UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2013.

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 For the transition period from ______ to ______.

Commission file number 001-34143

RACKSPACE HOSTING, INC.

(Exact name of registrant as specified in its charter)

Delaware	74-3016523
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

5000 Walzem Rd.

San Antonio, Texas 78218

(Address of principal executive offices, including zip code)

(210) 312-4000

(Registrant’s telephone number, including area code)

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer," "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

On August 2, 2013, 138,938,060 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.

RACKSPACE HOSTING, INC.

TABLE OF CONTENTS

Part I - Financial Information
Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets as of December 31, 2012 and June 30, 2013 (unaudited)	3
	Unaudited Condensed Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2013	4
	Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2013	5
	Notes to the Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4.	Controls and Procedures	31
Part II - Other Information
Item 1.	Legal Proceedings	32
Item 1A.	Risk Factors	33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 6.	Exhibits	54
Signatures		55

PART I – FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)	December 31, 2012			June 30, 2013
				(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	292,061		$	263,052
Accounts receivable, net of allowance for doubtful accounts and customer credits of $4,236 as of December 31, 2012 and $3,720 as of June 30, 2013	92,834			102,591
Deferred income taxes	10,320			20,770
Prepaid expenses	25,195			21,897
Other current assets	4,835			8,464
Total current assets	425,245			416,774
Property and equipment, net	724,985			802,666
Goodwill	68,742			76,831
Intangible assets, net	23,802			26,100
Other non-current assets	52,777			55,557
Total assets	$	1,295,551		$	1,377,928
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	105,174		$	113,421
Accrued compensation and benefits	48,404			49,673
Income and other taxes payable	21,550			15,458
Current portion of deferred revenue	17,265			17,803
Current portion of obligations under capital leases	61,302			50,245
Current portion of debt	1,744			1,808
Total current liabilities	255,439			248,408
Non-current liabilities:
Deferred revenue	3,695			4,833
Obligations under capital leases	60,335			35,237
Debt	1,991			1,144
Deferred income taxes	71,081			83,423
Deferred rent	32,293			36,887
Other liabilities	27,070			34,099
Total liabilities	451,904			444,031
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; 138,853,330 shares issued and outstanding as of June 30, 2013	138			139
Additional paid-in capital	515,188			567,738
Accumulated other comprehensive loss	(8,089		)	(20,018		)
Retained earnings	336,410			386,038
Total stockholders’ equity	843,647			933,897
Total liabilities and stockholders’ equity	$	1,295,551		$	1,377,928

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
(In thousands, except per share data)	2012			2013			2012			2013
Net revenue	$	318,990		$	375,847		$	620,345		$	738,047
Costs and expenses:
Cost of revenue	102,572			117,658			202,653			231,268
Research and development	16,742			26,776			30,189			49,549
Sales and marketing	41,310			52,269			81,596			102,083
General and administrative	55,854			69,280			111,160			132,359
Depreciation and amortization	61,808			74,460			116,959			144,571
Total costs and expenses	278,286			340,443			542,557			659,830
Income from operations	40,704			35,404			77,788			78,217
Other income (expense):
Interest expense	(1,233		)	(833		)	(2,505		)	(1,773		)
Interest and other income (expense)	(405		)	(303		)	(268		)	(104		)
Total other income (expense)	(1,638		)	(1,136		)	(2,773		)	(1,877		)
Income before income taxes	39,066			34,268			75,015			76,340
Income taxes	13,932			11,901			26,701			26,712
Net income	$	25,134		$	22,367		$	48,314		$	49,628
Other comprehensive income, net of tax
Foreign currency translation adjustments	$	(3,515	)	$	(1,860	)	$	977		$	(11,929	)
Other comprehensive income (loss)	(3,515		)	(1,860		)	977			(11,929		)
Comprehensive income	$	21,619		$	20,507		$	49,291		$	37,699
Net income per share
Basic	$	0.19		$	0.16		$	0.36		$	0.36
Diluted	$	0.18		$	0.16		$	0.34		$	0.34
Weighted average number of shares outstanding
Basic	135,033			138,011			134,045			139,463
Diluted	140,786			142,178			140,396			144,180

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
(In thousands)	2012			2013
Cash Flows From Operating Activities
Net income	$	48,314		$	49,628
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization	116,959			144,571
Loss on disposal of equipment, net	365			225
Provision for bad debts and customer credits	3,133			2,361
Deferred income taxes	2,673			(1,891		)
Deferred rent	4,050			5,484
Share-based compensation expense	17,884			25,498
Excess tax benefits from share-based compensation arrangements	(29,836		)	(16,197		)
Changes in certain assets and liabilities
Accounts receivable	(19,314		)	(13,488		)
Prepaid expenses and other current assets	7,880			(556		)
Accounts payable and accrued expenses	26,179			15,535
Deferred revenue	705			2,065
All other operating activities	714			6,757
Net cash provided by operating activities	179,706			219,992
Cash Flows From Investing Activities
Purchases of property and equipment	(134,006		)	(225,377		)
Acquisitions, net of cash acquired	(712		)	(6,203		)
All other investing activities	39			(372		)
Net cash used in investing activities	(134,679		)	(231,952		)
Cash Flows From Financing Activities
Principal payments of capital leases	(35,042		)	(35,550		)
Principal payments of notes payable	(879		)	(897		)
Payments for deferred acquisition obligations	(4,726		)	(1,238		)
Receipt of Texas Enterprise Fund Grant	3,500			—
Proceeds from employee stock plans	17,843			6,400
Excess tax benefits from share-based compensation arrangements	29,836			16,197
Net cash provided by (used in) financing activities	10,532			(15,088		)
Effect of exchange rate changes on cash and cash equivalents	33			(1,961		)
Increase (decrease) in cash and cash equivalents	55,592			(29,009		)
Cash and cash equivalents, beginning of period	159,856			292,061
Cash and cash equivalents, end of period	$	215,448		$	263,052
Supplemental cash flow information:
Acquisition of property and equipment by vendor financed capital leases	$	43,944		$	415
Acquisition of property and equipment by vendor financed notes payable	2,045			—
Increase (decrease) in property and equipment in accounts payable and accrued expenses	(15,711		)	6,132
Non-cash purchases of property and equipment	$	30,278		$	6,547
Shares issued in business combinations	$	—		$	4,457
Cash payments for interest, net of amount capitalized	$	2,466		$	1,908
Cash payments for income taxes	$	4,072		$	10,035

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

 NOTES TO THE UNAUDITED CONDENSED 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 on March 7, 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

The accompanying consolidated financial statements as of June 30, 2013, and for the three and six months ended June 30, 2012 and 2013, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all financial information and disclosures required by GAAP for complete financial statements, and certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include normal recurring adjustments, necessary for a fair statement of our financial position as of June 30, 2013, our results of operations for the three and six months ended June 30, 2012 and 2013, and our cash flows for the six months ended June 30, 2012 and 2013.

