10-Q 1 rax0930201410-q.htm FORM 10-Q RAX 09.30.2014 10-Q

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 September 30, 2014.
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from ______ to ______.
 
Commission file number 001-34143
RACKSPACE HOSTING, INC.
(Exact name of registrant as specified in its charter)

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

1 Fanatical Place
City of Windcrest
San Antonio, Texas 78218
(Address of principal executive offices, including zip code)

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

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 Website, 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 November 6, 2014, 143,554,418 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:
 
 
 
Unaudited Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2013 and 2014
 
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2014
 
Item 2.
Item 3.
Item 4.
 
 
 
Part II - Other Information
 
Item 1.
Item 1A.
Item 6.
 
 
 
 



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,
2013
 
September 30,
2014
 
 
 
 
(Unaudited)
ASSETS
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
259,733

 
$
349,480

Accounts receivable, net of allowance for doubtful accounts and customer credits of $3,891 as of December 31, 2013 and $4,650 as of September 30, 2014
 
123,898

 
134,555

Deferred income taxes
 
12,637

 
11,061

Prepaid expenses
 
30,782

 
42,349

Other current assets
 
11,918

 
16,509

Total current assets
 
438,968

 
553,954

 
 
 
 
 
Property and equipment, net
 
890,776

 
1,014,168

Goodwill
 
81,084

 
81,084

Intangible assets, net
 
23,880

 
18,241

Other non-current assets
 
57,089

 
57,095

Total assets
 
$
1,491,797

 
$
1,724,542

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable and accrued expenses
 
$
122,047

 
$
139,501

Accrued compensation and benefits
 
62,459

 
80,580

Income and other taxes payable
 
11,388

 
24,316

Current portion of deferred revenue
 
22,868

 
19,562

Current portion of capital lease obligations
 
37,885

 
20,144

Current portion of debt
 
1,861

 
160

Total current liabilities
 
258,508

 
284,263

 
 
 
 
 
Non-current liabilities:
 
 
 
 
Deferred revenue
 
3,662

 
1,875

Capital lease obligations
 
25,048

 
11,168

Finance lease obligations for assets under construction
 

 
67,046

Debt
 
124

 

Deferred income taxes
 
69,729

 
47,924

Deferred rent
 
43,046

 
49,233

Other liabilities
 
36,268

 
39,261

Total liabilities
 
436,385

 
500,770

 
 
 
 
 
COMMITMENTS AND CONTINGENCIES
 


 


 
 
 
 
 
Stockholders' equity:
 
 
 
 
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 141,123,904 shares issued and outstanding as of December 31, 2013; 143,547,558 shares issued and outstanding as of September 30, 2014
 
141

 
144

Additional paid-in capital
 
636,660

 
736,208

Accumulated other comprehensive loss
 
(4,536
)
 
(9,364
)
Retained earnings
 
423,147

 
496,784

Total stockholders’ equity
 
1,055,412

 
1,223,772

Total liabilities and stockholders’ equity
 
$
1,491,797

 
$
1,724,542


See accompanying notes to the unaudited condensed consolidated financial statements.

- 3 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In thousands, except per share data)
 
2013
 
2014
 
2013
 
2014
 
 
 
 
 
 
 
 
 
Net revenue
 
$
388,636

 
$
459,776

 
$
1,126,683

 
$
1,321,935

Costs and expenses:
 
 
 
 
 
 
 
 
Cost of revenue
 
127,404

 
142,954

 
358,672

 
428,422

Research and development
 
23,773

 
30,718

 
65,364

 
85,621

Sales and marketing
 
50,869

 
60,582

 
152,952

 
178,421

General and administrative
 
78,075

 
86,702

 
218,392

 
239,276

Depreciation and amortization
 
80,753

 
98,307

 
225,324

 
276,671

Total costs and expenses
 
360,874

 
419,263

 
1,020,704

 
1,208,411

Income from operations
 
27,762

 
40,513

 
105,979

 
113,524

Other income (expense):
 
 
 
 
 
 
 
 
Interest expense
 
(689
)
 
(445
)
 
(2,462
)
 
(1,469
)
Interest and other income (expense)
 
440

 
(2,191
)
 
336

 
(1,755
)
Total other income (expense)
 
(249
)
 
(2,636
)
 
(2,126
)
 
