term Incentive Plan
 
28,761,165

 
11,678,318

 
12,856,424

Total
 
43,013,180

 
15,490,383

 
12,856,424


The composition of the shares outstanding as of December 31, 2010 and 2011 was as follows: 
 
 
December 31,
2010
 
December 31,
2011
Restricted stock units
 
2,869,832
 
3,446,970
Stock options
 
15,551,009
 
12,043,413
     Total outstanding awards
 
18,420,841
 
15,490,383
 
The following table summarizes our restricted stock unit activity for the year ended December 31, 2011:
 
 
Number of Units
 
Weighted Average Grant Date Fair Value
Outstanding at December 31, 2010
 
2,869,832
 
$
9.23

     Granted
 
873,185
 
$
36.22

     Released (1)
 
(203,141)
 
$
18.39

     Cancelled
 
(92,906)
 
$
25.36

Outstanding at December 31, 2011
 
3,446,970
 
$
14.87

 
 
 
 
 
Expected to vest after December 31, 2011*
 
3,240,268
 
$
14.12

 (1) Includes 5,358 shares of restricted stock units issued to certain members of our board of directors.
*Includes reduction of shares outstanding due to estimated forfeitures

- 81 -


The weighted average grant date fair value of restricted stock units granted during fiscal years 2009 and 2010 was $5.45 and $19.06, respectively. The total pre-tax intrinsic value of the restricted stock units released during fiscal years 2009, 2010 and 2011 was $0.2 million, $0.8 million and $7.7 million, respectively.

In February 2009, our board approved grants of restricted stock units (RSUs) to our chief executive officer and another member of the executive team. A total of 2,000,000 RSUs were granted. The vesting of the RSUs is dependent on the company’s total shareholder return (TSR) on its common stock compared to other companies in the Russell 2000 Index. In addition, the company’s TSR must be positive for vesting to occur. Of the total RSUs granted, 1,050,000 have a measurement period at the end of three years, and the remainder have a measurement period at the end of five years. The grant date fair value of these awards was $7.0 million and is being amortized over the awards’ service periods. The fair value was calculated using a Monte Carlo pricing model.

The remaining RSUs that have been granted fall into the following two general categories:

•
Service-based RSUs that vest, so long as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date. Stock-based compensation expense for these service-vesting RSUs is measured based on the closing fair market value of the company's common stock on the date of grant and is recognized ratably over the service period.

•
Performance-based RSUs (accounted for as market condition awards) are granted to members of our executive team. The vesting of these RSUs is dependent on the company's TSR on its common stock for a 3-year performance period as compared to the components of the NASDAQ Internet Index over this same period. In addition, the company's TSR must be positive for vesting to occur. Stock-based compensation expense for this type of RSU is measured using a Monte Carlo pricing method and is recognized ratably over the vesting period. 

As of December 31, 2011, there was $37.0 million of total unrecognized compensation cost related to non-vested RSUs that we have granted, which will be amortized using the straight-line method over a remaining weighted average period of 1.8 years.

The following table summarizes the stock option activity for the year ended December 31, 2011: 
 
 
Number of Shares
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Life
 
Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2010
 
15,551,009
 
$
8.45

 
6.84
 
$
356,993

     Granted
 
2,006,619
 
$
37.57

 
 
 
 

     Exercised
 
(4,715,721)
 
$
7.47

 
 
 
 

     Cancelled
 
(798,494)
 
$
15.67

 
 
 
 

Outstanding at December 31, 2011
 
12,043,413
 
$
13.22

 
5.93
 
$
358,754

 
 
 
 
 
 
 
 
 
Vested and exercisable at December 31, 2011
 
6,613,338
 
$
6.25

 
5.23
 
$
242,936

 
 
 
 
 
 
 
 
 
Vested and exercisable at December 31, 2011 and expected to vest thereafter*
 
11,330,648
 
$
12.37

 
5.89
 
$
347,191

*Includes reduction of shares outstanding due to estimated forfeitures

The stock options granted in 2009, 2010 and 2011 vest as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date and have a term of 7 or 10 years.
 
The total pre-tax intrinsic value of the stock options exercised during fiscal 2009, 2010 and 2011 was $54.2 million, $53.0 million and $149.2 million, respectively.