These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2012 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 1, 2013. The results for the three and six months ended June 30, 2013 are not necessarily indicative of the results to be expected for the year ending December 31, 2013, or for any other interim period, or for any other future year.

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

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The changes do not affect the Company's previously reported Income from Operations or Net Income for the three and six months ended June 30, 2012 or amounts in the Condensed Consolidated Balance Sheet as of December 31, 2012 and Condensed Consolidated Statement of Cash Flows for the six months ended June 30, 2012. In connection with (i) the filing of the Company's Form 10-Q for the third quarter of 2013 and (ii) the filing of the 2013 Form 10-K, similar reclassifications will be made to the Company's Consolidated Statements of Comprehensive Income.

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

	Three Months Ended
(In thousands)	June 30, 2012			September 30, 2012
Cost of revenue	$	12,520		$	12,617
Research and development	$	16,742		$	19,528
Sales and marketing	$	1,697		$	2,185
General and administrative	$	(30,959	)	$	(34,330	)

	Six Months Ended			Nine Months Ended
(In thousands)	June 30, 2012			September 30, 2012
Cost of revenue	$	25,361		$	37,978
Research and development	$	30,189		$	49,717
Sales and marketing	$	3,481		$	5,666
General and administrative	$	(59,031	)	$	(93,361	)

	Year Ended
(In thousands)	December 31, 2011			December 31, 2012
Cost of revenue	$	37,246		$	51,534
Research and development	$	41,423		$	69,928
Sales and marketing	$	4,669		$	8,064
General and administrative	$	(83,338	)	$	(129,526	)

Use of Estimates

The preparation of financial statements in conformity with 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.

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 as of December 31, 2012, included in our Annual Report on Form 10-K.

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2. Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share: 

	Three Months Ended June 30,				Six Months Ended June 30,
(In thousands, except per share data)	2012		2013		2012		2013
Basic net income per share:
Net income	$	25,134	$	22,367	$	48,314	$	49,628
Weighted average shares outstanding:
Common stock	135,033		138,011		134,045		139,463
Number of shares used in per share computations	135,033		138,011		134,045		139,463
Earnings per share	$	0.19	$	0.16	$	0.36	$	0.36
Diluted net income per share:
Net income	$	25,134	$	22,367	$	48,314	$	49,628
Weighted average shares outstanding:
Common stock	135,033		138,011		134,045		139,463
Stock options, awards and employee share purchase plan	5,753		4,167		6,351		4,717
Number of shares used in per share computations	140,786		142,178		140,396		144,180
Earnings per share	$	0.18	$	0.16	$	0.34	$	0.34

We excluded 1.1 million and 4.3 million potential common shares from the computation of dilutive earnings per share for the three months ended June 30, 2012 and 2013, respectively, and 0.9 million and 2.8 million potential shares for the six months ended June 30, 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		June 30, 2013
Cash deposits	$	131,271	$	126,199
Money market funds	160,790		136,853
Cash and cash equivalents	$	292,061	$	263,052

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

Our money market mutual funds 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.

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 of hierarchy, which prioritizes the inputs used in measuring fair value as follows:

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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.

There have been no material changes to the valuation techniques utilized in the fair value measurement of assets and liabilities presented on our balance sheet as disclosed in our Form 10-K for the year ended December 31, 2012.

Assets and liabilities measured at fair value on a recurring basis are summarized by level below. The table does not include assets and liabilities that are measured at historical costs or any other basis other than fair value.

	December 31, 2012
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Assets/Liabilities at Fair Value
Assets:
Money market funds (1)	$	160,790	$	—	$	—	$	160,790
Rabbi trust (2)	520		—		—		520
Total	$	161,310	$	—	$	—	$	161,310
Liabilities:
Deferred compensation (3)	$	410	$	—	$	—	$	410
Total	$	410	$	—	$	—	$	410

	June 30, 2013
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Assets/Liabilities at Fair Value
Assets:
Money market funds (1)	$	136,853	$	—	$	—	$	136,853
Rabbi trust (2)	668		—		—		668
Total	$	137,521	$	—	$	—	$	137,521
Liabilities:
Deferred compensation (3)	$	467	$	—	$	—	$	467
Total	$	467	$	—	$	—	$	467

(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 the three and six months ended June 30, 2012 and June 30, 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			June 30, 2013
Computers, software and equipment	1	-	5	years	$	1,140,772		$	1,301,847
Furniture and fixtures	7	years			40,557			47,542
Buildings and leasehold improvements	2	-	30	years	214,858			217,716
Land					15,864			16,022
Property and equipment, at cost					1,412,051			1,583,127
Less accumulated depreciation and amortization					(738,274		)	(844,392		)
Work in process					51,208			63,931
Property and equipment, net					$	724,985		$	802,666

Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $58.9 million and $72.0 million for the three months ended June 30, 2012 and 2013, respectively, and $112.3 million and $139.9 million for the six months ended June 30, 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 June 30, 2013, the work in process balance consisted of build outs of $27.5 million for office facilities, $4.9 million for data centers, and $31.5 million for capitalized software and other projects.

There was no interest capitalized during the three or six months ended June 30, 2012 or 2013. 

6. Business Combinations and Goodwill

During the first six months of 2013, we acquired two companies for total cash and equity consideration of $11.5 million, of which approximately $8.1 million was attributed to goodwill, $5.1 million to acquired intangible assets and $1.7 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. These estimates are subject to change within the measurement period. 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.

The following table provides a roll forward of our goodwill balance.

(In thousands)
Balance at December 31, 2012	$	68,742
Acquisitions	8,089
Balance at June 30, 2013	$	76,831

The goodwill recorded in 2013 is not deductible for tax purposes.

In prior periods, we acquired companies that required additional future payments in addition to the initial cash payment. During the first six months of 2013, we paid $1.3 million related to these previous acquisitions, and as of June 30, 2013, the fair value of the remaining liability recorded was $0.6 million.

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7. Contingencies

We have contingent liabilities resulting from various litigation, claims and commitments. We record accruals for loss contingencies when losses are considered probable and can be reasonably estimated. The amount that will ultimately be paid related to these matters may differ from the recorded accruals, and the timing of such payments is uncertain. 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 alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We believe that the amount or range of reasonably possible loss in this case will not have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows.

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.

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8. Share-Based Compensation

The Company has granted equity awards to its employees and directors in the form of stock options and restricted stock. The exercise price of all stock options granted is not less than 100% of the fair market value of a share of common stock as of the date of grant. The stock options granted generally vest ratably over a four-year period or cliff-vest at the third anniversary date of the grant. Stock options assumed through acquisitions vest 25% the first year and ratably over the remaining periods. All stock options expire seven to ten years following the grant date. The restricted stock generally vest ratably over a four-year period. Certain key executives receive restricted stock grants that vest based on predetermined market and/or performance conditions.

