10-K 1 rax1231201310-k.htm FORM 10-K RAX 12.31.2013 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, 2013.

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.)

1 Fanatical Place
City of Windcrest
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 R    No o  

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, 2013, 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 28, 2013) was $2,160,083,173.

On February 27, 2014, 141,832,652 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 2014 Annual Meeting of Stockholders, to be filed within 120 days of the Registrant's fiscal year ended December 31, 2013, 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®, Fanatical Support®, and RackConnect® are service marks of Rackspace US, Inc. registered in the United States and other countries. OpenStack® is either a registered trademark or trademark of OpenStack, LLC in the United States and/or other countries. Net Promoter, Net Promoter Score and NPS are trademarks of Satmetrix Systems, Inc., Bain & Company, Inc. and Fred Reichheld. EVA® is a registered trademark of Stern Stewart & Co. and EVA Dimensions. 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 open cloud company, delivering open technologies and specialist expertise that power more than 200,000 business customers in 120 countries. 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 us from our competitors is our emphasis on delivering an exceptional customer experience, our broad portfolio of services, and our leadership in open standards that give customers freedom of movement among cloud providers. We are the co-founder, with NASA, of OpenStack, the world's fastest-growing open cloud platform and developer community.

We are also a pioneer in the hybrid cloud, which combines the security, performance and scalability of our dedicated and public cloud hosting services, integrated through our RackConnect offering. In contrast to the one-size-fits-all approach taken by some vendors of public cloud services, we believe that the hybrid cloud gives each customer the best fit for its specific needs. It enables each of the customer’s workloads to run where it will achieve the best performance and cost-efficiency, whether on the public cloud, a private cloud, dedicated servers, or a combination of these platforms. Our rapid growth over the last 15 years is the result of our technology leadership and our renowned customer service, known as Fanatical Support.

We offer a diverse portfolio of cloud computing services, including public cloud, dedicated, private cloud, and hybrid cloud - all delivered with a commitment to open technologies. The equipment (servers, routers, switches, firewalls, load balancers, cabinets, software, wiring, etc.) required to deliver services is typically purchased and managed by us. We are committed to delivering Fanatical Support for the open cloud across our entire product portfolio, and we will continue to pursue our vision to be considered one of the world’s great service companies.

We were incorporated in Delaware in March 2000, but our operations began in 1998 as a limited partnership, which became our subsidiary through a corporate reorganization completed in August 2001.

Our Industry

The cloud computing industry, best described as delivering computing, storage, and applications as a service over the Internet, is fast-growing and crowded, and Rackspace has earned a well-defined leadership role within it. We are a company of specialists, with expertise in key skill-sets around hybrid cloud configurations, the deployment and operation of OpenStack, and the management of complex customer applications ranging from MongoDB to SharePoint. We are the industry's service leader and a leader in the open cloud and hybrid cloud. Our employees, who are called Rackers, are focused on providing open and standard cloud products, along with specialist expertise, advice and support 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 advisory and support 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 four ways in which businesses can fulfill their IT requirements:

1.
The first approach is in-house IT. 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 - often a systems integrator such as IBM or CSC.


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3.
The third approach is do-it-all-yourself cloud computing, where business customers essentially rent inputs in the form of access to computer hardware and software, on demand over the Internet. They receive few assurances in terms of business outcomes, and little in the way of specialized expertise, advice or support. Rather than focus on their core business, they also take on the full burden of operating IT infrastructure and learning to use the fast-expanding set of tools necessary to leverage cloud computing.

4.
The fourth approach is full-service cloud computing where business customers receive access not only to raw computing services but also to specialized expertise, advice and support, along with explicit assurances of business outcomes through their Service Level Agreements. This approach allows customers to focus their scarce technical talent on tasks that differentiate their businesses.

We believe that full-service cloud computing, delivered with exceptional customer support and expertise, provides better quality IT and more value for performance than does 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. As business IT applications grow in number and complexity, especially around software to leverage large and complex data sets that are difficult to process (referred to as Big Data), most smaller and mid-size companies do not have the IT staff needed to manage complicated, mission-critical websites, databases or other IT applications. They do not want to purchase expensive hardware with their available capital. Yet they must have an increasingly robust, reliable online presence, and must leverage their data about customer behavior and internal operations 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 databases or running a website.

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. This trend will accelerate as various barriers to adoption are broken down. The expansion of open technologies, for example, is removing business customers' fears of being locked into the proprietary software - and subject to the pricing - of a particular cloud provider. Similarly, advances such as software-defined networking are easing customers' concerns about the security of cloud computing. As time goes by, businesses 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, high speed and nimbleness, and the way it reduces 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 consumer applications. The rising supply of cloud computing is 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. The open technologies embraced by Rackspace and other members of the OpenStack community are accelerating innovation in cloud computing, as they engage the efforts of scores of companies and thousands of developers around the world. These technologies allow customers to avoid being locked into one vendor and to easily move to another cloud provider whenever they find better features, pricing, or service.

Our Business

We are a global company, selling our services to business customers in more than 120 countries. Our corporate headquarters is located in San Antonio. We also have operations located in multiple cities across the United States, as well as in London, Amsterdam, Zurich, Hong Kong, and Sydney. In 2013 we had net revenue of $1.5 billion, and as of December 31, 2013, we served more than 200,000 business customers, and we managed more than 103,000 servers. No single customer accounted for more than 2% of our net revenue in any of the past three years.


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We are focused on the segment of the cloud computing market that demands, and is willing to pay for, the value for performance that can only be delivered by 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 servers, public cloud and private cloud 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 ourselves. Fanatical Support, our unique brand of customer experience, is backed by a complex business process that we have built and refined over the past 15 years, and it distinguishes our company in the market. Fanatical Support, which is designed to generate an extraordinary customer experience, is incorporated into all aspects of our services. 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 the specialized expertise of U.S. and U.K. based technicians available to customers 24/7 by phone, 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 reward and celebrate successful 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.

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 concept of Fanatical Support has expanded to include technological improvements that make our services more reliable and easier to use. It has expanded to include prescriptive advice to customers and prospects about which applications work best in public cloud and private cloud, on dedicated servers and in hybrid cloud. It has expanded to include specialist expertise in complex applications such as MongoDB, Hadoop, Redis, Magento, and SharePoint. Many customers want to leverage these applications and would rather do so through a specialist provider rather than diverting scarce in-house technical resources from tasks core to their business. This evolution and expansion of Fanatical Support aligns with our company's purpose statement: to make cloud computing simple for business.

We have built our business around an understanding, born of experience, 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., Hong Kong, and Australia. Our services are defined, as follows:

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 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 public cloud 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 Sites for website hosting, Cloud Block Storage and Cloud Files for storage, Cloud Databases for hosting MySQL instances, Cloud Backup for file protection, Cloud Load Balancers for traffic management, Cloud Monitoring for infrastructure control, Cloud DNS for domain management, Cloud Networks for security enhancement, and Cloud Applications, which includes email, collaboration and file back-ups.

We continue to invest in our public cloud service and believe it is an important part of our future success. In early November, for example, we launched Performance Cloud Servers, which run computation and storage workloads several times faster than do our standard products. Despite these performance improvements in our public cloud, we do not believe that public cloud will replace traditional computing on dedicated servers. We believe the two complement one another, allowing customers to choose the best platform for each of their workloads. Many modern Big Data workloads, for example, perform better and more cost-efficiently on dedicated servers than on the public cloud.


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Dedicated Cloud, also 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.

Private Cloud 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. The hardware can be located in our data centers or in the customer's facilities. This approach is especially popular with some of our larger corporate customers. Our embrace of OpenStack and other open technologies has generated significant interest in our private cloud offerings. Revenue for private cloud is included within Dedicated Cloud revenue in our Key Metrics table in Item 7 of Part II.

Hybrid Cloud. We are pioneers in this emerging category, which allows a customer to easily and seamlessly utilize the benefits of both dedicated cloud and public cloud. We are also working to add private cloud to the technologies available. A customer using hybrid cloud is able to utilize any combination of dedicated and pooled resources and to manage them seamlessly through our RackConnect service. Each cloud computing form factor has specific and unique customer benefits, and through hybrid cloud, the various technologies 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.

See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 14 – Segment Information” for financial information related to our product categories.

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:

In-house and Colocation. 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.

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, Red Hat, Verizon and others. We increasingly face competition from large, diversified technology companies such as Amazon, Google, HP, IBM and Microsoft, who are making substantial investments in cloud computing.

Our Approach and Sources of Competitive Advantage

We are focused on creating a 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 specialist focus is to provide cloud computing services and expertise, 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, demonstrated by our leadership in the hybrid cloud, 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 into 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.


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Fanatical Support - We believe that an excellent customer experience creates customer loyalty and referrals, 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 we can provide additional service levels that are not capital intensive, which lead both 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. Rackers are rewarded for going above and beyond to serve customers. The highest form of recognition is the Straightjacket Award, which is given on a regular basis to the Racker 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. In six of the last seven years, Fortune magazine has honored us in its list of “100 Best Companies to Work For,” where we now rank #29. 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.

Specialist 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.

Seamless Portfolio - Many hosting providers offer only public cloud services and take a one-size-fits-all approach to customer needs. Others, rely on third-party reselling relationships to complete their hosting portfolio. Our portfolio of services allows us to deliver the best fit for each customer's unique needs - the right offering at the right budget. 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 cloud 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 three and a half years, OpenStack has attracted significant support, with more than 250 companies, nine successful Design Summits with participants from six continents, and the successful release of multiple versions of the software.

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Research and Development

For the years ended December 31, 2011, 2012 and 2013, we incurred $33.7 million, $56.7 million and $90.2 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, hybrid cloud and OpenStack;

•
Development and enhancement of proprietary tools; 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 capitalized internal-use software development and other project costs in the amount of $63.1 million, $79.1 million and $84.9 million in the years ended December 31, 2011, 2012 and 2013, 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 patents issued as well as patent applications pending in the U.S. and the European Union. 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. Many parts of our business are significantly reliant on proprietary technology and/or licensed technology. Although we rigorously protect our rights to use this technology, any significant impairment of, or third-party claim against, our intellectual property rights could harm our business or our ability to compete.

Employees

As of December 31, 2013, we employed 5,651 Rackers, a net increase of 799, or 16%, compared to December 31, 2012. 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.

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 market. 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 who can address a wide range of business and technical issues for a customer and are available 24/7/365.


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Financial Information About Geographic Areas

See Item 8 of Part II, “Financial Statements and Supplementary Data – Note 14 – 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

The Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on the Company's website at www.rackspace.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.

Our SEC filings are also available to the public at the SEC’s website at www.sec.gov. 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 (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;
▪
Security breaches to our infrastructure;
▪
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, security issues, 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.
 

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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;
▪
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 our 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 forecasting customer demands; improving the performance, features, and reliability of our products and 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.

For example, as the adoption and usage of public cloud in the marketplace has grown, we have had to make strategic decisions around improving our customers' experience on our cloud platform, including committing to replace our legacy cloud platform with an open source cloud platform that was developed under the OpenStack initiative that we founded with NASA in 2010 and building features and products on top of that platform. We believe that such a platform shift improves our customers' experience by providing them with features and services that have become possible through the rapidly changing environment in which we operate and because the adoption of the open source cloud platform provides us with additional opportunities to provide a service layer on top of the platform. However, making such a platform shift and introducing products on top of that platform presents a number of risks to our business, including the risks that current and prospective customers will not like or accept the new platform and/or the products that have been built on it, that the OpenStack open source cloud platform will not be adopted as the ubiquitous open source cloud computing platform standard for public and private clouds, or that even if the OpenStack cloud platform is widely adopted as a standard, we would not be seen as a leading platform specialist. Our transition also will require us to entice our legacy platform customers to eventually switch over to our new platform, which can be disruptive to their business in a way that is similar in some ways to switching service providers. Because of the disruption, the likelihood that these customers consider alternative solutions to our new platform is greater and can therefore increase the competitive environment, making it harder to for us to keep our own customers.

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 from 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.

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.


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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. For example, our recent cloud platform launch featured the release of several key products, including Cloud Servers, Cloud Databases, Cloud Monitoring, Cloud Backup, Cloud Block Storage, and Cloud Networks, along with a new Control Panel. While we believe that these new capabilities and features could drive future incremental demand, there are certain risks associated with such a significant product transition and platform shift. We believe these risks could adversely impact our ability to execute on our growth strategy and therefore capitalize on the current market opportunity, both in the short and long term. They include: (i) the non-acceptance by current and prospective customers of our new hybrid cloud platform and product set; (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources, larger customer bases, longer operating histories, greater brand recognition, more established relationships in the industry, and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities; (iii) new pricing strategies that may include lowering price points for cloud products and services to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our cloud products to significant cloud customers; (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases; and (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve.

Our failure to provide platforms, products and services to compete with new technologies or the obsolescence of our platforms, products or 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.


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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:
 
▪
In-house and Colocation solutions with a colocation partner such as AT&T, Equinix, CenturyLink and other telecommunications companies;
▪
IT outsourcing providers such as CSC, Hewlett-Packard, and IBM;
▪
Cloud computing providers such as AT&T, British Telecom, CenturyLink, Red Hat, IBM Softlayer, Verizon and other telecommunications companies; and
▪
Large technology companies such as Amazon, Hewlett-Packard, Google, IBM, and Microsoft, 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:
 
▪
Develop superior products or services, gain greater market acceptance, and expand their service offerings more efficiently or more rapidly;
▪
Adapt to new or emerging technologies and changes in customer requirements more quickly;
▪
Bundle hosting services with other services they provide at reduced prices;
▪
Take advantage of acquisition and other opportunities more readily;
▪
Adopt more aggressive pricing policies and devote greater resources to the promotion, marketing, and sales of their services, which could cause us to have to lower prices for certain products or services to remain competitive in the market; and
▪
Devote greater resources to the research and development of their products and services.

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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. We are a constant target of cyber attacks of varying degrees on a regular basis, and we have encountered security breaches in the past, although they did not have a material adverse effect on our operating results. There can be no assurance of a similar result in a future security breach.

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 agree to terms of service 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.

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. Our prior period operating results are not 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. 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.


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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, whom 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, including Graham Weston, our Chairman and Chief Executive Officer; and Taylor Rhodes, our President. We do not have long-term employment agreements with any members of our management team, including Messrs. Weston and Rhodes.

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 have claimed in the past and could claim in the future 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, and ultimately may not be an alternative that functions as well as the original or is accepted in the marketplace.

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 service offerings. This causes us to implement manual processes to overcome the fragmentation, which can result in increased expense and manual errors. Some of these systems are also on aging or undersized infrastructure and may be at risk of reaching capacity limits in the 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.


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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.
 
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 managed 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 public cloud 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 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 be assured 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.


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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 an 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 founded 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 continue to contribute to the ongoing development of OpenStack projects. In addition, we also participate in other open source projects and plan to continue to do so in the future. Our utilization of open source software and open data center design projects like the Facebook Open Compute project could cause us to use open source solutions as opposed to existing proprietary solutions and could result in an impairment of 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 participation in these projects.
 
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 be assured 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 patents issued and patent applications pending in the U.S. and the European Union. Our patent applications may be challenged and/or ultimately rejected, and our issued patents 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 or create disparities in personal wealth among our employees through our compensation philosophy and benefit plan utilization, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. If we cannot maintain a favorable corporate culture, then we can lose employee engagement, which can cause employees to lose the desire to innovate, foster teamwork and strive to delight our customers. Ultimately, we believe that the delivery of exceptional service to our customers by our employees is what produces customer "promoters" and fuels our growth aspirations. Therefore, if the corporate culture is not maintained, it could negatively impact our future operating results.
 
If we are unable to manage our growth effectively, our financial results could suffer.
 
The growth of our business and our service offerings could 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:
 
▪
A reduction in the demand for our services due to economic factors in the U.S., as well as the U.K. and European Union;
▪
Our inability to market our services in a cost-effective manner to new customers;
▪
The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;
▪
Our inability to successfully communicate the benefits of our services to businesses;
▪
The decision of businesses to host internally or in colocation facilities as an alternative to the use of our services;
▪
Our inability to penetrate international markets;
▪
Our inability to provide compelling services or effectively market them to existing customers;
▪
Our inability to strengthen awareness of our brand; and
▪
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 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 the next 20 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 have identified a material weakness in our internal control over financial reporting which could, if not remediated, result in material misstatements in our financial statements.

Although we have concluded that our consolidated financial statements as of December 31, 2013 present fairly, in all material respects, the financial position, results of operations and cash flow of our company and its subsidiaries in conformity with generally accepted accounting principles, we have identified a material weakness in internal control over financial reporting related to the controls around our accounting review of complex real estate development and lease arrangements. Under standards established by the Public Company Accounting Oversight Board, a material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected and corrected on a timely basis. See Item 9A, "Controls and Procedures."