- 82 -

The following table presents the assumptions used to estimate the fair values of the stock options granted in the periods presented:
 
 
Years Ended December 31,
 
 
2009
 
2010
 
2011
Expected stock volatility
 
57% - 61%
 
55% - 56%
 
56% - 57%
Expected dividend yield
 
0.0%
 
0.0%
 
0.0%
Risk-free interest rate
 
2.24% - 3.03%
 
1.35% - 2.79%
 
0.85% - 2.35%
Expected life
 
6.25 years
 
4.75 - 6.25 years
 
4.75 years
Weighted average grant date fair value of options granted during the year
 
$3.71
 
$10.55
 
$18.09
 
As of December 31, 2011, there was $48.2 million of total unrecognized compensation cost related to non-vested stock options that we have granted, which will be amortized using the straight line method over a weighted average period of 2.3 years.

Share-based compensation expense was recognized as follows: 
 
 
Year Ended December 31,
(in thousands)
 
2009
 
2010
 
2011
Cost of revenue
 
$
2,850

 
$
4,660

 
$
4,220

Sales and marketing
 
2,884

 
4,241

 
2,313

General and administrative
 
14,390

 
17,723

 
22,240

     Pre-tax share-based compensation
 
20,124

 
26,624

 
28,773

         Less: Income tax benefit
 
(7,059
)
 
(9,340
)
 
(9,890
)
Total share-based compensation expense, net of tax
 
$
13,065

 
$
17,284

 
$
18,883


14. Taxes
 
The provision for income taxes consisted of:

 
Year Ended December 31,
(In thousands)
2009
 
2010
 
2011
Current:
 
 
 
 
 
Federal
$
(5,911
)
 
$
691

 
$
18,372

Foreign
10,243

 
16,994

 
14,976

State
2,509

 
3,658

 
4,011

Total current
6,841

 
21,343

 
37,359

 
 
 
 
 
 
Deferred:
 
 
 
 
 
Federal
10,497

 
6,933

 
4,345

Foreign
(826
)
 
(2,908
)
 
(877
)
State
(184
)
 
(315
)
 
(809
)
Total deferred
9,487

 
3,710

 
2,659

 
 
 
 
 
 
Total provision for income taxes
$
16,328

 
$
25,053

 
$
40,018


Income before income taxes included income from foreign operations of approximately $31.2 million, $47.9 million and $51.7 million for the years ended December 31, 2009, 2010 and 2011, respectively.


- 83 -

A reconciliation of the statutory federal tax rate to the effective tax rate is as follows:

 
Year Ended December 31,
 
2009
 
2010
 
2011
Statutory federal tax rate
35.0
 %
 
35.0
 %
 
35.0
 %
State taxes, net of federal benefit
3.3
 %
 
3.0
 %
 
1.9
 %
Tax rate differentials for international jurisdictions
-3.2
 %
 
-4.0
 %
 
-4.1
 %
Permanent differences
0.3
 %
 
0.8
 %
 
1.8
 %
Other, net
-0.3
 %
 
0.3
 %
 
-0.2
 %
Effective tax rate
35.1
 %
 
35.1
 %
 
34.4
 %

Deferred Taxes

Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes. Significant components of our deferred tax assets and liabilities are as follows:

(In thousands)
December 31, 2010
 
December 31, 2011
Deferred tax assets:
 
 
 
Share-based compensation
$
16,096

 
$
15,927

Accounts receivable
948

 
1,079

State income taxes
901

 
455

Vacation accruals
1,493

 
2,159

Deferred revenue
2,650

 
2,591

Deferred rent
4,277

 
7,188

Accruals not currently deductible
4,476

 
6,508

Net operating loss carryforwards
9,321

 
2,843

Charitable contribution carryforward
284

 
560

Foreign tax credit
72

 
955

Research and development credits
1,369

 
3,142

Other
521

 
14

Total gross deferred tax assets
42,408

 
43,421

 
 
 
 
Deferred tax liabilities:
 
 
 
Depreciation
64,072

 
96,758

Share-based compensation
—

 
476

Prepaids
1,488

 
824

Total gross deferred tax liabilities
65,560

 
98,058

 
 
 
 
Net deferred tax assets (liabilities)
$
(23,152
)
 
$
(54,637
)

Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. A valuation allowance was not established or deemed necessary based upon the determination that future profits are anticipated.