(3,224
)
Income before income taxes
 
27,513

 
37,877

 
103,853

 
110,300

Income taxes
 
11,202

 
12,137

 
37,914

 
36,663

Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

 
 
 
 
 
 
 
 
 
Other comprehensive income, net of tax
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
 
$
11,893

 
$
(13,265
)
 
$
(36
)
 
$
(4,828
)
Other comprehensive income (loss)
 
11,893

 
(13,265
)
 
(36
)
 
(4,828
)
Comprehensive income
 
$
28,204

 
$
12,475

 
$
65,903

 
$
68,809

 
 
 
 
 
 
 
 
 
Net income per share
 
 
 
 
 
 
 
 
Basic
 
$
0.12

 
$
0.18

 
$
0.48

 
$
0.52

Diluted
 
$
0.11

 
$
0.18

 
$
0.46

 
$
0.51

 
 
 
 
 
 
 
 
 
Weighted average number of shares outstanding
 
 
 
 
 
 
 
 
Basic
 
138,714

 
142,978

 
138,140

 
142,036

Diluted
 
143,543

 
144,895

 
142,699

 
144,310

 
See accompanying notes to the unaudited condensed consolidated financial statements.

- 4 -


RACKSPACE HOSTING, INC. AND SUBSIDIARIES—
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Nine Months Ended September 30,
(In thousands)
 
2013
 
2014
Cash Flows From Operating Activities
 
 
 
 
Net income
 
$
65,939

 
$
73,637

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
225,324

 
276,671

Loss on disposal of equipment, net
 
892

 
159

Provision for bad debts and customer credits
 
3,843

 
4,323

Deferred income taxes
 
10,305

 
(30,140
)
Deferred rent
 
9,285

 
6,297

Share-based compensation expense
 
42,457

 
49,839

Excess tax benefits from share-based compensation arrangements
 
(17,383
)
 
(45,311
)
Changes in certain assets and liabilities:
 
 
 
 
Accounts receivable
 
(24,129
)
 
(15,729
)
Prepaid expenses and other current assets
 
(18,560
)
 
(17,199
)
Accounts payable and accrued expenses
 
26,948

 
93,882

Deferred revenue
 
1,191

 
(4,952
)
All other operating activities
 
8,430

 
147

Net cash provided by operating activities
 
334,542

 
391,624

 
 
 
 
 
Cash Flows From Investing Activities
 
 
 
 
Purchases of property and equipment
 
(325,873
)
 
(323,126
)
Acquisitions, net of cash acquired
 
(6,203
)
 

All other investing activities
 
(1,808
)
 
1,945

Net cash used in investing activities
 
(333,884
)
 
(321,181
)
 
 
 
 
 
Cash Flows From Financing Activities
 
 
 
 
Principal payments of capital leases
 
(51,208
)
 
(32,502
)
Principal payments of notes payable
 
(1,863
)
 
(1,866
)
Payments for deferred acquisition obligations
 
(1,296
)
 
(168
)
Receipt of Texas Enterprise Fund grant
 

 
5,500

Common shares withheld for employee withholding taxes
 

 
(13,620
)
Proceeds from employee stock plans
 
14,846

 
18,021

Excess tax benefits from share-based compensation arrangements
 
17,383

 
45,311

Net cash provided by (used in) financing activities
 
(22,138
)
 
20,676

 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
(586
)
 
(1,372
)
 
 
 
 
 
Increase (decrease) in cash and cash equivalents
 
(22,066
)
 
89,747

 
 
 
 
 
Cash and cash equivalents, beginning of period
 
292,061

 
259,733

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
269,995

 
$
349,480

 
 
 
 
 
Supplemental Cash Flow Information:
 
 
 
 
Acquisition of property and equipment by capital leases
 
$
415

 
$
929

Increase in property and equipment in accounts payable and accrued expenses
 
23,194

 
6,455

Non-cash purchases of property and equipment
 
$
23,609

 
$
7,384

 
 
 
 
 
Cash payments for interest, net of amount capitalized
 
$
2,599

 
$
1,399

Cash payments for income taxes
 
$
12,674

 
$
7,144

 
 
 
 
 
Shares issued in business combinations
 
$
4,457

 
$

Additional finance lease obligations for assets under construction and other
 
$

 
$
70,787


See accompanying notes to the unaudited condensed consolidated financial statements.