We are initiating remedial measures, but if our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements, and we could be required to restate our financial results. In addition, if we are unable to successfully remediate this material weakness and if we are unable to produce accurate and timely financial statements, our stock price may be adversely affected and we may be unable to maintain compliance with applicable stock exchange listing requirements.

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 the lease of data center space, equipment, maintenance and other services, the third party could fail to live up to the contractual obligations under those agreements. For example, a data center landlord may fail to adequately maintain its facilities or provide an appropriate data center infrastructure for which it is responsible. If that were to happen, we would not likely be able to deliver the services to our customers that we have agreed to provide according to our standards or at all. Additionally, if the third parties that we rely on do fail to deliver on their obligations, our customers may lose confidence in our company, which would make it likely that we would not able to retain those customers, and therefore negatively impede our growth and financial results.
 
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 operations 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.
 

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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. 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.
 
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.
 
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 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. 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 received the initial installment of $5 million from the State of Texas in September 2007, and, after achieving the Job Target, we received the remaining $3.5 million in March 2012. These amounts were recorded as non-current liabilities. 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 have met the required employment level of the second tranche and requested the related $5.5 million of funding in January 2014. 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. 


- 22 -

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.

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.
 
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 and, if those amounts owed at the time of the default are substantial, the repayment could materially and adversely affect our liquidity and business. As of December 31, 2013, there was no outstanding indebtedness under our credit facility other than immaterial outstanding letters of credit.
 
We also have substantial equipment and other lease obligations. The principal balance of these capital lease obligations totaled approximately $62.9 million as of December 31, 2013. The payment obligations under the equipment leases are generally 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.


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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 2013, we expensed approximately $26.9 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, 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, 2013, we did not have exposure to interest rate risk as there was no amount outstanding on our revolving credit facility.

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.
 

- 24 -

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.


- 25 -

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.

Our referral and reseller partners provide revenue to our business, and we benefit from our association with them. The loss of these participants could adversely affect our business.
 
Our referral and reseller partners drive revenue to our business. Most of these partners offer services that are complementary to our services; however, some 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.
 

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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 potential post-acquisition loss of personnel acquired through an acquisition;
▪
The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;
▪
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.

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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, operating results that do not meet the market analyst expectations, 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. For example, between December 31, 2012 and December 31, 2013, the closing trading price of our common stock was very volatile, ranging between $33.19 and $79.24 per share, including single-day increases of up to 8.2% and declines up to 24.7%. 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.
 
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.
  
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.

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.
 

- 28 -

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 700 thousand square feet of office space and will continue to remodel the formerly vacant facility as needed to facilitate our future growth and office requirements. In addition to our corporate headquarters, we have office locations throughout the U.S., the U.K., the Netherlands, Hong Kong, Switzerland and Australia. As of December 31, 2013, we utilized approximately 1.0 million square feet of leased office space for customer service, operations, sales, corporate and administrative functions.

Data Centers

As of December 31, 2013, we leased data centers located in the U.S. (in Texas, Virginia, and Illinois), the U.K., Hong Kong and Australia. At December 31, 2013, we were utilizing 27 Megawatts of power at our data centers and had 60 Megawatts of power under contract.

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.


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ITEM 3 – LEGAL PROCEEDINGS
 
We are party to various legal and administrative proceedings, which we consider routine and incidental to our business. In addition, we are involved in the following legal proceedings:

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 alleged 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. This matter has been settled as of February 19, 2014.

On May 29, 2012, Clouding IP, LLC filed a complaint against us in the United States District Court for the District of Delaware. The complaint alleges, among other things, infringement of the following nine patents: U.S. Patent No. 7,596,784 purporting to cover a “Method System and Apparatus for Providing Pay-Per-Use Distributed Computing Resources;” U.S. Patent No. 7,065,637 purporting to cover a “System for Configuration of Dynamic Computing Environments Using a Visual Interface;” U.S. Patent No. 6,738,799 purporting to cover a “Methods and Apparatuses for File Synchronization and Updating Using a Signature List;” U.S. Patent No. 5,495,607 purporting to cover a “Network Management System Having Virtual Catalog Overview of Files Disruptively Stored Across Network Domain;” U.S. Patent No. 6,925,481 purporting to cover a “Technique for Enabling Remote Data Access and Manipulation from a Pervasive Device;” U.S. Patent No. 7,254,621 purporting to cover a “Technique for Enabling Remote Data Access and Manipulation from a Pervasive Device;” U.S. Patent No. 6,963,908 purporting to cover a “System for Transferring Customized Hardware and Software Settings from One Computer to Another Computer to Provide Personalized Operating Environments;" U.S. Patent No. 6,631,449 purporting to cover a “Dynamic Distributed Data System and Method;” and U.S. Patent No. 6,918,014 purporting to cover a “Dynamic Distributed Data System and Method.” The plaintiff seeks monetary damages and costs. We dispute the allegations of wrongdoing and intend to vigorously defend ourselves in this matter.

On September 17, 2012, PersonalWeb Technologies LLC and Level 3 Communications, LLC filed a complaint against us in the United States District Court for the Eastern District of Texas. The complaint alleges, among other things, infringement of the following nine patents: U.S. Patent No. 5,978,791 purporting to cover “Data Processing System Using Substantially Unique Identifiers to Identify Data Items, Whereby Data Items Have the Same Identifiers;” U.S Patent No. 6,415,280 purporting to cover “Identifying and Requesting Data in Network Using Identifiers Which Are Based On Contents of Data;” U.S. Patent No. 6,928,442 purporting to cover “Enforcement and Policing of Licensed Content Using Content-based Identifiers;” U.S. Patent No. 7,802,310 purporting to cover “Controlling Access to Data in a Data Processing System;” U.S. Patent No. 7,945,539 purporting to cover “Distributing and Accessing Data in a Data Processing System;” U.S. Patent No. 7,945,544 purporting to cover “Similarity-Based Access Control of Data in a Data Processing System;” U.S. Patent No. 7,949,662 purporting to cover “De-duplication of Data in a Data Processing System;” U.S. Patent No. 8,001,096 purporting to cover “Computer File System Using Content-Dependent File Identifiers;” and U.S. Patent No. 8,099,420 purporting to cover “Accessing Data in a Data Processing System.” Plaintiff PersonalWeb Technologies seeks injunctive relief, monetary damages, costs, and attorney's fees. We dispute the allegations of wrongdoing and intend to vigorously defend ourselves in this matter.

On February 25, 2013, Rotatable Technologies LLC filed a complaint against us in the United States District Court for the Eastern District of Texas. The complaint alleges, among other things, infringement of U.S. Patent No. 6,326,978 purporting to cover “Display Method for Selectively Rotating Windows on a Computer Display.” The plaintiff seeks injunctive relief, monetary damages, costs, and attorney's fees. We dispute the allegations of wrongdoing and intend to vigorously defend ourselves in this matter.

On March 18, 2013, Parallel Iron, LLC filed a complaint against us in the United States District Court for the District of Delaware. The complaint alleged, among other things, infringement of the following three patents: U.S Patent No. 7,197,662, U.S. Patent 7,958,388, and U.S. Patent No. 7,543,177, purporting to cover “Methods and Systems for a Storage System.” On January 13, 2014, the matter was dismissed with prejudice.

We cannot predict the impact, if any, that any of the matters described above may have on our business, results of operations, financial position, or cash flows, except as otherwise indicated. Because of the inherent uncertainties of such matters, including the early stage and lack of specific damage claims in many of them, we cannot estimate the range of possible losses from them.

ITEM 4 – MINE SAFETY DISCLOSURES
 
Not applicable.

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

Fiscal Year 2013 Quarters:
 
High
 
Low
First Quarter
 
$
79.24

 
$
49.74

Second Quarter
 
$
52.24

 
$
34.46

Third Quarter
 
$
53.85

 
$
38.08

Fourth Quarter
 
$
53.50

 
$
33.19


Fiscal Year 2012 Quarters:
 
High
 
Low
First Quarter
 
$
58.64

 
$
41.66

Second Quarter
 
$
59.04

 
$
41.30

Third Quarter
 
$
66.65

 
$
41.22

Fourth Quarter
 
$
74.27

 
$
60.48


The last reported sale price for our common stock on the New York Stock Exchange was $74.27, $39.13 and $38.00 per share on December 31, 2012, December 31, 2013, and February 27, 2014, 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 27, 2014, there were 173 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."

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Stock Performance Graph

The graph set forth below compares the five-year cumulative total stockholder return on our common stock between December 31, 2008 and December 31, 2013 with the cumulative total return of (i) the Russell 1000 Index and (ii) the Nasdaq Internet Total Return Index over the same period. This graph assumes the investment of $100 on December 31, 2008 in our common stock, the Russell 1000 Index and the Nasdaq Internet Total Return Index and assumes the reinvestment of dividends, if any. The Russell 1000 Index, of which Rackspace is a member, measures the performance of the large-cap segment of U.S. equities. 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

In connection with an acquisition, on October 21, 2013 we issued an aggregate total of 7,084 shares of our common stock to a stockholder of the acquired company in partial consideration of his ownership of this company. Pursuant to the Agreement and Plan of Merger relating to this acquisition, a portion of the consideration payable to the stockholder in connection with our acquisition of this company was divided by a trailing average closing stock price to determine the number of restricted shares of our common stock that would be issued to the stockholder. The issuance of these shares of common stock was made in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933. The foregoing transaction did not involve any underwriters, underwriting discounts or commissions. Stock certificates issued in the foregoing transaction bear appropriate Securities Act legends as to the restricted nature of such securities.

- 32 -

ITEM 6 - SELECTED FINANCIAL DATA

The following selected financial data has been derived from the audited consolidated financial statements of the company and should be read in conjunction with those statements and the notes thereto, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this document. Historical results are not necessarily indicative of future results.

The statement of comprehensive income data for the fiscal years ended December 31, 2011, 2012 and 2013 and the balance sheet data as of December 31, 2012 and 2013 have been derived from our audited consolidated financial statements, which are included elsewhere in this document. The statement of comprehensive income data for the years ended December 31, 2009 and 2010 and the balance sheet data as of December 31, 2009, 2010 and 2011 have been derived from our audited consolidated financial statements, which are not included in this document.
 
 
Year Ended December 31,
(In thousands, except per share data)
2009
 
2010
 
2011
 
2012
 
2013
Statement of comprehensive income data
 
 
 
 
 
 
 
 
 
Net revenue
$
628,987

 
$
780,555

 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

Income from operations
$
55,241

 
$
79,602

 
$
123,471

 
$
172,741

 
$
133,136

Net income
$
30,218

 
$
46,358

 
$
76,411

 
$
105,418

 
$
86,737

 
 
 
 
 
 
 
 
 
 
Net income per share (1)
 
 
 
 
 
 
 
 
 
Basic
$
0.25

 
$
0.37

 
$
0.59

 
$
0.78

 
$
0.63

Diluted
$
0.24

 
$
0.35

 
$
0.55

 
$
0.75

 
$
0.61

 
 
 
 
 
 
 
 
 
 
Balance sheet data
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
125,425

 
$
104,941

 
$
159,856

 
$
292,061

 
$
259,733

Total assets
$
668,645

 
$
761,577

 
$
1,026,482

 
$
1,295,551

 
$
1,491,797

Long-term obligations
$
161,024

 
$
133,572

 
$
189,310

 
$
196,465

 
$
177,877


(1) 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.

- 33 -

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

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

Overview of our Business

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

We sell our services to small and medium-sized businesses, as well as large enterprises. During 2013, more than 25% of our net revenue was generated by our operations outside of the U.S., primarily from the U.K. Additionally, we have operations in Hong Kong and in Australia. Our growth strategy includes, among other strategies, targeting international customers as we plan to continue our expansion in continental Europe, the Asia-Pacific region and Latin America.

How We Earn Revenue

Our dedicated cloud (also referred to as managed hosting) IT services are based upon a subscription-based business model and generate the majority of our revenue. Our customers pay us a recurring fee based on the capacity and complexity of the IT systems we manage and the level of service intensity we provide, pursuant to service agreements that typically provide for monthly payments. Our public cloud service offers pay-as-you go services that are earned and recognized as recurring revenue as the services are provided. Revenue is reduced by credits issued to customers, primarily for service issues.

Company Highlights and Developments

Growth of Our Business

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

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

•
In 2013, we continued our hybrid cloud product and platform transition, which began with a strategic decision to adopt an open source solution to power our public cloud. This involved deploying significant resources to develop and implement the cloud products that comprise the key elements of the OpenStack platform, and then continued through the actual roll-out of the new platform.

•
Competition also impacted our growth rate in 2013. Our industry includes competitors that have greater financial, technical, and marketing resources, larger customer bases, longer operating histories, greater brand recognition, more established relationships in the industry, and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities. In some cases, we have adopted new pricing strategies that included lowering price points for cloud products to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our cloud products to certain significant cloud customers


- 34 -

•
Our net revenue is denominated in U.S. dollars as well as other foreign currencies, including the pound sterling, the euro, and the Hong Kong dollar. Changes in related currency exchange rates may affect our net revenue. The exchange rate between the U.S. dollar and pound sterling has the greatest impact on our revenue. In 2013, the weakening of the pound sterling against the U.S. dollar had an unfavorable impact on revenue of approximately $5 million.

Consistent with our goal to re-accelerate revenue growth and in order to take advantage of the long-term continued growth opportunities in the market, we have been making increased infrastructure investments to complement and leverage Fanatical Support, our principal differentiation from our competitors across our multiple service offerings. Our cloud computing services provide customers with a mission-critical service and world class support, and we believe this provides us with substantial growth opportunities. We believe that by offering a higher service level agreement and extending our support to new open-source technology platforms, our business becomes more capital efficient and our competitive advantage widens as our service capability increases. In 2014, we expect to continue making these investments in research and development, data centers, corporate facilities, information technology infrastructure, and employees.

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

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

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

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

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

Other Developments

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

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

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

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

Nature of Our Operating Expenses

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


- 35 -

Employee-related costs have historically been the primary driver of our operating expenses, and we expect this to continue. Employee-related costs include items such as wages, commissions, non-equity incentive compensation, earned time off, benefits, and share-based compensation. Employee non-equity incentive compensation through our current non-equity incentive plan is dependent upon net revenue growth in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense. Additionally, the Compensation Committee has the discretion to modify a payout under the plan at any time in the event that it determines that circumstances warrant adjustment or to pay bonuses outside of the plan. Previously, the metric by which we determined a payout under the bonus plan was net income, which was oriented towards cost management and profit.

We had 4,852 and 5,651 employees as of December 31, 2012 and 2013, respectively. The year-over-year increase was primarily attributable to increases in our customer and data center support teams, as well as an increase in product development positions involved in the development of internal-use software. Our headcount is expected to increase in 2014 as our business continues to grow.

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

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

Sales and marketing activities are directed toward both the acquisition of new customers and increasing our business with existing customers. We pay commissions to our sales representatives generally upon execution of a service agreement. Sales and marketing expense also includes compensation to our channel partners. Marketing expenditures are used to communicate the advantages of our services and to generate customer demand. Sales and marketing expenses are expected to increase slightly as a percentage of revenue as we focus on re-accelerating revenue growth.

General and administrative activities are comprised of employee-related costs, professional fees, general corporate costs and overhead. While we continue to invest in our administrative infrastructure and personnel to support our growth, our focus has been and continues to be on scaling general and administrative headcount additions. However in 2013 we made strategic hires of executives and incurred higher general and administrative costs related to developing and implementing new systems infrastructure to support the business.
 
Depreciation and amortization expense includes amortization of leasehold improvements associated with our data centers and corporate facilities, as well as depreciation of our data center infrastructure and equipment. Amortization expense is also comprised of the amortization of our customer-based intangible assets related to acquisitions, internally developed technology, and software licenses purchased from third-party vendors.

Our operating expenses are denominated in U.S. dollars as well as other foreign currencies, including the pound sterling, the euro, and the Hong Kong dollar. Changes in related currency exchange rates may affect our operating results. The decrease in operating expenses due to foreign currency fluctuations was approximately $3 million, or 1%, in 2013.

Capital Expenditures

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


- 36 -

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

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

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

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

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

Our data center infrastructure is built to accommodate future revenue growth. While we try to match the amount of capacity to customer demand, we consider appropriate lead times for these build-outs, which requires us to build capacity ahead of actual revenue growth. We also strive to align our investment in data center infrastructure with our revenue growth to keep utilization rates high. We measure our utilization rate as the power being consumed by all electrical equipment relative to the total available capacity in our data centers excluding portions of the data center that have not been placed on line. We pursue a modular build-out strategy within our data centers that expands the operational footprint when needed. From time to time, we will be required to make significant investments in new data centers or enter into long-term facility leases to support expected growth beyond our ability to build out additional modules in existing facilities. Our strategy of entering into operating lease agreements for data center space reduces the capital investments required to increase our data center capacity.