The company has not recognized a deferred tax liability for undistributed earnings of its foreign subsidiaries because such earnings are considered indefinitely invested in a foreign country. As of December 31, 2011, undistributed earnings of the company’s foreign subsidiaries considered indefinitely invested were approximately $124.1 million. We intend to reinvest these earnings in active non-U.S. business operations and do not currently intend to repatriate these earnings to fund U.S. operations.


- 84 -

We have $147.6 million of federal net operating loss carryforwards and $4.1 million of federal tax credit carryforwards expiring at various dates through 2031. The federal net operating loss carryforwards include approximately $147.6 million of gross windfall tax benefits from stock option exercises that have not been recorded as of December 31, 2011. We have $17.5 million of foreign net operating loss carryforwards with an indefinite expiration date.

Uncertain Tax Positions

We file income tax returns in each jurisdiction in which we operate, both domestically and internationally. Due to the complexity involved with certain tax matters, we have considered all relevant facts and circumstances for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. We believe that there are no other jurisdictions in which the outcome of uncertain tax matters is likely to be material to our results of operations, financial position or cash flows. We further believe that we have made adequate provision for all income tax uncertainties.

A reconciliation of our unrecognized tax benefits, excluding accrued interest, for 2010 and 2011 is as follows:
(In thousands)
2010
 
2011
Balance, beginning of year
$
356

 
$
2,456

Additions based on tax positions related to the current year
199

 
13,045

Additions for tax positions of prior years
1,901

 
1,228

Reductions for tax positions of prior years
—

 
—

Settlements
—

 
—

Balance, end of year
$
2,456

 
$
16,729


Unrecognized tax benefits of $2.5 million and $16.7 million for 2010 and 2011, respectively, are included in other non-current liabilities on the balance sheet. At December 31, 2010 and 2011, respectively, approximately $1.0 million and $2.3 million of these unrecognized tax benefits, if recognized, would favorably impact our effective tax rate in any future period. Also included in the balance of unrecognized tax benefits at December 31, 2011 are liabilities of $12.6 million that, if recognized, would be recorded as an adjustment to other current and non-current assets. We do not expect the amount of unrecognized tax benefits disclosed above to change significantly over the next 12 months.

We recognize interest expense and penalties related to income tax matters in interest and penalties expense within other income (expense) on our consolidated statements of income and not as income tax expense. As of December 31, 2010 and 2011, we had no accrued interest or penalties on the consolidated balance sheets. For the years ended December 31, 2009, 2010 and 2011, no amount for interest or penalties related to unrecognized tax benefits was recorded in the consolidated statements of income.

We are subject to U.S. federal income tax and various state, local, and international income taxes in numerous jurisdictions. Our domestic and international tax liabilities are subject to the allocation of revenue and expenses in different jurisdictions and the timing of recognizing revenue and expenses. As such, our effective tax rate is impacted by the geographical distribution of income and mix of profits in the various jurisdictions.  Additionally, the amount of income taxes paid is subject to our interpretation of applicable tax laws in the jurisdictions in which we file.
  
We currently file income tax returns in the U.S. and all foreign jurisdictions in which we have entities, which are periodically under audit by federal, state, and international tax authorities. These audits can involve complex matters that may require an extended period of time for resolution. We remain subject to U.S. federal and state income tax examinations for the tax years 2007 through 2011, U.K. income tax examinations for the years 2009 through 2011, Netherlands income tax examinations for the years 2007 through 2011, and Hong Kong income tax examinations for the years 2008 through 2011. There are no income tax examinations currently in process. Although the outcome of open tax audits is uncertain, in management’s opinion, adequate provisions for income taxes have been made. If actual outcomes differ materially from these estimates, they could have a material impact on our financial condition and results of operations. Differences between actual results and assumptions or changes in assumptions in future periods are recorded in the period they become known. To the extent additional information becomes available prior to resolution, such accruals are adjusted to reflect probable outcomes.

During 2011 we received federal income tax refunds totaling $4.5 million related to the 2007 and 2010 tax periods. We experienced a taxable profit in the U.S. and U.K. in 2011, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation As a result, we have recognized an excess tax benefit in the U.S. and U.K.


- 85 -

During 2011, Rackspace US, Inc. sold certain intellectual property to a wholly-owned offshore subsidiary in a taxable transaction.  As a result of the transaction, there is an asset on the consolidated balance sheet as of December 31, 2011 of $38.3 million (of which $37.2 million was recorded in Other non-current assets) that will be amortized through income tax expense over the lives of the applicable intellectual property. Although the transaction was taxable, the resulting gain was entirely offset against existing net operating losses, including excess stock compensation deductions. Thus, there was no cash tax impact from the sale of the intellectual property.