The composition of the equity awards outstanding as of December 31, 2012 and June 30, 2013 was as follows: 

	December 31, 2012	June 30, 2013
Restricted stock	2,800,230	3,348,737
Stock options	9,032,512	10,077,041
Total outstanding awards	11,832,742	13,425,778

The Company also has an Employee Stock Purchase Plan (the "ESPP"). 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 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. The current ESPP began on January 1, 2012 and will conclude on December 31, 2013. Eligible employees may enroll at the beginning of any semi-annual purchase interval.

Share-Based Compensation Expense

Share-based compensation expense was recognized as follows: 

	Three Months Ended June 30,						Six Months Ended June 30,
(in thousands)	2012			2013			2012			2013
Cost of revenue	$	2,068		$	2,735		$	4,334		$	5,254
Research and development	1,340			2,051			2,662			3,798
Sales and marketing	1,436			1,744			2,594			3,402
General and administrative	4,531			6,785			8,294			13,044
Pre-tax share-based compensation	9,375			13,315			17,884			25,498
Less: Income tax benefit	(3,344		)	(4,633		)	(6,366		)	(8,922		)
Total share-based compensation expense, net of tax	$	6,031		$	8,682		$	11,518		$	16,576

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 June 30, 2013, there was $161.7 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.

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9. Taxes

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 expect a taxable profit in the U.S. and U.K. for the full year 2013 before consideration of excess tax benefits, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2013. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the current period.

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. 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. The determination of the amount of unrecognized deferred tax liability related to undistributed earnings is not practicable.

10. Comprehensive Income

There was no income tax expense allocated to foreign currency translation adjustments during the three or six months ended June 30, 2012 or 2013.

The change in accumulated other comprehensive income (loss) for the six months ended June 30, 2013 was as follows:

(In thousands)	Accumulated other comprehensive loss
Balance at December 31, 2012	$	(8,089	)
Foreign currency cumulative translation adjustment	(11,929		)
Balance at June 30, 2013	$	(20,018	)

11. 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.

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ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

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

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

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

Overview of our Business

Rackspace is the open cloud company, delivering open source technologies at web scale to more than 200,000 business customers in 120 countries. We free our business customers from much of the expense and hassle of owning and managing their own computer hardware and software and allow them to focus on their core business. We are a founder of OpenStack^®, a fast-growing open cloud platform and developer community. Our leadership in open standards promotes faster innovation and gives customers freedom of movement among cloud providers. We are also a pioneer in hybrid cloud, which offers each customer the cloud that best fits its specific needs. This hybrid approach can deliver superior performance and cost savings for customers by running each of their applications where it runs best - whether on public cloud, private cloud, dedicated hardware, or a combination of these platforms. Our growth is the result of our technology leadership and our renowned customer service, known as Fanatical Support.

Over the last several years we have made significant investments in open technologies, hybrid cloud and Fanatical Support. We will continue to pursue strategic investments that have the potential to increase our capabilities to serve customers, enhance our competitive advantage, and generate savings. 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 sell our services to small and medium-sized businesses, as well as large enterprises. The majority of our revenue is generated by our operations in the U.S. and U.K. Additionally, we have operations in Hong Kong and recently opened a data center and sales office in Australia. Our growth strategy includes targeting additional international markets as we plan to continue our expansion in continental Europe, the Asia-Pacific region and Latin America. For the first six months of 2013, no individual customer accounted for greater than 2% of our net revenue.

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Product and Service Offerings

We continue to invest in our hybrid cloud, which provides each customer the cloud services that best fit its specific needs, with applications running where they run most cost-effectively, whether on public cloud, private cloud, or dedicated hardware; in our data centers; or in the customer's facilities. Customers using hybrid cloud can achieve higher performance and overall lower costs when compared to a one-size-fits-all provider that offers only one platform such as public cloud. We make public cloud and dedicated cloud work seamlessly together for customers through our innovative RackConnect^® offering, and we are working to extend that service to include private cloud.

We continue to invest in our public cloud service and believe it is an important part of our future success. The primary benefit of public cloud is the value proposition that it provides for businesses because it enables them to match costs directly to revenue and to scale up and down on a real-time basis as necessary. We do not believe that public cloud will replace traditional computing on dedicated servers. We believe the two complement one another, allowing customers to choose the best platform for each of their workloads. A focus in our growth strategy is to build our product portfolio to include higher service levels and additional capabilities. We are investing in this strategy and are creating new technologies to help businesses leverage the benefits of public cloud hosting.

Our product strategy includes the development of a variety of new capabilities and features and building a support business around the OpenStack cloud computing platform. In 2012, we introduced the Rackspace Open Cloud, which marks the first time any company has deployed a large-scale open source public cloud powered by OpenStack. With the complete suite of OpenStack-based cloud solutions in full production, Rackspace offers an open, fast and simple cloud experience. Rackspace provides customers with choice and control without the fear of being locked into proprietary technologies. Our open cloud solutions, backed by Fanatical Support, are also available under a managed service level that makes our expertise available to design, plan, deploy, optimize and maintain the environments our customers utilize for business-critical applications.

In 2012, we also released our Rackspace Private Cloud service offering. Private cloud refers to virtualized cloud computing resources that are dedicated to one particular customer, rather than being used by multiple customers. Rackspace facilitates implementation of the OpenStack platform, in combination with operations and support services, in any data center a customer may choose: theirs, ours, or one run by a third party. Customers can choose among support options that range from basic software support to advanced Rackspace operational support. Private cloud has proven popular among customers who value enhanced control, compliance, and customization and whose deployments are large enough to justify their own cloud infrastructure. When customers use Rackspace to install and operate a private cloud in the customer's data center or in a colocation facility, the business model becomes highly capital-efficient for Rackspace, as we do not have to buy additional hardware or lease additional data center space. It represents a new and promising way for Rackspace to deliver open technologies backed by Fanatical Support. Though our private cloud offering is relatively new, the research firm Forrester ranked Rackspace as one of its two “top performers” in its 2013 assessment of “Hosted Private Cloud” providers. Revenue for the Rackspace Private Cloud is included within dedicated cloud revenue in our Key Metrics table.

Our ongoing public cloud product and platform transition is a lengthy and complex process that began with a strategic decision to adopt an open source solution to power our public cloud. This involved deploying significant resources to develop and implement the cloud products that comprise the key elements of the OpenStack platform, then continued through the actual roll-out of the new platform, and continues today with infrastructure and support changes, new marketing and sales strategies, corporate-wide knowledge development and training, and reorganization of business units as necessary for the success of the platform and products. In the section titled "Risk Factors," see the risk factor titled, "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."

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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. 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 public cloud and Rackspace Private Cloud platform and product set; (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources, larger customer bases, longer operating histories, greater brand recognition, more established relationships in the industry, and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities; (iii) new pricing strategies that may include lowering price points for cloud products to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our cloud products to certain significant cloud customers; (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases; (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve, including the current volatile economic environment found in Europe; and (vi) other risks as set forth in the section titled “Risk Factors.”