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

Disciplined Use of Capital and Management of Profitability

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

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

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

Key Metrics

We carefully track several financial and operational metrics to monitor and manage our growth, financial performance, and capacity. Our key metrics are structured around growth, profitability, capital efficiency, infrastructure capacity, and utilization. The following data should be read in conjunction with the consolidated financial statements, the notes to the financial statements and other financial information included in this Annual Report on Form 10-K.

- 37 -

 
 
Year Ended December 31,
(Dollar amounts in thousands, except average monthly revenue per server)
 
2011
 
2012
 
2013
 
 
 
Growth
 
 
 
 
 
 
Dedicated cloud, net revenue
 
$
835,877

 
$
1,005,165

 
$
1,119,636

Public cloud, net revenue
 
$
189,187

 
$
304,074

 
$
415,150

Net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

Revenue growth (year over year)
 
31.3
 %
 
27.7
 %
 
17.2
 %
Net upgrades (monthly average)
 
1.9
 %
 
1.5
 %
 
1.3
 %
Churn (monthly average)
 
-0.9
 %
 
-0.8
 %
 
-0.8
 %
Growth in installed base (monthly average) (2)
 
1.0
 %
 
0.8
 %
 
0.5
 %
Number of employees (Rackers) at period end
 
4,040

 
4,852

 
5,651

Number of servers deployed at period end
 
79,805

 
90,524

 
103,886

Average monthly revenue per server
 
$
1,157

 
$
1,278

 
$
1,307

Profitability
 
 
 
 
 
 
Income from operations
 
$
123,471

 
$
172,741

 
$
133,136

Depreciation and amortization
 
$
195,412

 
$
249,845

 
$
313,007

Share-based compensation expense:
 
 
 
 
 
 
Cost of revenue
 
$
7,482

 
$
9,592

 
$
12,584

Research and development
 
$
2,975

 
$
4,856

 
$
8,168

Sales and marketing
 
$
2,408

 
$
6,379

 
$
7,317

General and administrative
 
$
15,908

 
$
20,719

 
$
31,576

Total share-based compensation expense
 
$
28,773

 
$
41,546

 
$
59,645

Adjusted EBITDA (1)
 
$
347,656

 
$
464,132

 
$
505,788

Adjusted EBITDA margin
 
33.9
 %
 
35.5
 %
 
33.0
 %
Operating income margin
 
12.0
 %
 
13.2
 %
 
8.7
 %
Income from operations
 
$
123,471

 
$
172,741

 
$
133,136

Effective tax rate
 
34.4
 %
 
37.3
 %
 
33.7
 %
Net operating profit after tax (NOPAT) (1)
 
$
80,997

 
$
108,309

 
$
88,269

NOPAT margin
 
7.9
 %
 
8.3
 %
 
5.8
 %
Capital efficiency and returns
 
 
 
 
 
 
Interest bearing debt
 
$
139,126

 
$
125,372

 
$
64,918

Stockholders' equity
 
$
599,423

 
$
843,647

 
$
1,055,412

Less: Excess cash
 
$
(125,865
)
 
$
(249,712
)
 
$
(210,761
)
Capital base
 
$
612,684

 
$
719,307

 
$
909,569

Average capital base
 
$
552,328

 
$
679,125

 
$
804,173

Capital turnover
 
1.86

 
1.93

 
1.91

Return on capital (1)
 
14.7
 %
 
15.9
 %
 
11.0
 %
Capital expenditures
 
 
 
 
 
 
Cash purchases of property and equipment
 
$
251,214

 
$
270,374

 
$
452,596

Non-cash purchases of property and equipment (3)
 
$
93,680

 
$
67,308

 
$
19,493

Total capital expenditures
 
$
344,894

 
$
337,682

 
$
472,089

Customer gear
 
$
196,096

 
$
217,870

 
$
297,787

Data center build outs
 
$
49,947

 
$
26,293

 
$
58,278

Office build outs
 
$
35,752

 
$
14,382

 
$
31,103

Capitalized software and other projects
 
$
63,099

 
$
79,137

 
$
84,921

Total capital expenditures
 
$
344,894

 
$
337,682

 
$
472,089

Infrastructure capacity and utilization
 
 
 
 
 
 
Megawatts under contract at period end
 
48.1

 
61.1

 
60.0

Megawatts available for use at period end
 
30.7

 
36.9

 
46.9

Megawatts utilized at period end
 
20.9

 
24.0

 
27.4

Net revenue per average Megawatt of power utilized
 
$
54,065

 
$
58,188

 
$
59,442


(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.
(2) Due to rounding, totals may not equal the sum of the line items in the table above.
(3) Non-cash purchases of property and equipment represents changes in amounts accrued for purchases under vendor financing and other deferred payment arrangements.


- 38 -

Results of Operations

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

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

Consolidated Statements of Income:
 
 
Year Ended December 31,
(In thousands)
 
2011
 
2012
 
2013
Net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
346,341

 
419,013

 
492,493

Research and development
 
33,709

 
56,736

 
90,213

Sales and marketing
 
131,174

 
166,172

 
208,417

General and administrative
 
194,957

 
244,732

 
297,520

Depreciation and amortization
 
195,412

 
249,845

 
313,007

Total costs and expenses
 
901,593

 
1,136,498

 
1,401,650

Income from operations
 
123,471

 
172,741

 
133,136

Other income (expense):
 
 
 
 
 
 
Interest expense
 
(5,848
)
 
(4,749
)
 
(3,118
)
Interest and other income (expense)
 
(1,194
)
 
15

 
741

Total other income (expense)
 
(7,042
)
 
(4,734
)
 
(2,377
)
Income before income taxes
 
116,429

 
168,007

 
130,759

Income taxes
 
40,018

 
62,589

 
44,022

Net income
 
$
76,411

 
$
105,418

 
$
86,737

 
Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
Year Ended December 31,
(Percent of net revenue)
 
2011
 
2012
 
2013
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
33.8
 %
 
32.0
 %
 
32.1
 %
Research and development
 
3.3
 %
 
4.3
 %
 
5.9
 %
Sales and marketing
 
12.8
 %
 
12.7
 %
 
13.6
 %
General and administrative
 
19.0
 %
 
18.7
 %
 
19.4
 %
Depreciation and amortization
 
19.1
 %
 
19.1
 %
 
20.4
 %
Total costs and expenses
 
88.0
 %
 
86.8
 %
 
91.3
 %
Income from operations
 
12.0
 %
 
13.2
 %
 
8.7
 %
Other income (expense):
 
 
 
 
 
 
Interest expense
 
(0.6
)%
 
(0.4
)%
 
(0.2
)%
Interest and other income (expense)
 
(0.1
)%
 
0.0
 %
 
0.0
 %
Total other income (expense)
 
(0.7
)%
 
(0.4
)%
 
(0.2
)%
Income before income taxes
 
11.4
 %
 
12.8
 %
 
8.5
 %
Income taxes
 
3.9
 %
 
4.8
 %
 
2.9
 %
Net income
 
7.5
 %
 
8.1
 %
 
5.7
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

- 39 -

Years ended December 31, 2012 and 2013

Net Revenue

Our net revenue was $1.3 billion during 2012 and $1.5 billion during 2013, an increase of $226 million, or 17%. The increase in net revenue was primarily due to both an increasing number of new customers and incremental services rendered to existing customers, as well as a broader suite of cloud computing services acquired through acquisitions and research and development activities. Year-over-year revenue increases were 11% for our dedicated cloud service and 37% for our public cloud service. Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the functional currencies of our foreign operations in 2013 compared to 2012. Net revenue for 2013 would have been approximately $5 million higher had foreign exchange rates remained constant from the prior year, with 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.

We use a metric called “installed base growth” to measure revenue growth derived only from our existing customer base. During 2013, our monthly average churn rate was 0.8%, compared to 0.8% in 2012. Overall, our installed base grew at a monthly average rate of 0.5% in 2013, compared to 0.8% in 2012.

Our revenue growth rate decelerated year-over-year on a quarterly basis during 2013 from 20% in the first quarter to 16% in the fourth quarter. A number of items have accounted for the growth rate deceleration with varying magnitude throughout the year, including our ongoing public cloud platform transition and competition.

Cost of Revenue

Cost of revenue increased $73 million, or 17%, from $419 million during 2012 to $492 million during 2013. Of this increase, $32 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits, and to a lesser extent, increases in share-based compensation. These increases are primarily due to additional headcount and salary increases. The cost increase was further attributable to an increase in license costs of $10 million and an increase in data center costs of $36 million, mostly related to rent, maintenance and utilities, partially offset by a decrease in consulting fees of $3 million. The remaining variance was due to small changes in other cost of revenue expenses.

Research and Development Expenses

Research and development expenses increased $33 million, or 58%, from $57 million during 2012 to $90 million during 2013. Of this increase, $29 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits and, to a lesser extent, increases in non-equity incentive compensation and share-based compensation expense. These increases are primarily due to additional headcount and salary increases. The remaining increase of $4 million was primarily attributable to increases in professional fees, travel costs, and internal software support and maintenance. Research and development costs increased as a percentage of net revenue, from 4.3% in 2012 to 5.9% in 2013, primarily due to employee-related expenses increasing at a faster rate than revenue.

Sales and Marketing Expenses

Sales and marketing expenses increased $42 million, or 25%, from $166 million during 2012 to $208 million during 2013. Of this increase, $22 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits and, to a lesser extent, increases in commissions, non-equity incentive compensation and share-based compensation. Total compensation increased primarily as a result of salary increases and the hiring of additional sales and marketing personnel. Marketing program expenses increased $14 million partially related to our open cloud branding campaign during the first half of the year. The cost increase was further attributable to an increase in travel costs of $2 million. The remaining variance was due to small changes in other sales and marketing expenses.


- 40 -

General and Administrative Expenses

General and administrative expenses increased $53 million, or 22%, from $245 million during 2012 to $298 million during 2013. Of this increase, $32 million was attributable to employee-related expenses primarily due to increases in salaries and benefits and share-based compensation expense. The increase in employee-related expenses is due to a 6% increase in average headcount, including strategic hires to support the growth of the business, as well as salary increases and new equity grants. Professional fees increased $11 million primarily as a result of legal expenses and strategic consulting. The remaining variance was due to small changes in other general and administrative expenses as we invest in the infrastructure to support the business.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $63 million, or 25%, from $250 million during 2012 to $313 million during 2013. This increase was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build-outs and internally developed and purchased software. Depreciation and amortization expenses increased as a percentage of net revenue, from 19.1% in 2012 to 20.4% in 2013, as a result of the increase in the balance of property and equipment.

Income Taxes

Our effective tax rate decreased from 37.3% in 2012 to 33.7% in 2013. 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, tax 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 13 – Taxes.”

Years ended December 31, 2011 and 2012

Net Revenue

Net revenue increased $284 million, or 28%, from $1.0 billion during 2011 to $1.3 billion during 2012. The increase in net revenue was primarily due to both an increasing number of new customers and incremental services rendered to existing customers. Year-over-year revenue increases were 20% for our Dedicated Cloud service and 61% for our Public Cloud service. Revenue increased 27% in the U.S. and 30% in the rest of the world. Revenue is attributed to geographic location based on the operating location that enters into the contractual relationship with the customer. Partially offsetting the revenue increase outside the U.S. was the negative impact of a stronger U.S. dollar relative to the functional currencies of our foreign operations in 2012 compared to 2011. Net revenue for 2012 would have been approximately $3 million higher had foreign exchange rates remained constant from the prior year, with 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.

During 2012, our monthly average churn rate was 0.8%, compared to 0.9% in 2011. Overall, our installed base grew at a monthly average rate of 0.8% in 2012, compared to 1.0% in 2011.

Our annual revenue growth was 28% for 2012. Our revenue growth rate decelerated year-over-year on a quarterly basis during 2012 from 31% in the first quarter to 25% in the fourth quarter. A number of items accounted for the growth rate deceleration with varying magnitude throughout the year, including without limitation, our public cloud platform transition, competition, and foreign exchange.


- 41 -

Cost of Revenue

Cost of revenue increased $73 million, or 21%, from $346 million during 2011 to $419 million during 2012. Of this increase, $33 million was attributable to employee-related expenses primarily due to an increase in salaries and benefits resulting from additional headcount and salary increases. The cost increase was further attributable to an increase in data center costs of $17 million, mostly related to rent, maintenance and bandwidth, and an increase in license costs of $17 million. The remaining increase was due to small changes in other cost of revenue expenses, including an increase in outsourced services of $1.0 million and an increase in internal software support and maintenance of $1.0 million. Cost of revenue decreased as a percentage of sales primarily due to payroll expenses increasing at a slower rate than revenue.

Research and Development Expenses

Research and development expenses increased $23 million, or 68%, from $34 million during 2011 to $57 million during 2012. Of this increase, $21 million was attributable to employee-related expenses due primarily to an increase in salaries and benefits and, to a lesser extent, increases in non-equity incentive compensation, share-based compensation expense, and contract labor costs. These increases are primarily due to additional headcount and salary increases. The remaining increase was due to small changes in other research and development expenses.

Sales and Marketing Expenses

Sales and marketing expenses increased $35 million, or 27%, from $131 million during 2011 to $166 million during 2012. Of this increase, $25 million was attributable to employee-related expenses due primarily to an increase in salaries and benefits, and to a lesser extent, increases in non-equity incentive compensation and share-based compensation. Commissions slightly decreased. Total compensation increased primarily as a result of salary increases and the hiring of additional sales and marketing personnel. Advertising and Internet-related marketing expenditures increased $7 million. The cost increase was further attributable to an increase of $2 million in travel and entertainment expenses. The remaining variance was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

General and administrative expenses increased $50 million, or 26%, from $195 million during 2011 to $245 million during 2012. Of this increase, $35 million was attributable to employee-related expenses due primarily to an increase in salaries and benefits, and to a lesser extent, an increase in share-based compensation. These increases are primarily due to additional headcount and equity awards granted in 2012. Professional fees increased $2 million primarily as a result of increased legal costs and consulting expenses. Additionally, office expenses including rent and maintenance increased $5 million, internal software support and maintenance increased $4 million, and merchant credit card fees increased $3 million. The remaining variance was due to small changes in other general and administrative expenses.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $55 million, or 28%, from $195 million during 2011 to $250 million during 2012. This increase was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build-outs and internally developed and purchased software.

Income Taxes

Our effective tax rate increased from 34.4% in 2011 to 37.3% in 2012. 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, tax 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 13 – Taxes.”


- 42 -

Quarterly Key Metrics and Results of Operations

The following tables set forth our unaudited quarterly key metrics and condensed consolidated statements of income data in dollars and as a percentage of revenue for each of our most recent five quarters as of the period ended December 31, 2013. 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.