- 5 -


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 in March 2000.

Basis of Consolidation

The accompanying consolidated financial statements include the accounts of Rackspace Hosting, Inc. 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.

Foreign currency translation adjustments arising from differences in exchange rates from period to period are included in the foreign currency translation adjustment account in accumulated other comprehensive income (loss). There was no income tax expense allocated to foreign currency translation adjustments during the three or nine months ended September 30, 2013 or 2014

Basis of Presentation
 
The accompanying consolidated financial statements as of September 30, 2014, and for the three and nine months ended September 30, 2013 and 2014, 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. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2013 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 3, 2014 (the "2013 Annual Consolidated Financial Statements"). The unaudited interim consolidated financial statements have been prepared on the same basis as the 2013 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 September 30, 2014, our results of operations for the three and nine months ended September 30, 2013 and 2014, and our cash flows for the nine months ended September 30, 2013 and 2014.
 
The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2014, or for any other interim period, or for any other future year.

- 6 -



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 have engaged third-party consultants to assist management in the valuation of acquired assets, including other intangibles, as well as share-based compensation.

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 the 2013 Annual Consolidated Financial Statements.

Recent Accounting Pronouncements Not Yet Adopted

In May 2014, the Financial Accounting Standards Board ("FASB") issued guidance to clarify principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and is to be applied retrospectively using one of two methods. One method is to apply the guidance retrospectively to each prior period presented with practical expedients available. The second method is to apply the guidance retrospectively with the cumulative effect of initially applying the Update recognized at the date of initial application. Early application is not permitted. We will adopt this standard in the first quarter of 2017, and we are evaluating the impact on our consolidated financial statements of adopting this new accounting standard.

In April 2014, the FASB issued guidance to revise the definition of discontinued operations by limiting discontinued operations reporting to disposals of components of an entity that represent strategic shifts that have (or will have) a major effect on an entity's operations and financial results. This guidance also requires expanded disclosures for discontinued operations and adds new disclosures for individually significant dispositions that do not qualify as discontinued operations. This guidance is effective prospectively for fiscal years, and interim periods within those years, beginning after December 15, 2014. The impact of the adoption of this guidance will be dependent on the nature of dispositions, if any, occurring after adoption.

In August 2014, the FASB issued guidance that will require management to evaluate, at each annual and interim reporting period, whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern and provide related footnote disclosures in certain circumstances. This guidance is effective for the annual period ending after December 15, 2016 and for annual and interim periods thereafter with early adoption permitted. We do not expect the adoption of this guidance to have an impact on our consolidated financial statements.

- 7 -


2. Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In thousands, except per share data)
 
2013
 
2014
 
2013
 
2014
Basic net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
138,714

 
142,978

 
138,140

 
142,036

Number of shares used in per share computations
 
138,714

 
142,978

 
138,140

 
142,036

Net income per share
 
$
0.12

 
$
0.18

 
$
0.48

 
$
0.52

 
 
 
 
 
 
 
 
 
Diluted net income per share:
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
25,740

 
$
65,939

 
$
73,637

Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Common stock
 
138,714

 
142,978

 
138,140

 
142,036

Stock options, awards and employee share purchase plans
 
4,829

 
1,917

 
4,559

 
2,274

Number of shares used in per share computations
 
143,543

 
144,895

 
142,699

 
144,310

Net income per share
 
$
0.11

 
$
0.18

 
$
0.46

 
$
0.51


We excluded 3.9 million and 5.8 million potential common shares from the computation of dilutive net income per share for the three months ended September 30, 2013 and 2014, respectively, and 2.8 million and 5.6 million potential shares for the nine months ended September 30, 2013 and 2014, respectively, because the effect would have been anti-dilutive.


- 8 -


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

 Assets and liabilities measured at fair value on a recurring basis are summarized by level below. As of December 31, 2013 and September 30, 2014, we did not hold any financial instruments categorized as Level 2 or Level 3. Our Level 1 assets and liabilities are valued using quoted market prices.
 