Recent 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. While the acquisitions did not have a material impact on our financial results, the acquisitions further enhance our portfolio of products and services. 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 cloud that best fits their specific needs. We believe this new hybrid cloud option could increase our ability to generate revenue in these markets.

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, and infrastructure capacity and utilization. The following data should be read in conjunction with the consolidated financial statements, the notes to the financial statements and other financial information included in this Quarterly Report on Form 10-Q.

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	Three Months Ended
(Dollar amounts in thousands, except average monthly revenue per server)	June 30, 2012			September 30, 2012			December 31, 2012			March 31, 2013			June 30, 2013
Growth
Dedicated cloud, net revenue	$	246,417		$	256,559		$	265,585		$	271,311		$	276,845
Public cloud, net revenue	$	72,573		$	79,426		$	87,324		$	90,889		$	99,002
Net revenue	$	318,990		$	335,985		$	352,909		$	362,200		$	375,847
Revenue growth (year over year)	29.0		%	27.0		%	24.6		%	20.2		%	17.8		%
Net upgrades (monthly average)	1.7		%	1.6		%	1.2		%	0.9		%	1.5		%
Churn (monthly average)	-0.8		%	-0.8		%	-0.7		%	-0.8		%	-0.8		%
Growth in installed base (monthly average) (2)	1.0		%	0.8		%	0.5		%	0.1		%	0.7		%
Number of employees (Rackers) at period end	4,528			4,596			4,852			5,043			5,272
Number of servers deployed at period end	84,978			89,051			90,524			94,122			98,884
Average monthly revenue per server	$	1,270		$	1,287		$	1,310		$	1,308		$	1,298
Profitability
Income from operations	$	40,704		$	45,330		$	49,623		$	42,813		$	35,404
Depreciation and amortization	$	61,808		$	63,972		$	68,914		$	70,111		$	74,460
Share-based compensation expense
Cost of revenue	$	2,068		$	2,499		$	2,759		$	2,519		$	2,735
Research and development	$	1,340		$	1,677		$	1,459		$	1,747		$	2,051
Sales and marketing	$	1,436		$	2,021		$	1,764		$	1,658		$	1,744
General and administrative	$	4,531		$	6,221		$	5,262		$	6,259		$	6,785
Total share-based compensation expense	$	9,375		$	12,418		$	11,244		$	12,183		$	13,315
Adjusted EBITDA (1)	$	111,887		$	121,720		$	129,781		$	125,107		$	123,179
Adjusted EBITDA margin	35.1		%	36.2		%	36.8		%	34.5		%	32.8		%
Operating income margin	12.8		%	13.5		%	14.1		%	11.8		%	9.4		%
Income from operations	$	40,704		$	45,330		$	49,623		$	42,813		$	35,404
Effective tax rate	35.7		%	38.3		%	38.8		%	35.2		%	34.7		%
Net operating profit after tax (NOPAT) (1)	$	26,173		$	27,969		$	30,369		$	27,743		$	23,119
NOPAT margin	8.2		%	8.3		%	8.6		%	7.7		%	6.2		%
Capital efficiency and returns
Interest bearing debt	$	149,226		$	150,112		$	125,372		$	105,807		$	88,434
Stockholders' equity	$	714,819		$	781,934		$	843,647		$	879,035		$	933,897
Less: Excess cash	$	(177,169	)	$	(217,333	)	$	(249,712	)	$	(235,163	)	$	(217,950	)
Capital base	$	686,876		$	714,713		$	719,307		$	749,679		$	804,381
Average capital base	$	674,461		$	700,795		$	717,010		$	734,493		$	777,030
Capital turnover (annualized)	1.89			1.92			1.97			1.97			1.93
Return on capital (annualized) (1)	15.5		%	16.0		%	16.9		%	15.1		%	11.9		%
Capital expenditures
Cash purchases of property and equipment	$	69,385		$	53,449		$	82,919		$	105,541		$	119,836
Non-cash purchases of property and equipment (3)	$	12,583		$	31,934		$	5,096		$	19,858		$	(13,311	)
Total capital expenditures	$	81,968		$	85,383		$	88,015		$	125,399		$	106,525
Customer gear	$	53,746		$	51,026		$	60,099		$	85,690		$	73,022
Data center build outs	$	3,285		$	5,767		$	7,768		$	13,228		$	10,085
Office build outs	$	4,015		$	3,413		$	2,288		$	7,860		$	1,683
Capitalized software and other projects	$	20,922		$	25,177		$	17,860		$	18,621		$	21,735
Total capital expenditures	$	81,968		$	85,383		$	88,015		$	125,399		$	106,525
Infrastructure capacity and utilization
Megawatts under contract at period end	58.0			58.0			61.1			59.4			59.6
Megawatts available for use at period end	32.7			33.7			36.9			38.8			44.4
Megawatts utilized at period end	22.7			23.5			24.0			24.7			26.0
Annualized net revenue per average Megawatt of power utilized	$	57,867		$	58,179		$	59,437		$	59,499		$	59,305

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

(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.

Beginning last quarter, we have removed customer count from the Key Metrics table above as management no longer believes it is a key indicator of financial condition and operating performance. Over time, the relevance of our total customer count has diminished in terms of analyzing or predicting revenue trends given the ongoing growth of our public cloud, a broader set of products with different price points, the acquisitions we’ve made, and customers migrating from legacy platforms to new platforms. Therefore, management believes that other reported metrics, such as server count, are more relevant metrics for analyzing our results and assessing performance and trends.

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 payable 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)

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 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 decreased from 15.5% for the three months ended June 30, 2012 to 11.9% for the three months ended June 30, 2013. A decrease in operating income margin and an increase in our capital base was partially offset by a decrease in the effective tax rate. Return on assets decreased from 9.0% for the three months ended June 30, 2012 to 6.6% for the three months ended June 30, 2013. This decrease was primarily due to operating expenses increasing as a percentage of revenue and growth in our asset base due to the purchase of property and equipment to support the growth of our business.