- 43 -


 
 
 
Three Months Ended
 
(Dollar amounts in thousands, except average monthly revenue per server)
 
December 31,
2012
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
 
 
Growth
 
 
 
 
 
 
 
 
 
 
 
Dedicated cloud, net revenue
 
$
265,585

 
$
271,311

 
$
276,845

 
$
280,215

 
$
291,265

 
Public cloud, net revenue
 
$
87,324

 
$
90,889

 
$
99,002

 
$
108,421

 
$
116,838

 
Net revenue
 
$
352,909

 
$
362,200

 
$
375,847

 
$
388,636

 
$
408,103

 
Revenue growth (year over year)
 
24.6
 %
 
20.2
 %
 
17.8
 %
 
15.7
 %
 
15.6
 %
 
Net upgrades (monthly average)
 
1.2
 %
 
0.9
 %
 
1.5
 %
 
1.5
 %
 
1.1
 %
 
Churn (monthly average)
 
-0.7
 %
 
-0.8
 %
 
-0.8
 %
 
-0.8
 %
 
-0.7
 %
 
Growth in installed base (monthly average) (2)
 
0.5
 %
 
0.1
 %
 
0.7
 %
 
0.7
 %
 
0.4
 %
 
Number of employees (Rackers) at period end
 
4,852

 
5,043

 
5,272

 
5,450

 
5,651

 
Number of servers deployed at period end
 
90,524

 
94,122

 
98,884

 
101,967

 
103,886

 
Average monthly revenue per server
 
$
1,310

 
$
1,308

 
$
1,298

 
$
1,290

 
$
1,322

 
Profitability
 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
49,623

 
$
42,813

 
$
35,404

 
$
27,762

 
$
27,157

 
Depreciation and amortization
 
$
68,914

 
$
70,111

 
$
74,460

 
$
80,753

 
$
87,683

 
Share-based compensation expense:
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
$
2,759

 
$
2,519

 
$
2,735

 
$
3,453

 
$
3,877

 
Research and development
 
$
1,237

 
$
1,528

 
$
1,813

 
$
2,306

 
$
2,521

 
Sales and marketing
 
$
1,764

 
$
1,658

 
$
1,744

 
$
2,149

 
$
1,766

 
General and administrative
 
$
5,484

 
$
6,478

 
$
7,023

 
$
9,051

 
$
9,024

 
Total share-based compensation expense
 
$
11,244

 
$
12,183

 
$
13,315

 
$
16,959

 
$
17,188

 
Adjusted EBITDA (1)
 
$
129,781

 
$
125,107

 
$
123,179

 
$
125,474

 
$
132,028

 
Adjusted EBITDA margin
 
36.8
 %
 
34.5
 %
 
32.8
 %
 
32.3
 %
 
32.4
 %
 
Operating income margin
 
14.1
 %
 
11.8
 %
 
9.4
 %
 
7.1
 %
 
6.7
 %
 
Income from operations
 
$
49,623

 
$
42,813

 
$
35,404

 
$
27,762

 
$
27,157

 
Effective tax rate
 
38.8
 %
 
35.2
 %
 
34.7
 %
 
40.7
 %
 
22.7
 %
 
Net operating profit after tax (NOPAT) (1)
 
$
30,369

 
$
27,743

 
$
23,119

 
$
16,463

 
$
20,992

 
NOPAT margin
 
8.6
 %
 
7.7
 %
 
6.2
 %
 
4.2
 %
 
5.1
 %
 
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
 
Interest bearing debt
 
$
125,372

 
$
105,807

 
$
88,434

 
$
72,579

 
$
64,918

 
Stockholders' equity
 
$
843,647

 
$
879,035

 
$
933,897

 
$
988,708

 
$
1,055,412

 
Less: Excess cash
 
$
(249,712
)
 
$
(235,163
)
 
$
(217,950
)
 
$
(223,359
)
 
$
(210,761
)
 
Capital base
 
$
719,307

 
$
749,679

 
$
804,381

 
$
837,928

 
$
909,569

 
Average capital base
 
$
717,010

 
$
734,493

 
$
777,030

 
$
821,155

 
$
873,749

 
Capital turnover (annualized)
 
1.97

 
1.97

 
1.93

 
1.89

 
1.87

 
Return on capital (annualized) (1)
 
16.9
 %
 
15.1
 %
 
11.9
 %
 
8.0
 %
 
9.6
 %
 
Capital expenditures
 
 
 
 
 
 
 
 
 
 
 
Cash purchases of property and equipment
 
$
82,919

 
$
105,541

 
$
119,836

 
$
100,496

 
$
126,723

 
Non-cash purchases of property and equipment (3)
 
$
5,096

 
$
19,858

 
$
(13,311
)
 
$
17,062

 
$
(4,116
)
 
Total capital expenditures
 
$
88,015

 
$
125,399

 
$
106,525

 
$
117,558

 
$
122,607

 
Customer gear
 
$
60,099

 
$
85,690

 
$
73,022

 
$
73,784

 
$
65,291

 
Data center build outs
 
$
7,768

 
$
13,228

 
$
10,085

 
$
12,441

 
$
22,524

 
Office build outs
 
$
2,288

 
$
7,860

 
$
1,683

 
$
6,700

 
$
14,860

 
Capitalized software and other projects
 
$
17,860

 
$
18,621

 
$
21,735

 
$
24,633

 
$
19,932

 
Total capital expenditures
 
$
88,015

 
$
125,399

 
$
106,525

 
$
117,558

 
$
122,607

 
Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end
 
61.1

 
59.4

 
59.6

 
60.0

 
60.0

 
Megawatts available for use at period end
 
36.9

 
38.8

 
44.4

 
46.9

 
46.9

 
Megawatts utilized at period end
 
24.0

 
24.7

 
26.0

 
27.0

 
27.4

 
Annualized net revenue per average Megawatt of power utilized
 
$
59,437

 
$
59,499

 
$
59,305

 
$
58,662

 
$
60,015


(1) See discussion and reconciliation of our Non-GAAP financial measures to the most comparable GAAP measures.
(2) Due to rounding, totals may not equal the sum of the line items in the table above.
(3) Non-cash purchases of property and equipment represents changes in amounts accrued for purchases under vendor financing and other deferred payment arrangements.

- 44 -


Consolidated Statements of Income by Quarter (Unaudited):
 
 
Three Months Ended
(In thousands)
 
December 31,
2012
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
Net revenue
 
$
352,909

 
$
362,200

 
$
375,847

 
$
388,636

 
$
408,103

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
109,012

 
113,610

 
117,658

 
127,404

 
133,821

Research and development
 
16,942

 
18,375

 
23,216

 
23,773

 
24,849

Sales and marketing
 
43,467

 
49,814

 
52,269

 
50,869

 
55,465

General and administrative
 
64,951

 
67,477

 
72,840

 
78,075

 
79,128

Depreciation and amortization
 
68,914

 
70,111

 
74,460

 
80,753

 
87,683

Total costs and expenses
 
303,286

 
319,387

 
340,443

 
360,874

 
380,946

Income from operations
 
49,623

 
42,813

 
35,404

 
27,762

 
27,157

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(991
)
 
(940
)
 
(833
)
 
(689
)
 
(656
)
Interest and other income (expense)
 
245

 
199

 
(303
)
 
440

 
405

Total other income (expense)
 
(746
)
 
(741
)
 
(1,136
)
 
(249
)
 
(251
)
Income before income taxes
 
48,877

 
42,072

 
34,268

 
27,513

 
26,906

Income taxes (1)
 
18,970

 
14,811

 
11,901

 
11,202

 
6,108

Net income
 
$
29,907

 
$
27,261

 
$
22,367

 
$
16,311

 
$
20,798


Consolidated Statements of Income by Quarter, as a Percentage of Net Revenue (Unaudited):
 
 
Three Months Ended
(Percent of net revenue)
 
December 31,
2012
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
30.9
 %
 
31.4
 %
 
31.3
 %
 
32.8
 %
 
32.8
 %
Research and development
 
4.8
 %
 
5.1
 %
 
6.2
 %
 
6.1
 %
 
6.1
 %
Sales and marketing
 
12.3
 %
 
13.8
 %
 
13.9
 %
 
13.1
 %
 
13.6
 %
General and administrative
 
18.4
 %
 
18.6
 %
 
19.4
 %
 
20.1
 %
 
19.4
 %
Depreciation and amortization
 
19.5
 %
 
19.4
 %
 
19.8
 %
 
20.8
 %
 
21.5
 %
Total costs and expenses
 
85.9
 %
 
88.2
 %
 
90.6
 %
 
92.9
 %
 
93.3
 %
Income from operations
 
14.1
 %
 
11.8
 %
 
9.4
 %
 
7.1
 %
 
6.7
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.3
)%
 
(0.3
)%
 
(0.2
)%
 
(0.2
)%
 
(0.2
)%
Interest and other income (expense)
 
0.1
 %
 
0.1
 %
 
(0.1
)%
 
0.1
 %
 
0.1
 %
Total other income (expense)
 
(0.2
)%
 
(0.2
)%
 
(0.3
)%
 
(0.1
)%
 
(0.1
)%
Income before income taxes
 
13.8
 %
 
11.6
 %
 
9.1
 %
 
7.1
 %
 
6.6
 %
Income taxes (1)
 
5.4
 %
 
4.1
 %
 
3.2
 %
 
2.9
 %
 
1.5
 %
Net income
 
8.5
 %
 
7.5
 %
 
6.0
 %
 
4.2
 %
 
5.1
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

(1)
The Q4 2013 effective tax rate of 22.7% is significantly lower than previous quarters due to additional Federal and Texas tax credits for research and development expenditures. Recent interpretations of 2013 legislation in the state of Texas resulted in a more favorable position for the company to claim a research and development credit against the state margins (income) tax and accounted for the most significant portion of the decrease in income tax expense for Q4.


- 45 -

Liquidity and Capital Resources

At December 31, 2013, we held $260 million in cash and cash equivalents. We use our cash and cash equivalents, cash flow from operations, vendor-financed arrangements, and existing amounts available under our revolving credit facility as our primary sources of liquidity. We currently believe that current cash and cash equivalents, cash generated by operations, and available borrowings will be sufficient to meet our operating and capital needs in the foreseeable future.

Of our cash and cash equivalents at December 31, 2013, $71 million was held by our foreign subsidiaries. If repatriated, we must accrue and pay taxes on such funds; 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. As we expand our business on a global basis, we may transfer additional cash to our foreign entities.

We have vendor-financed 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, 2012 and 2013, we had $125 million and $65 million outstanding with respect to these arrangements. While we believe our borrowings from these arrangements will continue to be available, we have shifted our current strategy and have begun to pay cash for most of our equipment purchases rather than financing them through these arrangements.

Our revolving credit facility has a total commitment in the amount of $200 million and matures in September 2016. The facility further includes an accordion feature, which allows for an increase in the commitment to a total of $400 million under the same terms and conditions, subject to credit approval of the banking syndicate. 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, 2013, 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, 2013, there were no outstanding borrowings under the revolving credit facility.
 
Capital Expenditure Requirements

Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. Our money market mutual funds comply with SEC Rule 2a-7 and invest exclusively in high-quality, short-term obligations that include securities issued or guaranteed by the U.S. government or by U.S. government agencies and floating rate and variable rate demand notes of U.S. and foreign corporations. We actively monitor the third-party depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on the safety of principal, secondly on the liquidity of our investments, and finally on 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.
 
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.
 
The following table sets forth a summary of our cash flows for the periods indicated: 
 
 
Year Ended December 31,
(In thousands)
 
2011
 
2012
 
2013
Cash provided by operating activities
 
$
324,395

 
$
399,499

 
$
444,060

Cash used in investing activities
 
$
(251,998
)
 
$
(276,221
)
 
$
(464,224
)
Cash provided by (used in) financing activities
 
$
(17,190
)
 
$
7,455

 
$
(11,772
)
Non-cash purchases of property and equipment
 
$
93,680

 
$
67,308

 
$
19,493


- 46 -


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 $399 million in 2012 compared to $444 million in 2013, an increase of $45 million, or 11%. Net income decreased $18 million from $105 million in 2012 to $87 million in 2013. A summary of the significant changes in non-cash adjustments affecting net income is as follows:

•
Depreciation and amortization expense was $250 million in 2012 compared to $313 million in 2013. 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.
•
Share-based compensation expense was $42 million in 2012 compared to $60 million in 2013. The increase in expense was due to an increase in the fair value of equity awards granted in 2012 and 2013.
•
Excess tax benefits from share-based compensation arrangements created an operating cash outflow of $46 million in 2012 and $34 million in 2013. In accordance with the accounting guidance, Rackspace recognizes an excess tax benefit from the exercise of options to the extent that it will result in a reduction of our current tax payable.
The changes in certain assets and liabilities in 2013 resulted in a cash outflow of $6 million compared to a cash inflow of $34 million in 2012, primarily due to the timing of payments for trade payables and payroll-related expenses.

Net cash provided by operating activities was $324 million in 2011 compared to $399 million in 2012, an increase of $75 million or 23%. Net income increased $29 million from $76 million in 2011 to $105 million in 2012. During 2011 and 2012, we incurred depreciation and amortization charges in the amount of $195 million and $250 million, respectively. The increase in depreciation and amortization was due to the 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. The changes in certain assets and liabilities in 2012 resulted in a cash inflow of $34 million compared to a cash inflow of $13 million in 2011, primarily due to the timing of payments for trade payables and payroll-related expenses.

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; and capitalized payroll costs related to software development.
 
Our net cash used in investing activities was $276 million during 2012 compared to $464 million during 2013, an increase of $188 million, or 68%. The increase was primarily due to an increase in the purchase of property and equipment of $182 million and a $4 million increase related to cash paid for acquisitions. Also contributing to the increase was the impact of the shift in our strategy away from using capital leases to finance purchases of equipment, which occurred in the second half of 2012.
 
Our net cash used in investing activities was $252 million during 2011 compared to $276 million during 2012, an increase of $24 million, or 10%. The increase was primarily due to an increase in the purchase of property and equipment of$19 million and a $5 million increase related to cash paid for acquisitions. Although there was an increase in the purchase of property and equipment, total capital expenditures decreased because in 2012 we decreased the amount of purchases financed through capital lease arrangements as we shifted our strategy away from using capital leases. 


- 47 -

 Financing Activities
 
Net cash provided by financing activities was $7 million during 2012 compared to net cash used in financing activities of $12 million during 2013, a change of $19 million. The largest driver of this change was the decrease in proceeds from employee stock plans, which decreased from $41 million in 2012 to $24 million in 2013, as a result of lower employee stock option exercise activity. Additionally, the financing cash inflow from excess tax benefits from share-based compensation arrangements decreased from $46 million in 2012 to $34 million in 2013. These decreases in financing cash inflows were partially offset by the $10 million decrease in principal payments on capital leases resulting from the shift in strategy discussed above.

Net cash used in financing activities was $17 million during 2011 compared to net cash provided by financing activities of $7 million during 2012, a change of $24 million. The majority of this change was related to excess tax benefits from share-based compensation arrangements, which created a financing cash inflow of $21 million in 2011 and $46 million in 2012. The $10 million increase in principal payments on capital leases, from $66 million in 2011 to $76 million in 2012, was mostly offset by increased cash inflow related to other financing activities.

Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of December 31, 2013: 
(In thousands)
 
Total
 
2014
 
2015-2016
 
2017-2018
 
2019 and Beyond
Capital leases (1)
 
$
63,987

 
$
39,221

 
$
19,690

 
$
1,257

 
$
3,819

Operating leases
 
917,760

 
67,160

 
134,430

 
125,116

 
591,054

Purchase obligations
 
78,430

 
50,472

 
27,089

 
869

 
—

Notes payable (1)
 
2,030

 
1,905

 
125

 
—

 
—

Total contractual obligations
 
$
1,062,207

 
$
158,758

 
$
181,334

 
$
127,242

 
$
594,873

(1)
Represents principal and interest.

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

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.  

Notes Payable
 
We currently finance certain software and equipment from third-party vendors. The terms of these arrangements are up to three years.
 
Uncertain Tax Positions
 
We have excluded $23 million of uncertain tax positions from the table above as we are uncertain as to if or when such amounts will be recognized.



- 48 -

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, accrued compensation and benefits, and income and other taxes payable – deferred revenue – other non-current liabilities, deferred income taxes, and deferred rent).
 
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 Comprehensive 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 calculate directly from amounts on the Statement of Comprehensive Income and the Balance Sheet. 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 14.7% in 2011 to 15.9% in 2012 and decreased to 11.0% in 2013. The decrease in the current year is due to income from operations increasing at a slower pace than our average capital base over that time period. Return on assets increased from 8.5% in 2011 to 9.1% in 2012 and decreased to 6.2% in 2013. The decrease in the current year is due to net income increasing at a slower pace than our average asset balance.
 

- 49 -

See our reconciliation of the calculation of annual return on assets to ROC in the following table: 
 
 
Year Ended December 31,
(In thousands)
 
2011
 
2012
 
2013
Income from operations
 
$
123,471

 
$
172,741

 
$
133,136

Effective tax rate
 
34.4
%
 
37.3
%
 
33.7
%
Net operating profit after tax (NOPAT)
 
$
80,997

 
$
108,309

 
$
88,269

 
 
 
 
 
 
 
Net income
 
$
76,411

 
$
105,418

 
$
86,737

 
 
 
 
 
 
 
Total assets at period end
 
$
1,026,482

 
$
1,295,551

 
$
1,491,797

Less: Excess cash
 
(125,865
)
 
(249,712
)
 
(210,761
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(156,004
)
 
(175,128
)
 
(195,894
)
Less: Deferred revenue (current and non-current)
 
(18,281
)
 
(20,960
)
 
(26,530
)
Less: Other non-current liabilities, deferred income taxes, and deferred rent
 
(113,648
)
 
(130,444
)
 
(149,043
)
Capital base
 
$
612,684

 
$
719,307

 
$
909,569

 
 
 
 
 
 
 
Average total assets
 
$
895,545

 
$
1,158,384

 
$
1,393,079

Average capital base
 
$
552,328

 
$
679,125

 
$
804,173

 
 
 
 
 
 
 
Return on assets (Net income/Average total assets)
 
8.5
%
 
9.1
%
 
6.2
%
Return on capital (NOPAT/Average capital base)
 
14.7
%
 
15.9
%
 
11.0
%

See our reconciliation of the calculation of quarterly return on assets to ROC in the following table:
 
 
Three Months Ended
(In thousands)
 
December 31,
2012
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
Income from operations
 
$
49,623

 
$
42,813

 
$
35,404

 
$
27,762

 
$
27,157

Effective tax rate
 
38.8
%
 
35.2
%
 
34.7
%
 
40.7
%
 
22.7
%
Net operating profit after tax (NOPAT)
 
$
30,369

 
$
27,743

 
$
23,119

 
$
16,463

 
$
20,992

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
29,907

 
$
27,261

 
$
22,367

 
$
16,311

 
$
20,798

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,295,551

 
$
1,348,350

 
$
1,377,928

 
$
1,451,769

 
$
1,491,797

Less: Excess cash
 
(249,712
)
 
(235,163
)
 
(217,950
)
 
(223,359
)
 
(210,761
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(175,128
)
 
(197,686
)
 
(178,552
)
 
(213,268
)
 
(195,894
)
Less: Deferred revenue (current and non-current)
 
(20,960
)
 
(21,811
)
 
(22,636
)
 
(22,211
)
 
(26,530
)
Less: Other non-current liabilities, deferred income taxes, and deferred rent
 
(130,444
)
 
(144,011
)
 
(154,409
)
 
(155,003
)
 
(149,043
)
Capital base
 
$
719,307

 
$
749,679

 
$
804,381

 
$
837,928

 
$
909,569

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,268,658

 
$
1,321,951

 
$
1,363,139

 
$
1,414,849

 
$
1,471,783

Average capital base
 
$
717,010

 
$
734,493

 
$
777,030

 
$
821,155

 
$
873,749

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
9.4
%
 
8.2
%
 
6.6
%
 
4.6
%
 
5.7
%
Return on capital (annualized)
 
16.9
%
 
15.1
%
 
11.9
%
 
8.0
%
 
9.6
%


- 50 -

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 $42 million, or 9%, from $464 million in 2012 to $506 million in 2013. Adjusted EBITDA as a percentage of revenue decreased from 35.5% in 2012 to 33.0% in 2013. The primary driver of the decrease in Adjusted EBITDA margin was an increase in Research and Development expenses as a percentage of revenue, expenses related to our open cloud branding campaign during the first half of the year, and increased General and Administrative professional fees as a result of legal expenses and strategic consulting.