(In thousands)
 
December 31, 2013
 
September 30, 2014
Level 1:
 
 
 
 
Assets:
 
 
 
 
Money market funds (1)
 
$
102,380

 
$
90,553

Rabbi trust (2)
 
835

 
1,123

     Total
 
$
103,215

 
$
91,676

 
 
 
 
 
Liabilities:
 
 
 
 
Deferred compensation (3)
 
$
540

 
$
829

     Total
 
$
540

 
$
829


(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 Consolidated 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 nine months ended September 30, 2013 and September 30, 2014, we recognized minimal net gains and losses as interest and other income (expense).


- 9 -


4. Property and Equipment, net
 
Property and equipment consisted of: 
(Dollar amounts in thousands)
 
Estimated Useful Lives
 
December 31,
2013
 
September 30,
2014
Computers, software and equipment
 
1
-
5
years
 
$
1,488,106

 
$
1,743,301

Furniture and fixtures
 
7
years
 
55,681

 
56,529

Buildings and leasehold improvements
 
2
-
30
years
 
236,255

 
258,636

Land
 
 
 
 
 
 
28,566

 
28,436

Property and equipment, at cost
 
 
 
 
 
 
1,808,608

 
2,086,902

Less accumulated depreciation and amortization
 
 
 
 
 
 
(983,618
)
 
(1,186,882
)
Work in process
 
 
 
 
 
 
65,786

 
114,148

Property and equipment, net
 
 
 
 
 
 
$
890,776

 
$
1,014,168

 
At December 31, 2013, the work in process balance consisted of build outs of $32.6 million for office facilities, $2.4 million for data centers, and $30.7 million for capitalized software and other projects. At September 30, 2014, the work in process balance consisted of build outs of $38.6 million for office facilities, $52.7 million for data centers, and $22.9 million for capitalized software and other projects.

5. Leases

We have entered into multiple complex real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects. While the independent developers legally own the real estate projects and must finance the overall construction, we agreed to fund certain structural improvements and/or retain obligations related to certain potential construction cost overruns which have triggered an accounting requirement to include construction costs in progress and a related long-term finance lease liability on our consolidated balance sheets as though we are the owner of the asset during the construction period. We do not depreciate the cost of the real estate projects or expect to fund this long-term finance lease liability during the construction period.

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

During the first quarter of 2014, construction of one of these real estate projects was completed, and we performed a sale-leaseback analysis. As a result of our continuing involvement in the project, we were precluded from derecognizing the asset and liability, and we will account for the lease as a capital lease obligation throughout the lease term. At the end of the lease term, we will derecognize the remaining lease obligation and asset balance.

As of December 31, 2013 and September 30, 2014 we had $0 and $67.0 million, respectively, of finance lease obligations for assets under construction recorded on our consolidated balance sheets related to real estate projects for which we are deemed the accounting owner during the construction period, with the corresponding construction costs in progress included in work in process within property and equipment, net.


- 10 -


6. 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 were involved in the following legal proceeding:

On October 22, 2008, Benjamin E. Rodriguez D/B/A Management and Business Advisors vs. Rackspace Hosting, Inc. and Graham Weston was filed in the 37th District Court in Bexar County Texas by a former consultant to the company, Benjamin E. Rodriguez. The suit alleged breach of an oral agreement to issue Mr. Rodriguez a 1% interest in our stock in the form of options or warrants for compensation for services he was engaged to perform for us. This matter was settled as of February 19, 2014, and there was not a material difference between the settlement amount and the amount for which we had accrued for the matter in our consolidated financial statements.

We are 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.

We record to cost of revenue state sales taxes related to software licenses acquired to provide hosting services to customers. We also remit state sales taxes collected from our customers for hosting services invoiced to our customers, with such services including the use of the aforementioned software licenses. During the three months ended September 30, 2014, we recorded a $7 million benefit to cost of revenue for settlement of a dispute related to sales taxes paid on such software licenses for the period September 2007 through April 2014. 

7. Share-Based Compensation
 
We have granted equity awards to our 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 vest ratably over a four-year period. All stock options expire seven to ten years following the grant date. The restricted stock generally vests ratably over a four-year period. Certain key executives have received restricted stock grants that cliff-vest over various terms from one to three years. Vesting of these grants are generally based on predetermined market and/or performance conditions.