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

	Three Months Ended
(In thousands)	June 30, 2012			September 30, 2012			December 31, 2012			March 31, 2013			June 30, 2013
Income from operations	$	40,704		$	45,330		$	49,623		$	42,813		$	35,404
Effective tax rate	35.7		%	38.3		%	38.8		%	35.2		%	34.7		%
Net operating profit after tax (NOPAT)	$	26,173		$	27,969		$	30,369		$	27,743		$	23,119
Net income	$	25,134		$	27,197		$	29,907		$	27,261		$	22,367
Total assets at period end	$	1,138,728		$	1,241,765		$	1,295,551		$	1,348,350		$	1,377,928
Less: Excess cash	(177,169		)	(217,333		)	(249,712		)	(235,163		)	(217,950		)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable	(148,091		)	(177,328		)	(175,128		)	(197,686		)	(178,552		)
Less: Deferred revenue (current and non-current)	(19,227		)	(18,483		)	(20,960		)	(21,811		)	(22,636		)
Less: Other non-current liabilities, deferred income taxes, and deferred rent	(107,365		)	(113,908		)	(130,444		)	(144,011		)	(154,409		)
Capital base	$	686,876		$	714,713		$	719,307		$	749,679		$	804,381
Average total assets	$	1,114,061		$	1,190,247		$	1,268,658		$	1,321,951		$	1,363,139
Average capital base	$	674,461		$	700,795		$	717,010		$	734,493		$	777,030
Return on assets (annualized)	9.0		%	9.1		%	9.4		%	8.2		%	6.6		%
Return on capital (annualized)	15.5		%	16.0		%	16.9		%	15.1		%	11.9		%

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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$11 million, or 10%, from $112 million in the three months ended June 30, 2012 to $123 million in the three months ended June 30, 2013; however, Adjusted EBITDA as a percentage of revenue decreased from 35.1% for the three months ended June 30, 2012 to 32.8% for the three months ended June 30, 2013. The decrease in Adjusted EBITDA margin was mainly due to a decrease in our operating income margin, from 12.8% for the three months ended June 30, 2012 to 9.4% for the three months ended June 30, 2013, primarily driven by increases in Research and Development, Sales and Marketing, and General and Administrative expenses as a percentage of revenue, partially offset by a decrease in Cost of Revenue expenses as a percentage of revenue. 

Adjusted EBITDA margin decreased from 34.5% for the three months ended March 31, 2013 to 32.8% for the three months ended June 30, 2013 primarily due to increases in Research and Development and General and Administrative expenses as a percentage of revenue. As we pursue our plans to re-accelerate revenue growth and deliberately increase operating investments into the business, we expect that in the near term Adjusted EBITDA margin could decline to approximately 30%, depending upon whether and how quickly those investments pay off.

Also impacting our results were changes in non-cash deferred rent and non-equity incentive compensation. Non-equity incentive compensation for the three months ended June 30, 2013decreased$2 million from the three months ended June 30, 2012 due to a decrease in the payout percentage, partially offset by increased headcount. Employee non-equity incentive compensation through our current non-equity incentive plan is dependent upon the net revenue of the company in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense. Additionally, the Compensation Committee has the discretion to 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. Beginning in 2013, the Board changed the metric by which we determine a payout under the bonus plan to net revenue growth to add a greater focus on our desire to accelerate our growth opportunities.

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See our reconciliation of Adjusted EBITDA to net income in the table below:

	Three Months Ended
(Dollars in thousands)	June 30, 2012			September 30, 2012			December 31, 2012			March 31, 2013			June 30, 2013
Net revenue	$	318,990		$	335,985		$	352,909		$	362,200		$	375,847
Income from operations	$	40,704		$	45,330		$	49,623		$	42,813		$	35,404
Net income	$	25,134		$	27,197		$	29,907		$	27,261		$	22,367
Plus: Income taxes	13,932			16,918			18,970			14,811			11,901
Plus: Total other (income) expense	1,638			1,215			746			741			1,136
Plus: Depreciation and amortization	61,808			63,972			68,914			70,111			74,460
Plus: Share-based compensation expense	9,375			12,418			11,244			12,183			13,315
Adjusted EBITDA	$	111,887		$	121,720		$	129,781		$	125,107		$	123,179
Operating income margin	12.8		%	13.5		%	14.1		%	11.8		%	9.4		%
Adjusted EBITDA margin	35.1		%	36.2		%	36.8		%	34.5		%	32.8		%

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 reconciliation of Adjusted Free Cash Flow to Adjusted EBITDA below, as well as our reconciliation of Adjusted EBITDA to net income provided above. 

	Three Months Ended			Six Months Ended
(In thousands)	June 30, 2013			June 30, 2013
Adjusted EBITDA	$	123,179		$	248,286
Non-cash deferred rent	1,519			5,484
Total capital expenditures	(106,525		)	(231,924		)
Cash payments for interest, net	(775		)	(1,826		)
Cash payments for income taxes, net	(5,911		)	(9,750		)
Adjusted free cash flow	$	11,487		$	10,270

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Results of Operations

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

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

Consolidated Statements of Income (Unaudited):

	Three Months Ended
(In thousands)	June 30, 2012			September 30, 2012			December 31, 2012			March 31, 2013			June 30, 2013
Net revenue	$	318,990		$	335,985		$	352,909		$	362,200		$	375,847
Costs and expenses:
Cost of revenue	102,572			107,348			109,012			113,610			117,658
Research and development	16,742			19,528			20,211			22,773			26,776
Sales and marketing	41,310			41,109			43,467			49,814			52,269
General and administrative	55,854			58,698			61,682			63,079			69,280
Depreciation and amortization	61,808			63,972			68,914			70,111			74,460
Total costs and expenses	278,286			290,655			303,286			319,387			340,443
Income from operations	40,704			45,330			49,623			42,813			35,404
Other income (expense):
Interest expense	(1,233		)	(1,253		)	(991		)	(940		)	(833		)
Interest and other income (expense)	(405		)	38			245			199			(303		)
Total other income (expense)	(1,638		)	(1,215		)	(746		)	(741		)	(1,136		)
Income before income taxes	39,066			44,115			48,877			42,072			34,268
Income taxes	13,932			16,918			18,970			14,811			11,901
Net income	$	25,134		$	27,197		$	29,907		$	27,261		$	22,367

Consolidated Statements of Income, as a Percentage of Net Revenue (Unaudited):

	Three Months Ended
(Percent of net revenue)	June 30, 2012		September 30, 2012		December 31, 2012		March 31, 2013		June 30, 2013
Net revenue	100.0	%	100.0	%	100.0	%	100.0	%	100.0	%
Costs and expenses:
Cost of revenue	32.2	%	32.0	%	30.9	%	31.4	%	31.3	%
Research and development	5.2	%	5.8	%	5.7	%	6.3	%	7.1	%
Sales and marketing	13.0	%	12.2	%	12.3	%	13.8	%	13.9	%
General and administrative	17.5	%	17.5	%	17.5	%	17.4	%	18.4	%
Depreciation and amortization	19.4	%	19.0	%	19.5	%	19.4	%	19.8	%
Total costs and expenses	87.2	%	86.5	%	85.9	%	88.2	%	90.6	%
Income from operations	12.8	%	13.5	%	14.1	%	11.8	%	9.4	%
Other income (expense):
Interest expense	(0.4	)%	(0.4	)%	(0.3	)%	(0.3	)%	(0.2	)%
Interest and other income (expense)	(0.1	)%	0.0	%	0.1	%	0.1	%	(0.1	)%
Total other income (expense)	(0.5	)%	(0.4	)%	(0.2	)%	(0.2	)%	(0.3	)%
Income before income taxes	12.2	%	13.1	%	13.8	%	11.6	%	9.1	%
Income taxes	4.4	%	5.0	%	5.4	%	4.1	%	3.2	%
Net income	7.9	%	8.1	%	8.5	%	7.5	%	6.0	%

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

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Second Quarter 2013 Overview

The highlights and significant events of the three months ended June 30, 2013 and the impact on our operating results compared to the three months ended March 31, 2013 were as follows:

Net Revenue

Net revenue increased$14 million, or 4%, from $362 million in the three months ended March 31, 2013 to $376 million in the three months ended June 30, 2013, primarily due to both an increasing number of new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased2% while net revenue for public cloud increased9% from the first quarter of 2013. Overall, our installed base grew at a monthly average rate of 0.7% in the three months ended June 30, 2013, compared to 0.1% in the three months ended March 31, 2013.