Income from operations has been unfavorably impacted by increases across each of the operating expense categories as a percentage of revenue. Our operating income margin decreased from 13.2% in 2012 to 8.7% in 2013.

See our annual Adjusted EBITDA reconciliation below: 
 
 
Year Ended December 31,
(Dollars in thousands)
 
2011
 
2012
 
2013
 
 
 
 
 
 
 
Net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

 
 
 
 
 
 
 
Income from operations
 
$
123,471

 
$
172,741

 
$
133,136

 
 
 
 
 
 
 
Net income
 
$
76,411

 
$
105,418

 
$
86,737

   Plus: Income taxes
 
40,018

 
62,589

 
44,022

   Plus: Total other (income) expense
 
7,042

 
4,734

 
2,377

   Plus: Depreciation and amortization
 
195,412

 
249,845

 
313,007

   Plus: Share-based compensation expense
 
28,773

 
41,546

 
59,645

Adjusted EBITDA
 
$
347,656

 
$
464,132

 
$
505,788

 
 
 
 
 
 
 
Operating income margin
 
12.0
%
 
13.2
%
 
8.7
%
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
33.9
%
 
35.5
%
 
33.0
%


- 51 -

See our quarterly Adjusted EBITDA reconciliation below:
 
 
Three Months Ended
(Dollars in thousands)
 
December 31,
2012
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
352,909

 
$
362,200

 
$
375,847

 
$
388,636

 
$
408,103

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
49,623

 
$
42,813

 
$
35,404

 
$
27,762

 
$
27,157

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
29,907

 
$
27,261

 
$
22,367

 
$
16,311

 
$
20,798

   Plus: Income taxes
 
18,970

 
14,811

 
11,901

 
11,202

 
6,108

   Plus: Total other (income) expense
 
746

 
741

 
1,136

 
249

 
251

   Plus: Depreciation and amortization
 
68,914

 
70,111

 
74,460

 
80,753

 
87,683

   Plus: Share-based compensation expense
 
11,244

 
12,183

 
13,315

 
16,959

 
17,188

Adjusted EBITDA
 
$
129,781

 
$
125,107

 
$
123,179

 
$
125,474

 
$
132,028

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
14.1
%
 
11.8
%
 
9.4
%
 
7.1
%
 
6.7
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
36.8
%
 
34.5
%
 
32.8
%
 
32.3
%
 
32.4
%

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 non-cash purchases of property and equipment), cash payments for interest, net, and cash payments for income taxes, net.
 
We believe that Adjusted Free Cash Flow is a performance metric used by investors to evaluate the strength and performance of a company's ongoing business. 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,
2013
Adjusted EBITDA
 
$
505,788

Non-cash deferred rent
 
11,564

Total capital expenditures
 
(472,089
)
Cash payments for interest, net
 
(3,096
)
Cash payments for income taxes, net
 
(14,930
)
Adjusted free cash flow
 
$
27,237

 

- 52 -

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. 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 material liabilities related to such indemnification obligations in our financial statements.

See Item 8 of Part II, "Financial Statements and Supplementary Data – Note 10 – Commitments and Contingencies" for more information related to these indemnification arrangements.

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 that require significant management judgment and estimates to be 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.
  
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 and hosting services to our customers and do not sell individual hardware and software products, we generally recognize revenue, including implementation and set-up fees, on a monthly basis, as services are delivered. For services that are billed according to customer usage, revenue is recognized in the month in which the usage is provided. Implementation and set-up 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.


- 53 -

Valuation of Accounts Receivable and Service Credits

We make judgments and estimates 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 recognize 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 2011, 2012 or 2013.

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 unit annually and, if necessary, reassign goodwill using a relative fair value allocation approach. The assumptions and estimates used to evaluate goodwill for impairment require 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 2013 that would require an update to our annual impairment test. Additionally, upon conclusion of our 2013 annual test, we noted that the fair value of our reporting unit was substantially in excess of the carrying value of the reporting unit’s net assets.

Contingencies

We accrue for contingent obligations 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.


- 54 -

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 extending 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 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.


- 55 -

ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Power Prices. We are a large consumer of power. During 2013, we expensed approximately $27 million that was paid to utility companies to power our data centers, representing approximately 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 June 2014. 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 expires in September 2014. These contracts have been designated as meeting the normal purchases and normal sales exception and thus are not accounted for as derivatives.

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, 2013, we did not have an outstanding balance on our credit facility, and therefore we have limited interest rate risk.

Leases. Prior to 2012, the majority of our purchases of customer gear were vendor-financed through capital leases with fixed payment terms generally over two to five years, coinciding with the depreciation period of the equipment. As of December 31, 2013, we have a principal liability for leases of $63 million on our consolidated balance sheet, of which $38 million is classified as current. During 2012 we shifted our strategy and now pay cash for our equipment purchases rather than financing them through these arrangements, reducing our exposure to the risks that vendor financing may no longer be available or that the rates will 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. During 2013, we recognized foreign currency losses of less than $1 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.

- 56 -

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

RACKSPACE HOSTING, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS




- 57 -

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 as of
December 31, 2012 and 2013, and the related consolidated statements of comprehensive income, cash flows, and stockholders' equity for each of the years in the three-year period ended December 31, 2013. In connection with our audits of the consolidated financial statements, we have also 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, 2012 and 2013, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013, 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, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 3, 2014 expressed an adverse opinion on the effectiveness of the Company's internal control over financial reporting.

/s/ KPMG LLP
San Antonio, Texas
March 3, 2014


- 58 -

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, 2013, based on criteria established in Internal Control - Integrated Framework (1992) 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.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness related to the design and operating effectiveness of controls over the recognition, measurement, and disclosure of complex real estate development and lease arrangements has been identified and included in management’s assessment in Item 9A(b). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the related consolidated balance sheet as of December 31, 2013, and the related consolidated statements of comprehensive income, cash flows, and stockholders' equity for each of the years in the three-year period ended December 31, 2013 of Rackspace Hosting, Inc. and subsidiaries. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2013 consolidated financial statements, and this report does not affect our report dated March 3, 2014, which expressed an unqualified opinion on those consolidated financial statements.

In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, Rackspace Hosting, Inc. has not maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We do not express an opinion or any other form of assurance on management’s statements referring to corrective actions taken after December 31, 2013, relative to the aforementioned material weakness in internal control over financial reporting.

/s/ KPMG LLP
San Antonio, Texas
March 3, 2014


- 59 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
 
December 31,
2012
 
December 31,
2013
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
292,061

 
$
259,733

Accounts receivable, net of allowance for doubtful accounts and customer credits of $4,236 as of December 31, 2012 and $3,891 as of December 31, 2013
 
92,834

 
123,898

Deferred income taxes
 
10,320

 
12,637

Prepaid expenses
 
25,195

 
30,782

Other current assets
 
4,835

 
11,918

Total current assets
 
425,245

 
438,968

 
 
 
 
 
Property and equipment, net
 
724,985

 
890,776

Goodwill
 
68,742

 
81,084

Intangible assets, net
 
23,802

 
23,880

Other non-current assets
 
52,777

 
57,089

Total assets
 
$
1,295,551

 
$
1,491,797

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
105,174

 
$
122,047

Accrued compensation and benefits
 
48,404

 
62,459

Income and other taxes payable
 
21,550

 
11,388

Current portion of deferred revenue
 
17,265

 
22,868

Current portion of obligations under capital leases
 
61,302

 
37,885

Current portion of debt
 
1,744

 
1,861

Total current liabilities
 
255,439

 
258,508

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Deferred revenue
 
3,695

 
3,662

Obligations under capital leases
 
60,335

 
25,048

Debt
 
1,991

 
124

Deferred income taxes
 
71,081

 
69,729

Deferred rent
 
32,293

 
43,046

Other liabilities
 
27,070

 
36,268

Total liabilities
 
451,904

 
436,385

 
 
 
 
 
COMMITMENTS AND CONTINGENCIES
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 137,797,855 shares issued and outstanding as of December 31, 2012; 141,123,904 shares issued and outstanding as of December 31, 2013
 
138

 
141

Additional paid-in capital
 
515,188

 
636,660

Accumulated other comprehensive loss
 
(8,089
)
 
(4,536
)
Retained earnings
 
336,410

 
423,147

Total stockholders’ equity
 
843,647

 
1,055,412

Total liabilities and stockholders’ equity
 
$
1,295,551

 
$
1,491,797


See accompanying notes to the consolidated financial statements.

- 60 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
 
 
Year Ended December 31,
(In thousands, except per share data)
 
2011
 
2012
 
2013
Net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

Costs and expenses:
 
 
 
 
 
 
Cost of revenue
 
346,341

 
419,013

 
492,493

Research and development
 
33,709

 
56,736

 
90,213

Sales and marketing
 
131,174

 
166,172

 
208,417

General and administrative
 
194,957

 
244,732

 
297,520

Depreciation and amortization
 
195,412

 
249,845

 
313,007

Total costs and expenses
 
901,593

 
1,136,498

 
1,401,650

Income from operations
 
123,471

 
172,741

 
133,136

Other income (expense):
 
 
 
 
 
 
Interest expense
 
(5,848
)
 
(4,749
)
 
(3,118
)
Interest and other income (expense)
 
(1,194
)
 
15

 
741

Total other income (expense)
 
(7,042
)
 
(4,734
)
 
(2,377
)
Income before income taxes
 
116,429

 
168,007

 
130,759

Income taxes
 
40,018

 
62,589

 
44,022

Net income
 
$
76,411

 
$
105,418

 
$
86,737

 
 
 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
 
 
Foreign currency translation adjustments
 
$
(2,316
)
 
$
6,643

 
$
3,553

Other comprehensive income (loss)
 
(2,316
)
 
6,643

 
3,553

Comprehensive income
 
$
74,095

 
$
112,061

 
$
90,290

 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
Basic
 
$
0.59

 
$
0.78

 
$
0.63

Diluted
 
$
0.55

 
$
0.75

 
$
0.61

 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
Basic
 
129,922

 
135,279

 
138,577

Diluted
 
138,064

 
141,265

 
143,011

 
See accompanying notes to the consolidated financial statements.

- 61 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
 
Year Ended December 31,
(In thousands)
 
2011
 
2012
 
2013
Cash Flows From Operating Activities
 
 
 
 
 
 
Net income
 
$
76,411

 
$
105,418

 
$
86,737

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
Depreciation and amortization
 
195,412

 
249,845

 
313,007

Loss on disposal of equipment, net
 
247

 
1,586

 
992

Provision for bad debts and customer credits
 
5,913

 
6,300

 
4,498

Deferred income taxes
 
13,991

 
(775
)
 
(2,102
)
Deferred rent
 
9,471

 
9,259

 
11,564

Share-based compensation expense
 
28,773

 
41,546

 
59,645

Excess tax benefits from share-based compensation arrangements
 
(20,627
)
 
(46,046
)
 
(33,539
)
Changes in certain assets and liabilities:
 
 
 
 
 
 
Accounts receivable
 
(26,805
)
 
(29,265
)
 
(34,473
)
Prepaid expenses and other current assets
 
1,800

 
(4,903
)
 
(12,270
)
Accounts payable and accrued expenses
 
38,886

 
66,268

 
35,303

Deferred revenue
 
(482
)
 
2,185

 
5,367

All other operating activities
 
1,405

 
(1,919
)
 
9,331

Net cash provided by operating activities
 
324,395

 
399,499

 
444,060

 
 
 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
 
 
Purchases of property and equipment
 
(251,214
)
 
(270,374
)
 
(452,596
)
Acquisitions, net of cash acquired
 
(952
)
 
(5,945
)
 
(9,930
)
All other investing activities
 
168

 
98

 
(1,698
)
Net cash used in investing activities
 
(251,998
)
 
(276,221
)
 
(464,224
)
 
 
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
 
 
Principal payments of capital leases
 
(65,778
)
 
(75,928
)
 
(65,860
)
Principal payments of notes payable
 
(1,913
)
 
(1,962
)
 
(1,915
)
Payments for debt issuance costs
 
(1,114
)
 
—

 
—

Payments for deferred acquisition obligations
 
(5,299
)
 
(6,176
)
 
(1,353
)
Proceeds from notes payable
 
—

 
691

 
—

Receipt of Texas Enterprise Fund Grant
 
—

 
3,500

 
—

Proceeds from employee stock plans
 
36,287

 
41,284

 
23,817

Excess tax benefits from share-based compensation arrangements
 
20,627

 
46,046

 
33,539

Net cash provided by (used in) financing activities
 
(17,190
)
 
7,455

 
(11,772
)
 
 
 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
(292
)
 
1,472

 
(392
)
 
 
 
 
 
 
 
Increase (decrease) in cash and cash equivalents
 
54,915

 
132,205

 
(32,328
)
 
 
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
104,941

 
159,856

 
292,061

 
 
 
 
 
 
 
Cash and cash equivalents, end of period
 
$
159,856

 
$
292,061

 
$
259,733

 
 
 
 
 
 
 
Supplemental cash flow information:
 
 
 
 
 
 
Acquisition of property and equipment by vendor financed capital leases
 
$
75,090

 
$
59,833

 
$
7,190

Acquisition of property and equipment by vendor financed notes payable
 
—

 
3,950

 
—

Increase in property and equipment in accounts payable and accrued expenses
 
18,590

 
3,525

 
12,303

Non-cash purchases of property and equipment
 
$
93,680

 
$
67,308

 
$
19,493

 
 
 
 
 
 
 
Shares issued in business combinations
 
$
—

 
$
2,745

 
$
4,457

Cash payments for interest, net of amount capitalized
 
$
5,577

 
$
4,900

 
$
3,234

Cash payments for income taxes
 
$
19,088

 
$
12,574

 
$
15,670


See accompanying notes to the consolidated financial statements.

- 62 -

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
Years Ended December 31, 2011, 2012, and 2013
 
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, 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

Net income
 
 
 
 
 
 
 
 
76,411

 
76,411

Cumulative translation adjustment
 
 
 
 
 
 
(2,316
)
 
 
 
(2,316
)
Balance at December 31, 2011
131,912,829

 
$
132

 
$
383,031

 
$
(14,732
)
 
$
230,992

 
$
599,423

Issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options and release of stock awards (including excess tax benefit of $46,046)
5,689,164

 
6

 
82,308

 
 
 
 
 
82,314

Stock-based activity and issuance of common stock to board of directors
12,862

 
—

 
542

 
 
 
 
 
542

Issuance of shares from Employee Stock Purchase Plan
137,104

 
—

 
5,016

 
 
 
 
 
5,016

Issuance of shares in acquisitions
45,896

 
—

 
2,745

 
 
 
 
 
2,745

Total issuance of common stock
5,885,026

 
6

 
90,611

 
 
 
 
 
90,617

Share-based compensation expense
 
 
 
 
41,546

 
 
 
 
 
41,546

Net income
 
 
 
 
 
 
 
 
105,418

 
105,418

Cumulative translation adjustment
 
 
 
 
 
 
6,643

 
 
 
6,643

Balance at December 31, 2012
137,797,855

 
$
138

 
$
515,188

 
$
(8,089
)
 
$
336,410

 
$
843,647

Issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options and release of stock awards (including excess tax benefit of $33,539)
3,027,169

 
3

 
51,184

 
 
 
 
 
51,187

Issuance of shares from Employee Stock Purchase Plans
190,235

 
—

 
6,186

 
 
 
 
 
6,186

Issuance of shares in acquisitions
108,645

 
—

 
4,457

 
 
 
 
 
4,457

Total issuance of common stock
3,326,049

 
3

 
61,827

 
 
 
 
 
61,830

Share-based compensation expense
 
 
 
 
59,645

 
 
 
 
 
59,645

Net income
 
 
 
 
 
 
 
 
86,737

 
86,737

Cumulative translation adjustment
 
 
 
 
 
 
3,553

 
 
 
3,553

Balance at December 31, 2013
141,123,904

 
$
141

 
$
636,660

 
$
(4,536
)
 
$
423,147

 
$
1,055,412


See accompanying notes to the consolidated financial statements.