Rackspace takes certain non-income tax positions in the jurisdictions in which it operates and may be subject to audit from these jurisdictions. Rackspace is also involved in related non-income tax matters. We believe our positions are supportable, and we have accrued for known exposure; however, significant judgment is required in determining the ultimate outcome of such matters. In the normal course of business, our position and conclusion related to these non-income taxes may be challenged and assessments may be made. To the extent new information is obtained and changes our views on our positions, probable outcome of assessments, or litigation, changes in estimates to accrued liabilities would be recorded in the period the determination is made.

15. Comprehensive Income
 
Total comprehensive income was as follows: 
 
 
Year Ended December 31,
(In thousands)
 
2009
 
2010
 
2011
Net income
 
$
30,218

 
$
46,358

 
$
76,411

Derivative instrument, net of deferred taxes of $(379), $(636) and $0 for the years ended December 31, 2009, 2010 and 2011
 
704

 
1,182

 
—

Foreign currency cumulative translation adjustment, net of taxes of $(1,393), $266 and $51 for the years ended December 31, 2009, 2010 and 2011
 
5,066

 
(3,341
)
 
(2,316
)
Total other comprehensive income (loss)
 
5,770

 
(2,159
)
 
(2,316
)
Total comprehensive income
 
$
35,988

 
$
44,199

 
$
74,095


The changes in accumulated other comprehensive income (loss) for the years ended December 31, 2010 and 2011 were as follows:
(In thousands)
Derivative Instrument
 
Translation Adjustment
 
Accumulated other comprehensive income (loss)
Balance at December 31, 2009
$
(1,182
)
 
$
(9,075
)
 
$
(10,257
)
2010 changes in fair value
1,182

 
—

 
1,182

2010 translation adjustment
—

 
(3,341
)
 
(3,341
)
Balance at December 31, 2010
$
—

 
$
(12,416
)
 
$
(12,416
)
2011 translation adjustment
—

 
(2,316
)
 
(2,316
)
Balance at December 31, 2011
$
—

 
$
(14,732
)
 
$
(14,732
)


- 86 -

16. Segment Information
 
Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision-maker is our chief executive officer. Our chief executive officer reviews financial information presented on a consolidated basis, accompanied by information by reporting unit and geographic region for purposes of evaluating financial performance and allocating resources.  We are organized as and operate two operating segments based around our products and services.  The company's service offerings all provide computing power to similar types of customers. Furthermore, the service offerings have similar production processes, deliver their services in a similar manner and use the same data centers and similar technologies. As a result of our evaluation of the criteria for aggregation by products and services, we determined we have one reportable segment, which we describe as Cloud Computing.

Revenue is attributed to geographic location based on the Rackspace operating location that enters into the contractual relationship with the customer, either the U.S. or International, primarily the U.K. Total net revenue by geographic region was as follows: 

 
 
Year Ended December 31,
(In thousands)
 
2009
 
2010
 
2011
United States
 
$
467,901

 
$
583,546

 
$
767,752

International
 
161,086

 
197,009

 
257,312

Total net revenue
 
$
628,987

 
$
780,555

 
$
1,025,064

 
Our long-lived assets are primarily located in the U.S. and the U.K., and to a lesser extent Hong Kong.  Property and equipment, net by geographic region was as follows: 

(In thousands)
 
December 31,
2010
 
December 31,
2011
United States
 
$
395,318

 
$
485,608

International
 
99,910

 
141,882

Total property and equipment, net
 
$
495,228

 
$
627,490


17. Employee Benefit Plans

We sponsor a defined contribution retirement plan ("the Plan"), which has been determined by the IRS to be qualified as a 401(k) plan. The Plan covers substantially all employees located in the U.S. and provides for voluntary tax-deferred contributions of up to 100% of gross compensation, subject to certain IRS limitations. Based on approval by the board of directors, we began making matching contributions in 2011. During 2011, $3.9 million of contribution expense was recognized. The Company matches $340 for every 1% of earnings that the employee contributes, up to a maximum of 6%, or $2,040 per employee. The matching contributions vest when the employee has been employed by Rackspace for three years.