While sequential revenue growth accelerated from the first quarter to the second quarter, year over year revenue growth of 17.8% in the second quarter reflected lower growth than prior quarters. A number of items have accounted for the growth rate deceleration, including, without limitation, our ongoing public cloud platform transition, competition, and foreign exchange. We reasonably expect that the ongoing public cloud platform transition will continue throughout 2013, which may negatively impact our revenue growth rate. We have provided an expected revenue range for the third quarter of 2013 of $383 million to $389 million, representing sequential growth between approximately 2.0% and 3.5%.

During the second quarter, sequential quarter revenue growth was negatively impacted by a stronger U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the second quarter of 2013 would have been approximately $1 millionhigher had foreign exchange rates remained constant from the prior quarter, with minimal impact to our margins as the majority of 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.

Income from Operations

Operating income margin decreased from 11.8% in the three months ended March 31, 2013 to 9.4% in the three months ended June 30, 2013. While revenue growth over the last several quarters has decelerated from recent years, we have deliberately maintained spending in certain areas that we believe are important to our continued growth. These areas are primarily research and development spending around software development, particularly the OpenStack public cloud platform, as well as data center infrastructure investments, which includes taking on additional data center capacity through operating leases. Also impacting margins in the first six months of 2013 was increased marketing spend related to our open cloud branding campaign that was launched in the first quarter. Additionally, there was an increase in expenses related to corporate strategy initiatives.

These areas contrast with our sales and support functions, which have been scaling at a rate consistent with, or better than, revenue. Hiring in these functions has historically tracked closely with revenue growth. Overall, employee-related expenses increased 5.4% from the three months ended March 31, 2013 to the three months ended June 30, 2013 compared to revenue growth of 3.8%. Average headcount increased 4.2% with research and development increasing at the highest rate.

We reasonably expect to maintain spending at these levels for the remainder of the year as we deliberately continue to hire and make operating and capital investments into sectors of the business that are critical to accelerating future revenue growth.

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Three Months EndedJune 30, 2012 and June 30, 2013

Net Revenue

Net revenue increased$57 million, or 18%, from $319 million in the three months ended June 30, 2012 to $376 million in the three months ended June 30, 2013, primarily due to an increased volume of services provided, resulting from an increasing number of new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased12% while net revenue for public cloud increased36%. Overall, our installed base grew at a monthly average rate of 0.7% in the three months ended June 30, 2013, compared to 1.0% in the three months ended June 30, 2012.

Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the three months ended June 30, 2013 would have been approximately $3 millionhigher had foreign exchange rates remained constant from the prior year.

Cost of Revenue

Cost of revenue increased$15 million, or 15%, from $103 million in the three months ended June 30, 2012 to $118 million in the three months ended June 30, 2013. Of this increase, $5 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, partially offset by a decrease in non-equity incentive compensation. These increases are primarily due to additional headcount and salary increases, partially offset by a lower percentage attainment against the pre-set target for non-equity incentive compensation. The cost increase was further attributable to an increase in license costs of $2 million and an increase in data center costs of $9 million, mostly related to rent, maintenance and utilities. The remaining variance was due to small changes in other cost of revenue expenses.

Research and Development Expenses

Research and development expenses increased$10 million, or 59%, from $17 million in the three months ended June 30, 2012 to $27 million in the three months ended June 30, 2013. Of this increase, $8 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, primarily due to additional headcount and salary increases. The remaining variance was due to small changes in other research and development expenses. Research and development costs increased as a percentage of net revenue, from 5.2% in the three months ended June 30, 2012 to 7.1% in the three months ended June 30, 2013, primarily due to employee-related expenses increasing at a faster rate than revenue.

Sales and Marketing Expenses

Sales and marketing expenses increased$11 million, or 27%, from $41 million in the three months ended June 30, 2012 to $52 million in the three months ended June 30, 2013. Of this increase, $4 million was attributable to employee-related expenses due to increases in salaries and benefits, partially offset by a decrease in commissions due to sales targets increasing at a faster rate than attainment amounts. Total compensation increased primarily as a result of salary increases and the hiring of additional sales and marketing personnel. Marketing program expenses increased $5 million primarily due to the branding campaign launched during the first quarter of 2013. The remaining variance was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

General and administrative expenses increased$13 million, or 23%, from $56 million in the three months ended June 30, 2012 to $69 million in the three months ended June 30, 2013. Of this increase, $7 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, partially offset by a decrease in non-equity incentive compensation. These increases are primarily due to additional headcount, salary increases and new equity grants, partially offset by a lower non-equity incentive compensation payout percentage. Professional fees increased $3 million primarily as a result of consulting expenses. The remaining variance was due to small changes in other general and administrative expenses.

- 24 -

Depreciation and Amortization Expense

Depreciation and amortization expense increased$12 million, or 19%, from $62 million in the three months ended June 30, 2012 to $74 million in the three months ended June 30, 2013. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, 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 decreased from 35.7% for the three months ended June 30, 2012 to 34.7% for the three months ended June 30, 2013 due primarily to Research and Development credits that were not extended until Q1 2013. Overall, differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, certain 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.

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Six Months EndedJune 30, 2012 and June 30, 2013

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 Item 1 of this Form 10-Q for more information about these reclassifications.