- 63 -

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.

Our operations began in 1998 as a limited partnership, and Rackspace Hosting, Inc. was incorporated in Delaware in March 2000.

Basis of Consolidation

The consolidated financial statements include the accounts of Rackspace Hosting and our wholly-owned subsidiaries, which include, among others, Rackspace US, Inc., our domestic operating entity, and Rackspace Limited, our United Kingdom operating entity. Intercompany transactions and balances have been eliminated in consolidation.
 
Basis of Presentation

Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation. These include reclassifications within the Consolidated Statements of Comprehensive Income that we believe provide greater transparency and clarity about our costs and expenses. The changes to the Consolidated Statements of Comprehensive Income are summarized as follows:

•
Certain costs (primarily salaries and certain benefits) that were previously included in General and Administrative expenses have been reclassified to either Cost of Revenue or Sales and Marketing expenses because we believe the personnel or activities are directly related to supporting our customers, operating our data centers or selling and marketing our products and services.

•
Certain costs that were previously included in General and Administrative expenses have been reclassified to a new category, Research and Development costs. Our research and development efforts are focused on the deployment of new technologies to address emerging trends, the development and evolution of proprietary tools, and the enhancement of systems and processes for sales and support. Included in this category are costs related to preliminary project assessment, research and development, re-engineering, training, and application maintenance. These costs are consistent with the definition of research and development activities in the Financial Accounting Standard Board's Accounting Standards Codification Topic 730, Research and Development.

The changes do not affect the Company's previously reported Income from Operations or Net Income for the years ended December 31, 2011 and 2012 or amounts in the Consolidated Balance Sheet as of December 31, 2012 and Consolidated Statements of Cash Flows for the years ended December 31, 2011 and 2012.

The table below summarizes the amount by which each category in the Consolidated Statement of Comprehensive Income increased/(decreased) for each period:

 
Year Ended December 31,
(In thousands)
2011
 
2012
Cost of revenue
$
37,246

 
$
51,534

Research and development
$
33,709

 
$
56,736

Sales and marketing
$
4,669

 
$
8,064

General and administrative
$
(75,624
)
 
$
(116,334
)


- 64 -

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. 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 share-based compensation, contingencies, and income taxes, among others. Whenever possible, we base our estimates and assumptions on historical experience. However, certain estimates require us to make assumptions about expected future cash flow, events and usage patterns that we cannot influence or control. Our judgments, assumptions and estimates are based upon facts and circumstances known to us when we prepare the financial statements and that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities or recording revenue and expenses in our financial statements. Changes in facts and circumstances may cause us to change our assumptions and estimates in future periods, and it is possible that actual results could differ from our estimates. We engaged third-party consultants to assist management in the valuation of acquired assets, including other intangibles, as well as share-based compensation.

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 could 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 applicable 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, 2012 and 2013, no customer, reseller or strategic partner comprised more than 10% 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.

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 thereto during 2013.

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 comprehensive income.


- 65 -

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 collectibility 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, 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 service level 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.

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 using a fair value approach on an annual basis at the beginning of the fourth quarter or whenever events or circumstances indicate that impairment may have occurred. Our assessment did not utilize the qualitative assessment as we went directly to Step 1 of the test. No goodwill impairment was recognized in any of the years presented.

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.

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.


- 66 -

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 two to five years for 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.

Revenue and Deferred Revenue

Revenue is reported net of customer credits and sales and use tax. 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 provide cloud computing services to our customers and generally do not sell hardware and software products. We recognize cloud computing revenue, including installation fees, beginning on the date the customer commences use of our services. Cloud computing revenue is recognized over the contractual term of the customer contract.

Customers using our Dedicated Cloud services typically pay us a monthly recurring charge based upon the capacity 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. Since our Dedicated Cloud customers usually continue to utilize our services beyond the initial contract term, these installation fees are recognized ratably over the estimated average life of a customer relationship.

Our Public Cloud services offers pay-as-you-go cloud computing services that are billed according to customer usage. Revenue is recognized in the month in which the customer uses the services.

Invoiced amounts 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, 2013, of the total $26.5 million in deferred revenue recorded on our balance sheet (the majority of which related to prepaid amounts), $22.9 million, $3.4 million, and $0.2 million will be amortized to revenue in 2014, 2015 and 2016, respectively.

Cost of Revenue

Cost of revenue consists primarily of expenses related to personnel, licenses, and our data center facilities. Personnel expenses include the salaries, non-equity incentive compensation, share-based compensation and related expenses of our support teams and data center employees, and data center facility costs include rental fees, power costs, maintenance fees, and bandwidth.

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, 2011, 2012 and 2013 were approximately $37.8 million, $44.7 million and $58.9 million, respectively.


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Internally Developed Software

We capitalize certain costs of computer software developed or acquired 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 amortized on a straight-line basis over the expected useful life of the software, which is generally over periods extending to 36 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—The end of day market price on the grant date is 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 for the four-year period immediately following our IPO, we elected to use the simplified method due to insufficient historical exercise data available to provide a reasonable basis upon which to estimate the expected term. 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. Beginning in August 2012, management determined that sufficient historical data is available for a fair evaluation and therefore we began to use historical exercise data in our estimation of the expected term.

•
Expected Volatility—Management estimates volatility for option grants by evaluating the weighted average of the implied volatility and the mean reversion volatility of the company’s stock.

•
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.

•
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, a portion of which have vesting conditions dependent upon the financial performance of the company and/or 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 restricted stock granted that vests 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.


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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 and 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 13, "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.

Fair Value of Financial Instruments

The carrying 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 carrying value of our debt approximates the fair value as of December 31, 2012 and 2013.

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). The income tax expense allocated to foreign currency translation adjustments during the year ended December 31, 2011 was $0.1 million. There was no income tax expense allocated in the years ended December 31, 2012 and 2013.

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 comprehensive income.


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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)
 
2011
 
2012
 
2013
Basic net income per share:
 
 
 
 
 
 
Net income
 
$
76,411

 
$
105,418

 
$
86,737

Weighted average shares outstanding:
 
 
 
 
 
 
Common stock
 
129,922

 
135,279

 
138,577

Number of shares used in per share computations
 
129,922

 
135,279

 
138,577

Earnings per share
 
$
0.59

 
$
0.78

 
$
0.63

 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
Net income
 
$
76,411

 
$
105,418

 
$
86,737

Weighted average shares outstanding:
 
 
 
 
 
 
Common stock
 
129,922

 
135,279

 
138,577

Stock options, awards and employee share purchase plans
 
8,142

 
5,986

 
4,434

Number of shares used in per share computations
 
138,064

 
141,265

 
143,011

Earnings per share
 
$
0.55

 
$
0.75

 
$
0.61


We excluded 1.2 million, 1.1 million and 3.5 million potential common shares from the computation of dilutive earnings per share for the years ended December 31, 2011, 2012 and 2013, respectively, because the effect would have been anti-dilutive.

3. Cash and Cash Equivalents

Cash and cash equivalents consisted of:
(In thousands)
 
December 31,
2012

December 31,
2013
Cash deposits
 
$
131,271

 
$
157,353

Money market funds
 
160,790

 
102,380

Cash and cash equivalents
 
$
292,061

 
$
259,733


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 the safety of principal, secondly on the liquidity of our investments, and finally on maximizing yield on those funds.

Our money market mutual funds comply with SEC Rule 2a-7 and invest exclusively in high-quality, short-term obligations that include securities issued or guaranteed by the U.S. government or by U.S. government agencies and floating rate and variable rate demand notes of U.S. and foreign corporations.


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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.

Assets and liabilities measured at fair value on a recurring basis are summarized in the table below. As of December 31, 2012 and 2013, we did not hold any financial instruments categorized as Level 2 or Level 3. Our Level 1 assets and liabilities are valued using quoted market prices.  
(In thousands)
 
December 31,
2012
 
December 31,
2013
Level 1:
 
 
 
 
Assets:
 
 
 
 
Money market funds (1)
 
$
160,790

 
$
102,380

Rabbi trust (2)
 
520

 
835

     Total
 
$
161,310

 
$
103,215

 
 
 
 
 
Liabilities:
 
 
 
 
Deferred compensation (3)
 
$
410

 
$
540

     Total
 
$
410

 
$
540

 
(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.

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 Comprehensive Income in the same period as the gains and losses are incurred as part of the non-qualified deferred compensation plan. During 2011, 2012, and 2013, we recognized minimal net gains as interest and other income.


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5. Property and Equipment, net
 
Property and equipment consisted of: 
(Dollar amounts in thousands)
 
Estimated Useful Lives
 
December 31,
2012
 
December 31,
2013
Computers, software and equipment
 
1
-
5
years
 
$
1,140,772

 
$
1,488,106

Furniture and fixtures
 
7
years
 
40,557

 
55,681

Buildings and leasehold improvements
 
2
-
30
years
 
214,858

 
236,255

Land
 
 
 
 
 
 
15,864

 
28,566

Property and equipment, at cost
 
 
 
 
 
 
1,412,051

 
1,808,608

Less accumulated depreciation and amortization
 
 
 
 
 
 
(738,274
)
 
(983,618
)
Work in process
 
 
 
 
 
 
51,208

 
65,786

Property and equipment, net
 
 
 
 
 
 
$
724,985

 
$
890,776

 
Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $189.8 million, $240.9 million and $303.2 million for the years ended December 31, 2011, 2012 and 2013, respectively.

At December 31, 2012, the work in process balance consisted of build outs of $28.4 million for office facilities, $2.8 million for data centers, and $20.0 million for capitalized software and other projects. At December 31, 2013, the work in process balance consisted of build outs of $32.6 million for office facilities, $2.4 million for data centers, and $30.7 million for capitalized software and other projects.
 
The unamortized balance of computer software costs on our balance sheets was $78.7 million and $88.7 million as of December 31, 2012 and 2013, respectively. Amortization expense for capitalized computer software costs was $26.2 million, $36.4 million and $50.6 million for the years ended December 31, 2011, 2012 and 2013, respectively.


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6. Business Combinations and Goodwill

During the year ended December 31, 2013, we acquired three companies for total consideration of $16.2 million, of which approximately $12.3 million was attributed to goodwill, $5.1 million to acquired intangible assets and $1.2 million to other net liabilities assumed. The acquisitions were accounted for using the acquisition method, and the purchase prices were allocated based on the estimated fair values of the individual assets acquired and liabilities assumed at the date of acquisition. The Consolidated Statements of Comprehensive Income include the results of operations for the acquired companies commencing on their respective acquisition dates. Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate.

The finite-lived intangible assets acquired as part of these acquisitions have a weighted-average useful life of 3.2 years.

During the year ended December 31, 2012, we acquired two companies for total consideration of $10.9 million, including cash payments, deferred cash payments and equity consideration. Approximately $8.7 million was attributed to goodwill, $2.3 million to acquired intangible assets and $0.1 million to other net liabilities assumed.

The following table provides a roll forward of our goodwill balance.
(In thousands)
 
December 31, 2011
$
59,993

Acquisitions
8,749

December 31, 2012
$
68,742

Acquisitions
12,342

December 31, 2013
$
81,084


None of the goodwill recorded in 2013 is deductible for tax purposes.

In prior periods, we acquired companies that required additional future payments in addition to the initial cash payment. During 2013, we paid $1.5 million related to these previous acquisitions, and as of December 31, 2013, the fair value of the remaining liability recorded was $0.5 million.


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7. Intangible Assets

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

 
December 31, 2012
(In thousands)
Gross carrying amount
 
Accumulated amortization
 
Net carrying amount
Intangible assets:
 
 
 
 
 
Licenses
$
30,620

 
$
(16,826
)
 
$
13,794

Purchased technologies
8,762

 
(5,062
)
 
3,700

Domain name purchases
446

 
(441
)
 
5

Non-compete agreements
1,900

 
(1,186
)
 
714

Customer relationships
5,725

 
(4,477
)
 
1,248

Trademarks, tradenames and patents
3,062

 
(1,671
)
 
1,391

Other
4,040

 
(1,090
)
 
2,950

Total
$
54,555

 
$
(30,753
)
 
$
23,802


 
December 31, 2013
(In thousands)
Gross carrying amount
 
Accumulated amortization
 
Net carrying amount
Intangible assets:
 
 
 
 
 
Licenses
$
31,443

 
$
(21,216
)
 
$
10,227

Purchased technologies
13,180

 
(7,428
)
 
5,752

Domain name purchases
442

 
(442
)
 
—

Non-compete agreements
2,165

 
(1,613
)
 
552

Customer relationships
6,137

 
(5,442
)
 
695

Trademarks, tradenames and patents
3,581

 
(1,985
)
 
1,596

Other
7,539

 
(2,481
)
 
5,058

Total
$
64,487

 
$
(40,607
)
 
$
23,880


Amortization expense on intangibles was $5.6 million, $8.9 million and $9.8 million in 2011, 2012 and 2013, respectively. Intangible assets are recorded at cost and are amortized on a straight-line basis over their estimated useful lives, which generally range from two to five years.

As of December 31, 2013, amortization expense on intangible assets for the next five years was expected to be as follows:

(In thousands)
 
Year ending:
Amount
2014
$
9,408

2015
8,504

2016
4,970

2017
536

2018
293

Thereafter
169

Total
$
23,880


As of December 31, 2013, there were no indicators that our intangible assets were impaired.

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8. Debt
 
Revolving Credit Facility
 
In 2011 we entered into a revolving credit facility with a syndicate of seven banks led by JPMorgan Chase. This facility, which matures in September 2016, has a total commitment of $200 million and 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 a 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.

Since entering into this credit facility, we have not had any borrowings outstanding except for letters of credit, which were insignificant at the end of 2013. Therefore, as of December 31, 2013, we had $200 million available for future borrowings. As of the same date, we were in compliance with all of the covenants under our facility.

Notes Payable

We have entered into various financing arrangements with equipment and software vendors. As of December 31, 2013, the total amount financed under these relationships was $2.0 million with various terms extending to July 2015 and stated interest rates ranging from 0.0% to 1.7%. 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 5.3% as of December 31, 2013.


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9. Leases

Capital Leases

We have master lease agreements with our primary vendors that supply us with servers and computer equipment. Historically, we have financed most equipment purchases through their respective finance companies. The terms vary with each vendor but typically include a term of two to five years and interest rates ranging from 1% to 4%. 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 these capital leases consisted of:
(In thousands)
December 31, 2012
 
December 31, 2013
Computers, software and equipment
$
389,720

 
$
391,833

Less: accumulated depreciation and amortization
(272,708
)
 
(335,599
)
 
$
117,012

 
$
56,234


Additionally, we have entered into some complex real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects. While the independent developer legally owns the real estate projects and must finance the overall construction, we have funded certain structural improvements and/or retained obligations related to certain potential construction cost overruns which have triggered an accounting requirement to include construction costs in progress and a related long-term lease finance liability on our balance sheets as though we are the owner of the asset during the construction period. We have reported $6.8 million of costs incurred at December 31, 2013 as work in process and recorded a corresponding long-term lease finance liability. We do not depreciate the cost of the real estate projects or expect to fund this long-term lease finance liability during the construction period.

Upon completion of construction, we will perform a sale-leaseback analysis pursuant to ASC 840, Leases, to determine if we can remove the asset and liability from our consolidated balance sheet. If the asset and corresponding liability can be derecognized, then the lease will be accounted for as an operating lease, and we will recognize rent expense over the lease term. However, certain factors may be considered “continuing involvement” which precludes derecognizing the asset and liability from the consolidated balance sheet when construction is complete. If the sale-leaseback criteria are not met, the asset would be considered to be owned for accounting purposes during the lease term. Accordingly, it would be depreciated and rental payments under the lease would be recorded as a reduction of the lease finance liability and interest expense.