We also sponsor a non-mandatory defined contribution plan for our employees located in the U.K. Pursuant to this plan, we contribute on a monthly basis a certain percentage of the employee’s salary. The plan is non-contributory; thus, the employee is not obligated to make any contribution to the plan, and contributions vest immediately. During 2009, 2010 and 2011, expense recognized was $1.2 million, $1.5 million and $1.9 million, respectively.

18. Risks and Uncertainties

Our future results of operations involve a number of risks and uncertainties. Factors that could affect our future operating results and cause actual results to vary materially from expectations include, but are not limited to: current economic conditions, uncertainty in the potential market for our services, increasing competition, dependence on our existing management and key personnel, and protection of our intellectual property rights.


- 87 -

SUPPLEMENTARY FINANCIAL DATA

 
 
Quarters Ended
(In thousands, except per share amounts)
 
March 31,
2010
 
June 30,
2010
 
September 30,
2010
 
December 31,
2010
 
 
(Unaudited)
Net revenue
 
$
178,805

 
$
187,314

 
$
199,710

 
$
214,726

Cost of revenue
 
$
57,007

 
$
61,470

 
$
64,616

 
$
66,747

Gross margin
 
$
121,798

 
$
125,844

 
$
135,094

 
$
147,979

Net income
 
$
9,812

 
$
11,198

 
$
11,809

 
$
13,539

Earnings per share - basic
 
$
0.08

 
$
0.09

 
$
0.09

 
$
0.11

Earnings per share - diluted
 
$
0.07

 
$
0.08

 
$
0.09

 
$
0.10

Cash and cash equivalents
 
$
131,297

 
$
148,496

 
$
166,557

 
$
104,941


 
 
Quarters Ended
(In thousands, except per share amounts)
 
March 31,
2011
 
June 30,
2011
 
September 30,
2011
 
December 31,
2011
 
 
(Unaudited)
Net revenue
 
$
230,002

 
$
247,229

 
$
264,572

 
$
283,261

Cost of revenue
 
$
69,742

 
$
74,057

 
$
82,445

 
$
82,851

Gross margin
 
$
160,260

 
$
173,172

 
$
182,127

 
$
200,410

Net income
 
$
13,821

 
$
17,561

 
$
19,982

 
$
25,047

Earnings per share - basic
 
$
0.11

 
$
0.14

 
$
0.15

 
$
0.19

Earnings per share - diluted
 
$
0.10

 
$
0.13

 
$
0.14

 
$
0.18

Cash and cash equivalents
 
$
133,868

 
$
132,025

 
$
124,680

 
$
159,856



- 88 -

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A - CONTROLS AND PROCEDURES
 
Evaluation of disclosure controls and procedures
 
Under the supervision and with the participation of our senior management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), as amended, as of the end of the period covered by this annual report (the “Evaluation Date”). Based on this evaluation, our chief executive officer and chief financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our SEC reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
 
Changes in internal control over financial reporting

There were no changes in our internal controls over financial reporting during our most recent fiscal quarter reporting period identified in connection with management’s evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
Inherent Limitations of Internal Controls

Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Report of Management on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2011. Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2011 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in its attestation report, which is included in Item 8 of this Annual Report on Form 10-K.

ITEM 9B - OTHER INFORMATION
 
None.


- 89 -

PART III

ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this item is incorporated by reference to Rackspace Hosting’s Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2011.

We have adopted the Rackspace Hosting, Inc. Code of Business Conduct and Ethics (the “code of conduct”) that applies to all of our employees, officers and directors, including without limitation, our Chief Executive Officer, Chief Financial Officer, and Corporate Controller, and other finance organization employees. The code of conduct, as well as any waiver of a provision of the code of conduct granted to any senior officer or director or material amendment to the code of conduct, if any, may be found in the “Investors” section of our website at www.rackspace.com.

ITEM 11 - EXECUTIVE COMPENSATION

The information required by this item is incorporated by reference to Rackspace Hosting's Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2011.

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED PARTY STOCKHOLDER MATTERS

The information required by this item is incorporated by reference to Rackspace Hosting's Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2011.

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this item is incorporated by reference to Rackspace Hosting's Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2011.

ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is incorporated by reference to Rackspace Hosting's Proxy Statement for its 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2011.


- 90 -

PART IV

ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Financial Statements

(1)
The financial statements filed as part of this report are listed on the Index to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

(2)
Any financial statement schedules required to be filed as part of this report are set forth in section (c) below.