Consolidated Statements of Income (Unaudited):

	Six Months Ended
(In thousands)	June 30, 2012			June 30, 2013
Net revenue	$	620,345		$	738,047
Costs and expenses:
Cost of revenue	202,653			231,268
Research and development	30,189			49,549
Sales and marketing	81,596			102,083
General and administrative	111,160			132,359
Depreciation and amortization	116,959			144,571
Total costs and expenses	542,557			659,830
Income from operations	77,788			78,217
Other income (expense):
Interest expense	(2,505		)	(1,773		)
Interest and other income (expense)	(268		)	(104		)
Total other income (expense)	(2,773		)	(1,877		)
Income before income taxes	75,015			76,340
Income taxes	26,701			26,712
Net income	$	48,314		$	49,628

Consolidated Statements of Income, as a Percentage of Net Revenue (Unaudited):

	Six Months Ended
(Percent of net revenue)	June 30, 2012		June 30, 2013
Net revenue	100.0	%	100.0	%
Costs and expenses:
Cost of revenue	32.7	%	31.3	%
Research and development	4.9	%	6.7	%
Sales and marketing	13.2	%	13.8	%
General and administrative	17.9	%	17.9	%
Depreciation and amortization	18.9	%	19.6	%
Total costs and expenses	87.5	%	89.4	%
Income from operations	12.5	%	10.6	%
Other income (expense):
Interest expense	(0.4	)%	(0.2	)%
Interest and other income (expense)	0.0	%	0.0	%
Total other income (expense)	(0.4	)%	(0.3	)%
Income before income taxes	12.1	%	10.3	%
Income taxes	4.3	%	3.6	%
Net income	7.8	%	6.7	%

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

- 26 -

Net Revenue

Net revenue increased$118 million, or 19%, from $620 million in the six months ended June 30, 2012 to $738 million in the six months ended June 30, 2013, primarily due to an increased volume of services provided, resulting from an increasing number of new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased13% while net revenue for public cloud increased38%. Overall, our installed base grew at a monthly average rate of 0.4% in the six months ended June 30, 2013, compared to 0.9% in the six months ended June 30, 2012.

Partially offsetting the revenue increase was the negative impact of a stronger U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the six months ended June 30, 2013 would have been approximately $4 millionhigher had foreign exchange rates remained constant from the prior year.

Cost of Revenue

Cost of revenue increased$28 million, or 14%, from $203 million in the six months ended June 30, 2012 to $231 million in the six months ended June 30, 2013. Of this increase, $9 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, partially offset by a decrease in non-equity incentive compensation. These increases are primarily due to additional headcount and salary increases, partially offset by a lower percentage attainment against the pre-set target for non-equity incentive compensation. The cost increase was further attributable to an increase in license costs of $4 million and an increase in data center costs of $17 million, mostly related to rent, maintenance and utilities. The remaining variance was due to small changes in other cost of revenue expenses. Cost of revenue decreased as a percentage of net revenue, from 32.7% in the six months ended June 30, 2012 to 31.3% in the six months ended June 30, 2013, primarily due to employee-related expenses and license expenses each increasing at a slower rate than revenue, partially offset by data center costs increasing at a faster rate than revenue.

Research and Development Expenses

Research and development expense increased$20 million, or 67%, from $30 million in the six months ended June 30, 2012 to $50 million in the six months ended June 30, 2013. Of this increase, $16 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, primarily due to additional headcount and salary increases. The remaining variance was due to small changes in other research and development expenses. Research and development costs increased as a percentage of net revenue, from 4.9% in the six months ended June 30, 2012 to 6.7% in the six months ended June 30, 2013, primarily due to employee-related expenses increasing at a faster rate than revenue.

Sales and Marketing Expenses

Sales and marketing expenses increased$20 million, or 24%, from $82 million in the six months ended June 30, 2012 to $102 million in the six months ended June 30, 2013. Of this increase, $8 million was attributable to employee-related expenses due to increases in salaries and benefits, share-based compensation expense, and non-equity incentive compensation, partially offset by a decrease in commissions due to sales targets increasing at a faster rate than attainment amounts. Total compensation increased primarily as a result of salary increases and the hiring of additional sales and marketing personnel. Marketing program expenses increased $10 million primarily due to the branding campaign launched during the first quarter of 2013. The remaining variance was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

General and administrative expenses increased$21 million, or 19%, from $111 million in the six months ended June 30, 2012 to $132 million in the six months ended June 30, 2013. Of this increase, $13 million was attributable to employee-related expenses due to increases in salaries and benefits and share-based compensation expense, partially offset by decreases in payroll taxes and non-equity incentive compensation. These increases are primarily due to additional headcount, salary increases and new equity grants, partially offset by a lower non-equity incentive compensation payout percentage and lower payroll taxes on reduced stock option exercise activity. Professional fees increased $4 million primarily as a result of consulting expenses. The remaining variance was due to small changes in other general and administrative expenses.

- 27 -

Depreciation and Amortization Expense

Depreciation and amortization expense increased$28 million, or 24%, from $117 million in the six months ended June 30, 2012 to $145 million in the six months ended June 30, 2013. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, 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 decreased from 35.6% for the six months ended June 30, 2012 to 35.0% for the six months ended June 30, 2013 due primarily to Research and Development credits that were not extended until Q1 2013. Overall, differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, certain 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.

Liquidity and Capital Resources

At June 30, 2013, we held $263 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.

Our available cash and cash equivalents are held in bank deposits, money market funds, and overnight sweep accounts. Our money market mutual funds comply with 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 safety of principal while secondarily maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation, or “FDIC,” insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

Of our cash and cash equivalents at June 30, 2013, $47 million was held by our foreign subsidiaries. If these funds are repatriated, we will be required to accrue and pay taxes; however, we do not currently intend to repatriate these funds because we believe cash available in the U.S. is sufficient to meet our domestic operating and capital needs.

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 June 30, 2013, we had $125 million and $88 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. This shift in strategy was a main factor in the decrease in our cash and cash equivalents, increase in accounts payable and accrued expenses and decrease in working capital from December 31, 2012 to June 30, 2013.

Our revolving credit facility has a total commitment in the amount of $200 million and matures in September of 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 June 30, 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 June 30, 2013 there were no outstanding borrowings under the revolving credit facility.

- 28 -

Capital Expenditure Requirements

For the full year 2013, we continue to expect to have total capital expenditures between $375 million and $445 million. We expect the bulk of capital expenditures to be on customer gear to support revenue growth.

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: 

	Six Months Ended June 30,
	(Unaudited)
(In thousands)	2012			2013
Cash provided by operating activities	$	179,706		$	219,992
Cash used in investing activities	$	(134,679	)	$	(231,952	)
Cash provided by (used in) financing activities	$	10,532		$	(15,088	)
Non-cash purchases of property and equipment	$	30,278		$	6,547

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 activitiesincreased$40 million, or 22%, from $180 million in the first six months of 2012 to $220 million in the first six months of 2013. Net income increased from $48 million in the first six months of 2012 to $50 million in the first six months of 2013.  

A summary of the significant changes in non-cash adjustments affecting net income is as follows:

• Depreciation and amortization expense increased by $28 million, from $117 million in the first six months of 2012 compared to $145 million in the first six months of 2013, due mainly to purchases of customer gear and computer software (internally developed technology).

• Share-based compensation expense increased by $7 million, from $18 million in the first six months of 2012 to $25 million in the first six months of 2013, due to an increase in the fair value of equity awards granted in 2012 and the first six months of 2013.