Future capital lease payments under non-cancelable leases as of December 31, 2013 were as follows:
(In thousands)
 
Year ending:
Amount
2014
$
39,221

2015
17,448

2016
2,242

2017
622

2018
635

Thereafter
3,819

Total minimum capital lease payments
63,987

Less amount representing interest
(1,054
)
Present value of net minimum lease payments
62,933

Less current portion of obligations under capital leases
(37,885
)
Non-current obligations under capital leases
$
25,048



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Operating Leases

We lease our data center facilities and certain office space 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, 2013 were as follows:

(In thousands)
 
Year ending:
Amount
2014
$
67,160

2015
69,306

2016
65,124

2017
64,944

2018
60,172

Thereafter
591,054

Total minimum operating lease payments
$
917,760


Rent expense for the years ended December 31, 2011, 2012 and 2013 was $34.1 million, $46.1 million and $66.0 million, respectively.


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10. Commitments and Contingencies
 
Purchase Commitments

Non-cancelable purchase commitments primarily relate to costs associated with our data centers, including bandwidth and electricity, as well as commitments for consulting services and to purchase hardware and to prepay for certain software licenses. The agreements can generally extend up to five 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, 2013 approximated $50.5 million, $26.0 million, $1.0 million, $0.7 million and $0.2 million for the years ended December 31, 2014, 2015, 2016, 2017 and 2018, 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. 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. In addition, we were involved in the following legal proceeding as of December 31, 2013:

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 alleged 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. This matter was settled as of February 19, 2014, and there was not a material difference between the settlement amount and the amount for which we had accrued for the matter in our consolidated financial statements.

We are also a party to various claims that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, products, or services, and may also cause us to change our business practices and require development of non-infringing products or technologies, which could result in a loss of revenue for us and otherwise harm our business. We have disputed the allegations of wrongdoing in these proceedings and intend to vigorously defend ourselves in all such matters.

We cannot predict the impact, if any, that any of the matters described above may have on our business, results of operations, financial position, or cash flows. Because of the inherent uncertainties of such matters, including the early stage and lack of specific damage claims in many of them, we cannot estimate the range of possible losses from them.

Indemnifications

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 had no significant liabilities recorded for these agreements as of December 31, 2012 or 2013.

Additionally, 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 had no significant liabilities recorded for these agreements as of December 31, 2012 or 2013.


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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 required that we meet certain employment levels each year in exchange for 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 for the year ended December 31, 2013, and we believe that it is probable that we will continue to 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 $3.5 million in 2012 and may receive up to an additional $13.5 million from the Texas Enterprise Fund in multiple installments, provided that we meet certain new job levels in the State of 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, 2013, the $8.5 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.

11. Stockholders' Equity

Common Stock

At December 31, 2012 and 2013, we had 137,797,855 and 141,123,904 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.

Preferred Stock

As of December 31, 2012 and 2013, there were 50 million authorized shares of preferred stock, of which none was issued or outstanding.


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12. Share-Based Compensation
 
In December 2007, we adopted our 2007 Long-Term Incentive Plan (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 had an automatic share reserve increase effective the first day of each fiscal year, from 2009 through 2012. For fiscal years 2011 and 2012, this resulted in an increase of approximately 5.8 million and 5.9 million shares, respectively, available under our Stock Plans.

At our 2012 annual meeting of the stockholders, our stockholders approved certain amendments to the 2007 Stock Plan. The amendments included, among other things, setting a fixed number of shares available of 12 million, removing the evergreen provision and requiring new grants of restricted stock, restricted stock units, performance units and performance shares to count against the numerical limits of the 2007 Stock Plan as 1.76 shares for every one share that is subject to such an award.

The following have been granted under our 2007 Stock Plan: stock options, restricted stock units (RSUs) and restricted stock awards (RSAs). Collectively, all such grants are referred to as "awards." All awards deduct one share from the 2007 Stock Plan shares available for issuance for each share granted, except as described above. To the extent awards granted under the 2007 Stock Plan terminate, expire or lapse, shares subject to such awards generally will again be available for future grant.

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 and generally vest ratably over a four-year period or cliff-vest at the third anniversary date of the grant.

As of December 31, 2013, 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
Amended and Restated 2007 Long-Term Incentive Plan
 
28,789,197

 
12,016,730

 
5,760,151

Other Stock Plans
 
14,252,015

 
1,009,111

 
—

Total
 
43,041,212

 
13,025,841

 
5,760,151


The composition of the equity awards outstanding as of December 31, 2012 and 2013 was as follows: 
 
 
December 31,
2012
 
December 31,
2013
Restricted stock
 
2,800,230
 
3,538,271
Stock options
 
9,032,512
 
9,487,570
     Total outstanding awards
 
11,832,742
 
13,025,841
 

- 80 -

Restricted Stock

The following table summarizes our RSU and RSA activity for the year ended December 31, 2013:
 
 
Number of Units or Shares
 
Weighted-Average Grant-Date Fair Value
Outstanding at December 31, 2012
 
2,800,230
 
$
25.57

     Granted
 
1,542,948
 
$
39.24

     Released
 
(588,550)
 
$
35.43

     Cancelled
 
(216,357)
 
$
42.23

Outstanding at December 31, 2013
 
3,538,271
 
$
28.79

 
 
 
 
 
Expected to vest after December 31, 2013*
 
3,106,300
 
$
29.78

*Includes reduction of shares outstanding due to estimated forfeitures

The weighted-average grant-date fair value of RSUs and RSAs granted during 2011 and 2012 was $36.22 and $51.78, respectively. The total pre-tax intrinsic value of the RSUs and RSAs released during 2011, 2012 and 2013 was $7.7 million, $75.5 million and $29.7 million, respectively.

In February 2009, our board approved grants of RSUs to our former chief executive officer and another member of the executive team. A total of 2,000,000 RSUs were granted. The vesting of these 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 had a measurement period at the end of three years. The Company's TSR was compared to the Russell 2000 Index in February 2012, and it was determined that the required market results were met. The remaining 950,000 RSUs 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.

In 2013, we granted 1,542,948 RSUs, of which 1,206,144 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. The fair value of these service-vesting awards is measured based on the closing fair market value of our common stock on the date of grant, and share-based compensation expense is recognized ratably over the four-year service period. The remaining 336,804 awards were granted to members of our executive team. The vesting of these awards is dependent upon predetermined market results over the next three years. The fair values of these market-vesting awards were measured using a Monte Carlo simulation based on the date of grant, and share-based compensation expense is recognized ratably over the three-year vesting period.


- 81 -

Stock Options

The following table summarizes the stock option activity for the year ended December 31, 2013: 
 
 
Number of Shares
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Life
 
Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2012
 
9,032,512
 
$
21.11

 
5.27
 
$
480,191

     Granted
 
3,128,561
 
$
43.95

 
 
 
 

     Exercised
 
(2,125,859)
 
$
8.29

 
 
 
 

     Cancelled
 
(547,644)
 
$
40.98

 
 
 
 

Outstanding at December 31, 2013
 
9,487,570
 
$
30.37

 
5.10
 
$
117,886

 
 
 
 
 
 
 
 
 
Vested and exercisable at December 31, 2013
 
4,423,014
 
$
15.64

 
4.21
 
$
109,170

 
 
 
 
 
 
 
 
 
Vested and exercisable at December 31, 2013 and expected to vest thereafter*
 
8,646,666
 
$
28.98

 
5.00
 
$
117,319

*Includes reduction of shares outstanding due to estimated forfeitures

The stock options granted in 2011, 2012 and 2013 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 seven years.
 
The total pre-tax intrinsic value of the stock options exercised during 2011, 2012 and 2013 was $149.2 million, $193.1 million and $76.4 million, respectively.

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,
 
 
2011
 
2012
 
2013
Expected stock volatility
 
56% - 57%
 
56% - 58%
 
46% - 47%
Expected dividend yield
 
—%
 
—%
 
—%
Risk-free interest rate
 
0.85% - 2.35%
 
0.50% - 0.77%
 
0.57% - 0.93%
Expected life
 
4.75 years
 
4.00 - 4.75 years
 
3.79 years
Weighted-average grant-date fair value of options granted during the year
 
$18.09
 
$24.38
 
$15.86
 

- 82 -

Employee Stock Purchase Plan

An Employee Stock Purchase Plan (the "ESPP") for U.S. employees was approved by the Company's Board of Directors in 2011 and adopted by the Company on January 1, 2012. Under the ESPP, eligible employees may purchase a limited number of shares of the Company's common stock at the lesser of 85% of the market value on the enrollment date or 85% of the market value on the purchase date. The ESPP is made up of a series of offering periods. Each offering period has a maximum term of 24 months and is divided into semi-annual purchase intervals. Eligible employees may enroll at the beginning of any semi-annual purchase interval.

The fair value on each enrollment date was determined using the Black-Scholes option-pricing model. The following table presents the assumptions used to estimate the fair values of the shares granted through the ESPP in the periods presented:
 
 
Years Ended December 31,
 
 
2012
 
2013
Expected stock volatility
 
41% - 53%
 
32% - 62%
Expected dividend yield
 
—%
 
—%
Risk-free interest rate
 
0.06% - 0.27%
 
0.09% - 0.34%
Expected life
 
0.5 - 2.0 years
 
0.5 - 2.0 years
Weighted-average grant-date fair value of shares granted during the year
 
$14.98
 
$16.04

Other

During the year ended December 31, 2013, we issued an aggregate total of 348,925 restricted shares of our common stock in connection with acquisitions. The restrictions release over a required service period of three to four years as defined in each respective Stock Repurchase Agreement. The issuance of these shares of common stock was made in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933. We measure the fair value of restricted shares issued based on the closing fair market value of the company’s common stock on the date of issuance. We recognize the expense straight-line over the service period.

Share-Based Compensation Expense

Share-based compensation expense was recognized as follows: 
 
 
Year Ended December 31,
(in thousands)
 
2011
 
2012
 
2013
Cost of revenue
 
$
7,482

 
$
9,592

 
$
12,584

Research and development
 
2,975

 
4,856

 
8,168

Sales and marketing
 
2,408

 
6,379

 
7,317

General and administrative
 
15,908

 
20,719

 
31,576

Pre-tax share-based compensation
 
28,773

 
41,546

 
59,645

Less: Income tax benefit
 
(9,890
)
 
(15,477
)
 
(20,080
)
Total share-based compensation expense, net of tax
 
$
18,883

 
$
26,069

 
$
39,565


The Company has made certain reclassifications to the prior year amounts above in order to conform to the current year's presentation. Refer to Note 1, "Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies," for more information about these reclassifications.

As of December 31, 2013, there was $173.0 million of total unrecognized compensation cost related to restricted stock, options and the ESPP, which will be amortized using the straight-line method over a weighted-average period of 2.3 years.


- 83 -

13. Taxes
 
The provision for income taxes consisted of:

 
Year Ended December 31,
(In thousands)
2011
 
2012
 
2013
Current:
 
 
 
 
 
Federal
$
18,372

 
$
38,720

 
$
35,912

Foreign
14,976

 
19,248

 
12,071

State
4,011

 
4,296

 
4,121

Total current
37,359

 
62,264

 
52,104

 
 
 
 
 
 
Deferred:
 
 
 
 
 
Federal
4,345

 
1,359

 
(3,886
)
Foreign
(877
)
 
(910
)
 
(1,621
)
State
(809
)
 
(124
)
 
(2,575
)
Total deferred
2,659

 
325

 
(8,082
)
 
 
 
 
 
 
Total provision for income taxes
$
40,018

 
$
62,589

 
$
44,022


Income before income taxes included income from foreign operations of approximately $51.7 million, $61.6 million and $39.7 million for the years ended December 31, 2011, 2012 and 2013, respectively.

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

 
Year Ended December 31,
 
2011
 
2012
 
2013
Statutory federal tax rate
35.0
 %
 
35.0
 %
 
35.0
 %
State taxes, net of federal benefit
1.9
 %
 
1.5
 %
 
0.7
 %
Tax rate differentials for international jurisdictions
-4.1
 %
 
-2.0
 %
 
-3.8
 %
Permanent differences
1.8
 %
 
2.5
 %
 
1.3
 %
Other, net
-0.2
 %
 
0.3
 %
 
0.5
 %
Effective tax rate
34.4
 %
 
37.3
 %
 
33.7
 %


- 84 -

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, 2012
 
December 31, 2013
Deferred tax assets:
 
 
 
Share-based compensation
$
17,703

 
$
23,487

Accounts receivable
1,232

 
1,275

State income taxes
590

 
2,293

Vacation accruals
4,033

 
5,235

Deferred revenue
3,815

 
3,793

Deferred rent
10,477

 
13,736

Accruals not currently deductible
7,212

 
7,850

Net operating loss carryforwards
5,697

 
3,534

Charitable contribution carryforward
782

 
754

Foreign tax credit
1,583

 
1,723

Research and development credits
3,401

 
13,871

Other
(348
)
 
1,674

Total gross deferred tax assets
56,177

 
79,225

 
 
 
 
Deferred tax liabilities:
 
 
 
Depreciation
108,208

 
125,209

Share-based compensation
821

 
107

Prepaids
2,593

 
2,981

Total gross deferred tax liabilities
111,622

 
128,297

 
 
 
 
Net deferred tax assets (liabilities)
$
(55,445
)
 
$
(49,072
)

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 to utilize deferred tax assets in the future.

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, 2013, undistributed earnings of the company’s foreign subsidiaries considered indefinitely invested were approximately $175.5 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 through either a dividend, liquidation or other means. Further, it is expected that the undistributed earnings of the company's foreign subsidiaries will be used to fund the additional investments made outside of the U.S. The determination of the amount of unrecognized deferred tax liability related to undistributed earnings is not practicable because of the complexities of the hypothetical calculation.
 
We have $250.8 million of federal net operating loss carryforwards and $15.6 million of federal tax credit carryforwards expiring at various dates through 2033. The entire balance of federal net operating loss carryforwards is due to gross excess tax benefits from stock option exercises that have not been recorded as of December 31, 2013. We have $21.4 million of foreign net operating loss carryforwards, which have an indefinite expiration date.


- 85 -

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 2012 and 2013 is as follows:
(In thousands)
2012
 
2013
Balance, beginning of year
$
16,729

 
$
18,664

Additions based on tax positions related to the current year
1,946

 
3,919

Additions for tax positions of prior years
—

 
663

Reductions for tax positions of prior years
(11
)
 
—

Balance, end of year
$
18,664

 
$
23,246


Unrecognized tax benefits of $18.7 million and $23.2 million for 2012 and 2013, respectively, are included in other non-current liabilities on the balance sheet. At December 31, 2012 and 2013, respectively, approximately $3.3 million and $8.2 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, 2013 are liabilities of $15.1 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 within other income (expense) on our consolidated statements of comprehensive income and not as income tax expense, when applicable. As of December 31, 2012 and 2013, we had no accrued interest or penalties on the consolidated balance sheets. For the years ended December 31, 2011, 2012 and 2013, no amount for interest or penalties related to unrecognized tax benefits was recorded in the consolidated statements of comprehensive 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 2009 through 2013 and in the international jurisdictions in which we operate for varying periods from 2007 through 2013. 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 2013 we did not receive any federal income tax refunds. We experienced taxable profits in the U.S. and U.K. in 2013 before consideration of excess tax benefits, 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.

During 2011, 2012 and 2013, Rackspace US, Inc. sold certain intangible assets to a wholly-owned offshore subsidiary in taxable transactions. As a result of the transactions, there is an asset on the consolidated balance sheet as of December 31, 2013 of $38.4 million (of which $34.8 million was recorded in other non-current assets) that will be amortized through income tax expense over the lives of the applicable intangible assets. Although the transactions were taxable, the resulting gains were entirely offset against existing net operating losses, including excess stock compensation deductions. Thus, there was no cash tax impact from the sales of the intangible assets.


- 86 -

In January 2013, the American Taxpayer Relief Act of 2012 was signed into law. The accounting for income taxes for 2013 included the impact of certain retroactive legislation, such as the Federal tax credit for research and development, as well as the impact of certain extended business provisions, such as bonus depreciation.

At the time of this filing, the provisions for the Federal tax credit and bonus depreciation amongst others have not been extended. If these provisions or other legislation is passed, it will be reflected in the 2014 financial statements in the period of enactment. Given our investments in developing new technologies for our business, the expiration of the Federal tax credit for research and development is expected to result in an increase to our effective tax rate in 2014.

14. Segment Information
 
We operate as one reportable segment based upon the financial information that our chief executive officer, who is the chief operating decision maker, regularly reviews to decide how to allocate resources and assess performance. We periodically review and align our internal reporting structure as our product and service offerings and our customer base expand in reach and presence to ensure our organization effectively serves the diverse and evolving Cloud Computing market. Since we operate in one reportable segment, all relevant financial information used to allocate resources and assess performance can be found in the consolidated financial statements.