(b) Exhibits - See Index to Exhibits at the end of this report, which is incorporated by reference.

(c) Financial Statement Schedules

The following financial statement schedule is filed as a part of this Annual Report:

Schedule II - Valuation and Qualifying Accounts

All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto.

(In thousands)
Beginning Balance
 
Additions Charged to Net Revenues, and Costs and Expenses
 
Write-offs of Accounts Receivable and Credit Memos Paid
 
Ending Balance
Allowance for doubtful accounts and customer credits for the years ending December 31:
 
 
 
 
 
 
 
2009
$
3,295

 
$
13,364

 
$
(12,361
)
 
$
4,298

2010
$
4,298

 
$
7,223

 
$
(8,675
)
 
$
2,846

2011
$
2,846

 
$
9,063

 
$
(8,489
)
 
$
3,420


- 91 -

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on February 17, 2012.

 
 
 
Rackspace Hosting, Inc.
Date:
February 17, 2012
 
By:
 
/s/ A. LANHAM NAPIER
 
 
 
 
 
A. Lanham Napier
 
 
 
 
 
Chief Executive Officer and Director
 
 
 
 
 
(Principal Executive Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Name
 
Title
 
Date
 
 
 
 
 
/s/ A. LANHAM NAPIER
 
Chief Executive Officer and Director
 
February 17, 2012
A. Lanham Napier
 
(Principal Executive Officer)
 
 
 
 
 
 
 
/s/ KARL PICHLER
 
Chief Financial Officer and Treasurer
 
February 17, 2012
Karl Pichler
 
(Principal Financial Officer)
 
 
 
 
 
 
 
/s/ GRAHAM WESTON
 
Chairman
 
February 17, 2012
Graham Weston
 
 
 
 
 
 
 
 
 
/s/ S. JAMES BISHKIN
 
Director
 
February 17, 2012
S. James Bishkin
 
 
 
 
 
 
 
 
 
/s/ SAM GILLILAND
 
Director
 
February 17, 2012
Sam Gilliland
 
 
 
 
 
 
 
 
 
/s/ MARK P. MELLIN
 
Director
 
February 17, 2012
Mark P. Mellin
 
 
 
 
 
 
 
 
 
/s/ PALMER L. MOE
 
Director
 
February 17, 2012
Palmer L. Moe
 
 
 
 
 
 
 
 
 
/s/ LEW MOORMAN
 
President and Director
 
February 17, 2012
Lew Moorman
 
 
 
 
 
 
 
 
 
/s/ FRED REICHHELD
 
Director
 
February 17, 2012
Fred Reichheld
 
 
 
 
 
 
 
 
 
/s/ GEORGE J. STILL, JR.
 
Director
 
February 17, 2012
George J. Still, Jr.
 
 
 
 


- 92 -

INDEX TO EXHIBITS
 
Exhibits
 
 Description
 
 
 
3.1
 
Certificate of Incorporation of the Registrant (2)
3.3
 
Amended and Restated Bylaws of the Registrant (3)
4.1
 
Form of Common Stock Certificate of the Registrant (3)
4.2
 
Founder's Registration Rights Agreement, dated October 1, 2002, among the Registrant and certain stockholders (1)
4.3
 
Investor's Registration Rights Agreement, dated October 1, 2002, among the Registrant and certain stockholders (1)
10.1
 
Form of Indemnification Agreement for directors and officers (2)
10.2
 
2003 Stock Option Plan and form of agreement thereunder (1)
10.3
 
2005 Non-Qualified Stock Option Plan and form of agreement thereunder (1)
10.4
 
Form of Share Option Agreement (U.K.) (4)
10.5(A)
 
Amended and Restated 2007 Long-Term Incentive Plan and form of agreement thereunder (2)
10.5(B)
 
Certificate of Amendment to Amended and Restated 2007 Long-Term Incentive Plan (2)
10.5(C)
 
Form of RSU Agreement Under 2007 Long Term Incentive Plan (Time-Based) (5)
10.5(D)
 
Form of RSU Agreement Under 2007 Long Term Incentive Plan (Performance-Based) (5)
10.5(E)
 
Form of RSU Agreement Under 2007 Long Term Incentive Plan (SLT Performance-Based) (14)
10.5(F)
 
Rules of the Rackspace Hosting, Inc. 2010 HM Revenue & Customs U.K. Approved Sub-plan (12)
10.5(G)
 