• Excess tax benefits from share-based compensation arrangements created an operating cash outflow of $30 million in the first six months of 2012 and $16 million in the first six months of 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 the first six months of 2012 resulted in a cash inflow of $15 million compared to a cash inflow of $4 million in the first six months of 2013, 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 activitiesincreased$97 million, or 72%, from $135 million in the first six months of 2012 to $232 million in the first six months of 2013, primarily due to an increase in the purchase of property and equipment of $91 million and a $5 millionincrease related to cash paid for acquisitions.

- 29 -

Financing Activities

Net cash provided by financing activities was $11 million during the first six months of 2012 compared to net cash used in financing activities of $15 million in the first six months of 2013, a change of $26 million. The majority of this change was related to excess tax benefits from share-based compensation arrangements, which created a financing cash inflow of $30 million in the first six months of 2012 and $16 million in the first six months of 2013. Additionally, proceeds from employee stock plans decreased from $18 million in the first six months of 2012 to $6 million in the first six months of 2013 as a result of less stock option exercise activity in 2013.

Off-Balance Sheet Arrangements

During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. These entities are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us, our employees, agents or representatives. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, significant judgment is required in making estimates and selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. These judgments and estimates affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We consider the 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.

A description of our critical accounting policies that involve significant management judgment appears in our Annual Report on Form 10-K filed with the SEC on March 1, 2013 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates.” 

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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no significant changes to our market risks since December 31, 2012. For a discussion of our exposure to market risk, refer to Part II, Item 7A "Quantitative and Qualitative Disclosures about Market Risk," contained in our Annual Report on Form 10-K for the year-ended December 31, 2012.

ITEM 4–CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

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

Changes in internal control over financial reporting

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

Inherent limitations of internal controls

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

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PART II – OTHER INFORMATION

ITEM 1 – 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 37^th District Court in Bexar County, Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleges breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. We believe that the plaintiff’s position is without merit and intend to vigorously defend this lawsuit. We believe that the amount or range of reasonably possible loss in this case will not have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows.

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.

In March 18, 2013, Parallel Iron, 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 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.” The plaintiff seeks injunctive relief, monetary damages, and costs. We dispute the allegations of wrongdoing and intend to vigorously defend ourselves in this matter.

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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 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 hosting services are marketed and delivered. The adoption of new technologies, a change in industry standards or introduction of more attractive products or services could make some or all of our offerings less desirable or even obsolete. These potential changes are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by 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 public cloud and Rackspace Private Cloud platform and product set; (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources, larger customer bases, longer operating histories, greater brand recognition, more established relationships in the industry, and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities; (iii) new pricing strategies that may include lowering price points for cloud products to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our cloud products to certain significant cloud customers; (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases; and (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve, including the current volatile economic environment found in Europe.

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:

▪ Do-it-yourself 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, 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; A. Lanham Napier, our Chief Executive Officer; and Lew Moorman, our President and Chief Strategy Officer. Mr. Moorman has recently announced that he is stepping down from his duties as President and Chief Strategy Officer but will continue to be a part-time employee and Board member. Certain of Mr. Moorman's duties will be transitioned to other members of the Company's senior leadership team, including Mr. Napier, who is expected to retain the title and role of President when Mr. Moorman steps down. While we believe that Mr. Moorman's leadership has had a significant impact on our success to date, we also believe that his continued involvement in the Company and his thorough transitioning of duties to other capable senior leaders helps to mitigate the risk that the loss of his services represents. We do not have long-term employment agreements with any members of our management team, including Messrs. Weston, Napier and Moorman. Mr. Napier is the only member of our management team on whom we maintain key man insurance.

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.

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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.

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 dedicated cloud hosting services typically have initial terms of one to two years which, unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire on these contracts. In addition, many of our other services and products, including most of our 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. 

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Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.

Because our hosting services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot 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.

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.

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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 twopatents issued and a number of 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.

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. 

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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 their Internet sites and web infrastructure internally or in colocation facilities as an alternative to the use of our hosting 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 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.

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. 

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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 $22.0 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest. 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 $5.0 million from the State of Texas in September 2007, and, after achieving the Job Target as of December 31, 2011, 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 currently met the required employment level of the second tranche and, if we maintain or increase our current employment level, we would expect to request an additional $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. 

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.

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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 June 30, 2013, there was no outstanding indebtedness under our credit facility other than an immaterial outstanding letter of credit.

We also have substantial equipment lease obligations. The principal balance of these capital lease obligations totaled approximately $85.5 million as of June 30, 2013. The payment obligations under these equipment leases are secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

If we are unable to generate sufficient cash to repay our debt obligations when they become due and payable, either when they mature or in the event of a default, we may not be able to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to continue as a going concern.

We may require additional capital and may not be able to secure additional financing on favorable terms to meet our future capital needs, which could adversely affect our financial position and result in stockholder dilution.

In order to fund future growth, we will be dependent on significant capital expenditures. We may need to raise additional funds through equity or debt financings in the future in order to meet our operating and capital needs. We may not be able to secure additional debt or equity financing on favorable terms, or at all, at the time when we need such funding. If we are unable to raise additional funds, we may not be able to pursue our growth strategy, and our business could suffer. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences, and privileges senior to those of holders of our common stock. In addition, any debt financing that we may obtain in the future could have restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions.

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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 the first six months of 2013, we expensed approximately $12.6 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 June 30, 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. 

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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.

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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 a significant portion of our revenues, and we benefit from our association with them. The loss of these participants could adversely affect our business.

Our referral and reseller partners drive a significant amount of 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 June 30, 2013, the closing trading price of our common stock was very volatile, ranging between $34.46 and $79.24 per share, including single-day increases of up to 5.9% 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 Quarterly Report on Form 10-Q.

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. 

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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.

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ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

In connection with our February 27, 2013 acquisition of ObjectRocket, Inc. ("ObjectRocket") and our March 22, 2013 acquisition of Exceptional Cloud Services, Inc. ("Exceptional Cloud Services"), on May 21, 2013, we issued an aggregate total of 341,841 shares of our common stock to certain stockholders of ObjectRocket and Exceptional Cloud Services in partial consideration of their ownership of these companies. Pursuant to the Agreement and Plan of Merger relating to these acquisitions, a portion of the consideration payable to such ObjectRocket and Exceptional Cloud Services stockholders in connection with our acquisition of these companies 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 such stockholders. 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.

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ITEM 6 – EXHIBITS

Exhibit Number	Description
10.1*	2008 Employee Stock Purchase Plan - Share Incentive Sub-Plan
31.1*	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS*	XBRL Instance Document
101.SCH*	XBRL Taxonomy Extension Schema
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.

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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 Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, on August 9, 2013.

Rackspace Hosting, Inc.

Date:	August 9, 2013	By:	/s/ Karl Pichler
			Karl Pichler
			Chief Financial Officer and Treasurer
			(Principal Financial Officer)

Date:	August 9, 2013	By:	/s/ Joseph Saporito
			Joseph Saporito
			Chief Accounting Officer
			(Principal Accounting Officer)

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