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)
 
2011
 
2012
 
2013
United States
 
$
767,752

 
$
973,733

 
$
1,133,645

International
 
257,312

 
335,506

 
401,141

Total net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786

 
In the future, we will attribute revenue to geographic location based on the customer's billing address, either the U.S. or International, primarily the U.K. While the geographic information is not significantly different from the current method, we believe the customer billing address is the best indicator of customer location. Due to system limitations, we have determined that it is impracticable to restate the 2011 and 2012 revenue information on this basis. Total net revenue by geographic region in 2013 based upon the customer's billing address was as follows:
 
 
Year Ended December 31,
(In thousands)
 
2013
United States
 
$
1,076,248

International
 
458,538

Total net revenue
 
$
1,534,786


Total net revenue by our product categories was as follows:
 
 
Year Ended December 31,
 
 
2011
 
2012
 
2013
Dedicated Cloud
 
$
835,877

 
$
1,005,165

 
$
1,119,636

Public Cloud
 
189,187

 
304,074

 
415,150

Total net revenue
 
$
1,025,064

 
$
1,309,239

 
$
1,534,786


Our long-lived assets are primarily located in the U.S. and the U.K., and to a lesser extent Hong Kong and Australia. Property and equipment, net by geographic region was as follows: 
(In thousands)
 
December 31,
2012
 
December 31,
2013
United States
 
$
534,275

 
$
654,507

International
 
190,710

 
236,269

Total property and equipment, net
 
$
724,985

 
$
890,776


- 87 -

15. Employee Benefit Plans

We sponsor a defined contribution retirement plan ("the Plan") for our U.S. employees, which has been determined by the IRS to qualify as a 401(k) plan. The Plan provides for voluntary tax-deferred contributions of up to 100% of gross compensation, subject to certain IRS limitations. The Plan also includes an employer contribution. During 2011, 2012 and 2013, contribution expense recognized for our U.S. plan was $3.9 million, $4.8 million and $6.5 million, respectively.

We also sponsor non-mandatory defined contribution plans for our international employees. Pursuant to these plans, we contribute a certain percentage of the employee’s salary. During 2011, 2012 and 2013, contribution expense recognized for our international plans was $1.9 million, $2.6 million and $3.8 million, respectively.


- 88 -

SUPPLEMENTARY FINANCIAL DATA
(UNAUDITED)

 
 
Quarters Ended
(In thousands, except per share amounts)
 
March 31,
2012
 
June 30,
2012
 
September 30,
2012
 
December 31,
2012
Net revenue
 
$
301,355

 
$
318,990

 
$
335,985

 
$
352,909

Cost of revenue
 
$
100,081

 
$
102,572

 
$
107,348

 
$
109,012

Gross profit
 
$
201,274

 
$
216,418

 
$
228,637

 
$
243,897

Net income
 
$
23,180

 
$
25,134

 
$
27,197

 
$
29,907

Earnings per share - basic
 
$
0.17

 
$
0.19

 
$
0.20

 
$
0.22

Earnings per share - diluted
 
$
0.17

 
$
0.18

 
$
0.19

 
$
0.21

Cash and cash equivalents
 
$
186,531

 
$
215,448

 
$
257,651

 
$
292,061


 
 
Quarters Ended
(In thousands, except per share amounts)
 
March 31,
2013
 
June 30,
2013
 
September 30,
2013
 
December 31,
2013
Net revenue
 
$
362,200

 
$
375,847

 
$
388,636

 
$
408,103

Cost of revenue
 
$
113,610

 
$
117,658

 
$
127,404

 
$
133,821

Gross profit
 
$
248,590

 
$
258,189

 
$
261,232

 
$
274,282

Net income
 
$
27,261

 
$
22,367

 
$
16,311

 
$
20,798

Earnings per share - basic
 
$
0.20

 
$
0.16

 
$
0.12

 
$
0.15

Earnings per share - diluted
 
$
0.19

 
$
0.16

 
$
0.11

 
$
0.14

Cash and cash equivalents
 
$
278,627

 
$
263,052

 
$
269,995

 
$
259,733


Certain reclassifications have been made to prior year amounts in order to conform to the current year's presentation. Refer to Note 1, "Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies," for more information about these reclassifications.


- 89 -

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

None.

ITEM 9A - CONTROLS AND PROCEDURES

(a) 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 identified the material weakness described below and solely based on that material weakness, concluded that, as of the Evaluation Date, our disclosure controls and procedures were not effective as of December 31, 2013.

Management concluded there was a material weakness in the design and operating effectiveness of controls over the recognition, measurement, and disclosure of complex real estate development and lease arrangements. Specifically, we have entered into certain complex real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects. While the independent developer legally owns the real estate projects and must finance the overall construction, we have funded certain structural improvements and/or retained obligations related to certain potential construction cost overruns which have triggered an accounting requirement to include construction costs in progress and a related long-term lease finance liability on our balance sheets as though we are the owner of the asset during the construction period. Our original assessment on the appropriate accounting treatment for these development and lease agreements was incorrect. The material weakness resulted in misstatements in our financial statements, specifically including a non-material change to the previously released unaudited balance sheet as of December 31, 2013, which we had disseminated in our fourth quarter and year-end earnings release and furnished in a Form 8-K on February 10, 2014. See Item 8 of Part II, "Financial Statements and Supplementary Data - Note 9 - Leases" for information on the effect that such leases had on our financial statements.

Notwithstanding the material weakness that existed as of December 31, 2013, our chief executive officer and chief financial officer have each concluded that the consolidated financial statements included in this Form 10-K present fairly, in all material respects, the financial position, results of operations and cash flows of our company and its subsidiaries in conformity with accounting principles generally accepted in the United States of America. We intend to remediate the underlying causes of the material weakness, primarily through enhancing internal controls and procedures with respect to our evaluation of complex development and lease agreements, as further described below.

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.


- 90 -

(b) 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 (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. During this evaluation, management identified a material weakness in internal control over financial reporting, as described below. Management has concluded that as a result of this material weakness, our internal control over financial reporting was not effective as of December 31, 2013.

Management concluded there was a material weakness in the design and operating effectiveness of controls over the recognition, measurement, and disclosure of complex real estate development and lease arrangements. The material weakness resulted in misstatements in our financial statements, as we determined we should record the construction costs in progress and a related long-term lease finance liability on our balance sheet.
 
While the misstatements as a result of this material weakness were not material to our financial statements, absent changes to our controls, there is a reasonable possibility that a material misstatement of the Company's annual or interim consolidated financial statements would not be prevented or detected on a timely basis.

Our independent registered public accounting firm, KPMG LLP, has issued an adverse audit report on the effectiveness of our internal control over financial reporting as of December 31, 2013, which is included in Item 8 of this Annual Report on Form 10-K.

(c) Changes in internal control over financial reporting

There were no changes in our internal control 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 other than the material weakness described above.

(d) Management’s Plan for Remediation of Our Material Weakness

To remediate this material weakness, we intend to enhance our process around identifying and reviewing complex real estate development and lease agreements, beginning with the 2014 fiscal year, by (i) formalizing the process of timely identifying the origination of transactions with development and lease arrangements; (ii) implementing more comprehensive procedures for the accounting review of such transactions; (iii) creating a formal checklist of accounting provisions to be considered and evaluated during the review process; (iv) creating specific documentation standards of how accounting provisions were identified, considered and concluded upon and (v) developing more robust review standards. Our internal audit department will also conduct a review of the enhanced process during fiscal 2014.

ITEM 9B - OTHER INFORMATION
 
None.


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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 2014 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2013.

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, Chief Accounting Officer, 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 2014 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2013.

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

The information required by this item is incorporated by reference to Rackspace Hosting's Proxy Statement for its 2014 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2013.

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 2014 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2013.

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 2014 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year ended December 31, 2013.


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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 the 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:
 
 
 
 
 
 
 
2011
$
2,846

 
$
9,063

 
$
(8,489
)
 
$
3,420

2012
$
3,420

 
$
9,411

 
$
(8,595
)
 
$
4,236

2013
$
4,236

 
$
8,167

 
$
(8,512
)
 
$
3,891


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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 March 3, 2014.

 
 
 
Rackspace Hosting, Inc.
Date:
March 3, 2014
 
By:
 
/s/ GRAHAM WESTON
 
 
 
 
 
Graham Weston
 
 
 
 
 
Chief Executive Officer and Chairman
 
 
 
 
 
(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/ GRAHAM WESTON
 
Chief Executive Officer and Chairman
 
March 3, 2014
Graham Weston
 
(Principal Executive Officer)
 
 
 
 
 
 
 
/s/ KARL PICHLER
 
Chief Financial Officer and Treasurer
 
March 3, 2014
Karl Pichler
 
(Principal Financial Officer)
 
 
 
 
 
 
 
/s/ JOSEPH SAPORITO
 
Chief Accounting Officer
 
March 3, 2014
Joseph Saporito
 
(Principal Accounting Officer)
 
 
 
 
 
 
 
/s/ S. JAMES BISHKIN
 
Director
 
March 3, 2014
S. James Bishkin
 
 
 
 
 
 
 
 
 
/s/ OSSA FISHER
 
Director
 
March 3, 2014
Ossa Fisher
 
 
 
 
 
 
 
 
 
/s/ SAM GILLILAND
 
Director
 
March 3, 2014
Sam Gilliland
 
 
 
 
 
 
 
 
 
/s/ MARK P. MELLIN
 
Director
 
March 3, 2014
Mark P. Mellin
 
 
 
 
 
 
 
 
 
/s/ PALMER L. MOE
 
Director
 
March 3, 2014
Palmer L. Moe
 
 
 
 
 
 
 
 
 
/s/ LEW MOORMAN
 
Director
 
March 3, 2014
Lew Moorman
 
 
 
 
 
 
 
 
 
/s/ FRED REICHHELD
 
Director
 
March 3, 2014
Fred Reichheld
 
 
 
 
 
 
 
 
 
/s/ GEORGE J. STILL, JR.
 
Director
 
March 3, 2014
George J. Still, Jr.
 
 
 
 

- 94 -

INDEX TO EXHIBITS
 
Exhibits
 
 Description
 
 
 
3.1(A)
 
Form of Restated Certificate of Incorporation of the Registrant (2)
3.1(B)
 
Certificate of Amendment to the Restated Certificate of Incorporation of the Registrant (3)
3.2
 
Amended and Restated Bylaws of Rackspace Hosting, Inc. (19)
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
 
2003 Stock Option Plan and form of agreement thereunder (1)
10.2
 
Webmail.us., Inc. 2004 Stock Incentive Plan, as amended in 2006 (1)
10.3
 
2005 Non-Qualified Stock Option Plan and form of agreement thereunder (1)
10.4
 
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)
10.5(A)
 
2007 Long-Term Incentive Plan as Amended and Restated (22)
10.5(B)
 
Form of RSU Agreement Under 2007 Long-Term Incentive Plan (Time-Based) (5)
10.5(C)
 
Form of RSU Agreement Under 2007 Long-Term Incentive Plan (Performance-Based) (5)
10.5(D)
 
Form of RSU Agreement Under 2007 Long-Term Incentive Plan (SLT Performance-Based) (13)
10.5(E)
 
Rules of the Rackspace Hosting, Inc. 2010 HM Revenue & Customs U.K. Approved Sub-plan (11)
10.5(F)
 
Form of the 2010 HM Revenue & Customs U.K. Approved Sub-plan, Notice of Grant of Stock Options (11)
10.5(G)
 
Notice of Grant of RSUs for Outside Directors (21)
10.6(A)
 
Economic Development Agreement between the State of Texas and Rackspace US, Inc., dated August 1, 2007 (1)
10.6(B)
 
Amendment Number One to the Economic Development Agreement between the State of Texas and Rackspace US, Inc. (7)
10.7
 
Ground Lease Agreement, dated August 2, 2007, between Windcrest Economic Development Corporation and Rackspace US, Inc., as amended on April 24, 2008 (1)
10.8
 
City Economic Development Grant Agreement between the City of Windcrest, Texas and Rackspace US, Inc., dated August 2, 2007 (1)
10.9
 
County Economic Development Grant Agreement between Bexar County, Texas and Rackspace US, Inc., dated August 2, 2007 (1)
10.10
 
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)
10.11
 
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
 
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)
10.13(A)
 
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)
10.13(B)
 
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, 2001 (1)
10.13(C)
 
Third Amendment to Lease Agreement, dated January 8, 2008, between CLPF-Heritage Four, L.P. and Rackspace DAL1DC Management LLC (1)
10.14
 
Agreement for Lease, dated April 2, 2007, between Slough Trading Estate Limited and Rackspace Managed Hosting Limited (1)
10.15
 
Form of Indemnification Agreement for directors and officers (2)

- 95 -

Exhibits
 
 Description
10.16
 
Rackspace US, Inc. Deferred Compensation Plan (3)
10.17
 
Form of Share Option Agreement (U.K.) (4)
10.18
 
Rackspace Standard Form of Employment Agreement (5)
10.19
 
Non-employee Director Compensation Schedule, Approved November 2011 (21)
10.20(A)
 
Offer letter from the Registrant to James Lewandowski, dated September 9, 2008 (5)
10.20(B)
 
Agreement and Release of Claims with James Lewandowski, dated October 9, 2012 (23)
10.21(A)†
 
Lease Agreement by and between Grizzly Ventures LLC and Rackspace US, Inc., dated February 5, 2009 (6)
10.21(B)
 
First Amendment to Lease Agreement by and between Grizzly Ventures LLC and Rackspace US, Inc., dated October 1, 2009 (9)
10.22(A)†
 
Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated July 31, 2009 (8)
10.22(B)†
 
First Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated May 4, 2010 (12)
10.22(C)†
 
Second Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated February 24, 2011 (15)
10.22(D)†
 
Fourth Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated August 19, 2011 (17)
10.22(E)
 
Fifth Amendment to Lease Agreement by and between Tarantula Ventures LLC and Rackspace US, Inc., dated January 6, 2012 (18)
10.23†
 
Agreement for Lease between Digital Realty (St. Denis SARL) and Rackspace Limited, dated January 11, 2013 (25)
10.24
 
Employment Agreement between Rackspace US, Inc. and Mark Roenigk, dated December 14, 2009 (10)
10.25
 
Property Lease by and among Rackspace Limited, Hyde Park GP Limited and Hyde Park Nominee Limited, dated August 18, 2010 (14)
10.26(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. (20)
10.26(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 (16)
10.27†
 
Lease Agreement by and between Collins Technology Park Partners, LLC, and Rackspace US, Inc., dated December 29, 2011 (18)
10.28
 
Employment Offer Letter for Joe Saporito, dated January 16, 2012 (21)
10.29
 
Compensation Agreement between Rackspace US, Inc. and Karl Pichler, dated January 27, 2012 (18)
10.30
 
Lease Agreement by and between Fox Properties LLC and Rackspace US, Inc., dated April 26, 2012 (22)
10.31
 
Cash Bonus Plan (24)
10.32
 
2008 Employee Stock Purchase Plan and form of agreement thereunder (2)
10.33
 
2008 Employee Stock Purchase Plan- Share Incentive Sub-Plan (26)
10.34
 
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)
10.35
 
Storage Lease, effective March 1, 2004, between Santa Clara Land Company, Ltd. and the Registrant (2)
10.36(A)
 
Lease Agreement, dated January 28, 2008, between Santa Clara Land Company, Ltd. and Rackspace US, Inc. (1)
10.36(B)
 
First Amendment to Office Building Lease Agreement between Santa Clara and Company, Ltd. and Rackspace US, Inc., dated July 10, 2008 (3)
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

- 96 -

Exhibits
 
 Description
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
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 July 30, 2009.
(8)
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.
(9)
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.
(10)
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.
(11)
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.
(12)
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.
(13)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed August 27, 2010.
(14)
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.
(15)
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.
(16)
Incorporated by reference to the Company's Current Report on Form 8-K/A (File No. 001-34143), filed September 29, 2011.
(17)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 2011 (File No. 001-34143), filed November 8, 2011.
(18)
Incorporated by reference to the Company's Annual Report on Form 10-K for the Year ended December 31, 2011 (File No. 001-34143), filed February 17, 2012.
(19)
Incorporated by reference to the Company's Current Report on Form 8-K (File No. 001-34143), filed March 21, 2012.
(20)
Incorporated by reference to the Company's Current Report on Form 8-K/A (File No. 001-34143), filed May 2, 2012.
(21)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended March 31, 2012 (File No. 001-34143), filed May 9, 2012.
(22)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended June 30, 2012 (File No. 001-34143), filed August 9, 2012.
(23)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended September 30, 2012 (File No. 001-34143), filed November 7, 2012.

- 97 -

(24)
Incorporated by reference to the Company's Annual Report on Form 10-K for the Year ended December 31, 2012 (File No. 001-34143), filed March 1, 2013.
(25)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q/A for the Quarter ended March 31, 2013 (File No. 001-34143), filed December 31, 2013.
(26)
Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Quarter ended June 30, 2013 (File No. 001-34143), filed August 9, 2013.

- 98 -