Form of the 2010 HM Revenue & Customs U.K. Approved Sub-plan, Notice of Grant of Stock Options (12)
10.6
 
Webmail.us., Inc. 2004 Stock Incentive Plan, as amended in 2006 (1)
10.7
 
2008 Employee Stock Purchase Plan and form of agreement thereunder (2)
10.8
 
Rackspace US, Inc. Deferred Compensation Plan (3)
10.9
 
Office Building Lease, dated March 16, 2004, between Data Rose Limited Partnership and Rackspace Headquarters, LLC, as amended on April 26, 2004, June 1, 2006, and April 17, 2008 (1)
10.10
 
Ground Lease Agreement, dated August 2, 2007, between Windcrest Economic Development Corporation and Rackspace US, Inc., as amended on April 24, 2008 (1)
10.11
 
Walzem Road Redevelopment Project Master Economic Incentives Agreement among the City of Windcrest, Texas, the City of San Antonio, Texas, the County of Bexar, Texas, the Windcrest Economic Development Corporation, the Windcrest Economic Development Company, LLC, and Rackspace US, Inc., dated August 2, 2007 (1)
10.12
 
City Economic Development Grant Agreement between the City of Windcrest, Texas and Rackspace US, Inc., dated August 2, 2007 (1)
10.13
 
County Economic Development Grant Agreement between Bexar County, Texas and Rackspace US, Inc., dated August 2, 2007 (1)
10.14
 
Developer Economic Development Grant Agreement among the City of Windcrest, Texas, the Windcrest Economic Development Corporation, and Windcrest Economic Development Company, LLC, dated August 2, 2007 (1)
10.15(A)
 
Economic Development Agreement between the State of Texas and Rackspace US, Inc., dated August 1, 2007 (1)
10.15(B)
 
Amendment Number One to the Economic Development Agreement between the State of Texas and Rackspace US, Inc. (8)
10.16
 
Office Building Lease Agreement, dated February 22, 2000, between Santa Clara Land Company, Ltd. and the Registrant, as amended on March 30, 2000, December 9, 2004, and March 1, 2007 (1)
10.17
 
Storage Lease, effective March 1, 2004, between Santa Clara Land Company, Ltd. and the Registrant (2)
10.18(A)
 
Lease Agreement, dated January 28, 2008, between Santa Clara Land Company, Ltd. and Rackspace US, Inc. (1)
10.18(B)
 
First Amendment to Office Building Lease Agreement between Santa Clara and Company, Ltd. and Rackspace US, Inc., dated July 10, 2008 (3)

- 93 -

Exhibits
 
 Description
10.19
 
Assignment of Lease, effective December 1, 2006, between Qwest Communications Corporation and Rackspace DAL1DC Management, LLC with attached Lease dated January 26, 2000 between CSI Industrial Development L.P. and Qwest Communication Corporation, as amended January 23, 2011 (1)
10.20
 
Third Amendment to Lease Agreement, dated January 8, 2008, between CLPF-Heritage Four, L.P. and Rackspace DAL1DC Management LLC (1)
10.21
 
Consent to Assignment and Other Agreements, dated November 30, 2006, by and among CLPF Heritage Four L.P., Macro Holding, Inc., Qwest Communications Corporation, and Rackspace DAL1DC, Ltd. (1)
10.22
 
Agreement for Lease, dated April 2, 2007, between Slough Trading Estate Limited and Rackspace Managed Hosting Limited (1)
10.23(A)
 
Amended and Restated Revolving Credit Agreement dated August 31, 2007 between Comerica Bank and Rackspace US, Inc., as amended October 11, 2007, December 7, 2007, February 25, 2008, and April 23, 2008 (1)
10.23(B)
 
Fifth Amendment to Amended and Restated Revolving Credit Agreement (7)
10.24
 
Global Amendment to the Registrant's 1999 Assumed Stock Option Plan, 2003 Stock Option Plan, 2005 Non-Qualified Stock Option Plan, Webmail.us, Inc. 2004 Stock Incentive Plan and Amended and Restated 2007 Long-Term Incentive Plan (2)
10.25
 
Offer letter from the Registrant to James Lewandowski, dated September 9, 2008 (5)
10.26
 
Rackspace Standard Form of Employment Agreement (5)
10.27(A)†
 
Lease Agreement by and between Grizzly Ventures LLC and Rackspace US, Inc. (6)
10.27(B)
 
First Amendment to Lease Agreement by and between Grizzly Ventures LLC and Rackspace US, Inc. (10)
10.28(A)†
 
Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated July 31, 2009 (9)
10.28(B)†
 
First Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated May 4, 2010 (13)
10.28(C)†
 
Second Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated February 24, 2011 (16)
10.28(D)†
 
Fourth Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated August 19, 2011 (18)
10.29
 
Employment Agreement between Rackspace US, Inc. and Mark Roenigk, dated December 14, 2009 (11)
10.30
 
Non-employee Director Compensation Schedule (13)
10.31
 
Property Lease for HPH1 Hyde Park Hayes Millington Road Hayes Middlesex UB3 4AY (15)
10.32
 
Service Agreement by and Between Rackspace Limited and David Kelly, dated June 1, 2010 (15)
10.33
 
Bruce Knooihuizen Transition Employment Agreement (16)
10.34(A)
 
Revolving Credit Agreement, dated September 26, 2011, by and between Rackspace Hosting, Inc. and JPMorgan Chase Bank, N.A., Barclays Bank PLC, Regions Bank, and Wells Fargo Bank, N.A. (17)
10.34(B)
 
Guarantee Agreement, dated September 26, 2011, by Guarantors of Rackspace Hosting, Inc., in favor of JPMorgan Chase Bank, N.A. as Administrative Agent for the benefit of the Lenders pursuant to the Revolving Credit Agreement dated September 26, 2011 (17)
10.35*
 
Compensation Agreement between Rackspace US, Inc. and Karl Pichler, dated January 27, 2012
10.36*
 
Fifth Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated January 6, 2012
10.38*†
 
Lease Agreement by and between Collins Technology Park Partners, LLC, and Rackspace US, Inc., dated December 29, 2011
21.1*
 
List of subsidiaries of the Registrant
23.1*
 
Consent of KPMG LLP, Independent Registered Public Accounting Firm.
31.1*
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*
 
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**
 
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**
 
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS**
 
XBRL Instance Document
101.SCH**
 
XBRL Taxonomy Extension Schema

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Exhibits
 
 Description
101.CAL**
 
XBRL Taxonomy Extension Calculation Linkbase
101.DEF**
 
XBRL Taxonomy Extension Definition Linkbase
101.LAB**
 
XBRL Taxonomy Extension Label Linkbase
101.PRE**
 
XBRL Taxonomy Extension Presentation Linkbase

*
Filed herewith.
**
Furnished herewith.
†
Confidential treatment has been requested for portions of these exhibits. These portions have been omitted from this Annual Report on Form 10-K and submitted separately to the Securities and Exchange Commission.
(1)
Incorporated by reference to the Company's Registration Statement on Form S-1 (File No. 333-150469), filed April 25, 2008.
(2)
Incorporated by reference to the Company's Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-150469), filed June 18, 2008.
(3)
Incorporated by reference to the Company's Amendment No. 2 to the Registration Statement on Form S-1 (File No. 333-150469), filed July 15, 2008.
(4)
Incorporated by reference to the Company's Amendment No. 1 to the Registration Statement on Form S-8 (File No. 333-153009), filed February 4, 2009.
(5)
Incorporated by reference to the Company's Annual Report on Form 10-K for the Year ended December 31, 2008 (File No. 001-34143), filed March 2, 2009.
(6)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 2009 (File No. 001-34143), filed May 12, 2009.
(7)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed June 23, 2009.
(8)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed July 30, 2009.
(9)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended June 30, 2009 (File No. 001-34143), filed August 13, 2009.
(10)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 2009 (File No. 001-34143), filed November 12, 2009.
(11)
Incorporated by reference to the Company's Annual Report on Form 10-K for the Year ended December 31, 2009 (File No. 001-34143), filed February 26, 2010.
(12)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 2010 (File No. 001-34143), filed May 6, 2010.
(13)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended June 30, 2010 (File No. 001-34143), filed August 9, 2010.
(14)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed August 27, 2010.
(15)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 2010 (File No. 001-34143), filed November 9, 2010.
(16)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 2011 (File No. 001-34143), filed May 10, 2011.
(17)
Incorporated by reference to the Company's Current Report on Form 8-K/A (File No. 001-34143), filed September 29, 2011.
(18)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed November 8, 2011.


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