The composition of the equity awards outstanding as of December 31, 2013 and September 30, 2014 was as follows: 
 
 
December 31,
2013
 
September 30,
2014
Restricted stock
 
3,538,271
 
4,252,132
Stock options
 
9,487,570
 
7,499,819
     Total outstanding awards
 
13,025,841
 
11,751,951
 
We also have an Employee Stock Purchase Plan (the "ESPP"). Under the ESPP, eligible employees may purchase a limited number of shares of our common stock at the lesser of 85% of the market value on the enrollment date or 85% of the market value on the purchase date. The ESPP is made up of a series of offering periods. Each offering period has a maximum term of 24 months and is divided into semi-annual purchase intervals. The current ESPP began on July 1, 2013 and will conclude on June 30, 2015. Eligible employees may enroll at the beginning of any semi-annual purchase interval.


- 11 -


Share-Based Compensation Expense

Share-based compensation expense was recognized as follows: 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in thousands)
 
2013
 
2014
 
2013
 
2014
Cost of revenue
 
$
3,453

 
$
4,175

 
$
8,707

 
$
12,093

Research and development
 
2,306

 
3,399

 
5,647

 
9,472

Sales and marketing
 
2,149

 
2,637

 
5,551

 
6,790

General and administrative
 
9,051

 
9,631

 
22,552

 
21,484

Pre-tax share-based compensation
 
16,959

 
19,842

 
42,457

 
49,839

Less: Income tax benefit
 
(6,578
)
 
(6,408
)
 
(15,500
)
 
(16,566
)
Total share-based compensation expense, net of tax
 
$
10,381

 
$
13,434

 
$
26,957

 
$
33,273


As of September 30, 2014, there was $193.2 million of total unrecognized compensation cost related to restricted stock, stock options and the ESPP, which will be amortized using the straight-line method over a weighted average period of 2.5 years.

8. 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 2014 before consideration of excess tax benefits, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2014. As a result, we have recognized an excess tax benefit in the U.S. and U.K. during the current period.

9. Subsequent Event
 
On November 6, 2014, the Company's Board of Directors authorized the repurchase of up to $500.0 million of our common stock over the next two years.


- 12 -


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 and with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.
 
Overview of our Business

Rackspace is the world leader in the managed cloud segment of the business IT market. We serve hundreds of thousands of business customers from our data centers on four continents. We help them tap the power of cloud computing without the pain of having to become experts in dozens of complex technologies, and without the expense of hiring or contracting with engineers who do not differentiate their businesses.

Our focus on the managed cloud separates us from the big providers of unmanaged, commodity cloud computing, who rent out access to raw cloud infrastructure and then expect customers to do everything required to operate that infrastructure, as well as the many tools and applications that run on top of it, including data engines and e-commerce platforms.

Rackspace helps each business customer find the IT infrastructure that best fits its unique needs. Our broad hybrid cloud portfolio and specialized expertise enables each customer to run each of its workloads where it will perform best and most cost-efficiently, whether on single-tenant servers or the multi-tenant public cloud, or a combination of these platforms. This emphasis on the best fit for each workload differentiates Rackspace from the one-size-fits-all providers who offer only multi-tenant public cloud.

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 Switzerland, Hong Kong and Australia, and recently opened an office in Mexico. Our growth strategy includes targeting additional international customers as we continue our expansion in continental Europe, the Asia-Pacific region and Latin America. For the first nine months of 2014, 32% of our net revenue was from non-U.S. customers, and no individual customer accounted for greater than 2% of our net revenue.

- 13 -



We believe that the segment of the cloud computing market on which we are focused is a large market that represents a significant opportunity. We see a high level of interest building from companies who want to focus their scarce engineering assets on their core business and want a trusted partner to manage their cloud. They want Fanatical Support every step of the way, they want specialized expertise in running the ever-expanding set of technologies that are at the heart of cloud scale applications, and they want a partner who is committed to open and standard technologies, so that they are not locked into any single vendor.

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

Recent Developments

In July 2014, we announced our new managed cloud strategy for delivering public cloud services to market, including enhanced service levels and a more transparent service-based pricing model. We also created developer+, a new program for developers that offers essential services needed to build scalable applications. The managed cloud strategy focuses on businesses and developers looking for a strong partner to help design, manage and scale their cloud operations.

Also in July 2014, we launched OnMetal Cloud Servers to reduce cloud complexity and help cloud applications scale. These API-driven bare metal servers can be spun up as quickly as virtual machines. OnMetal Cloud Servers are designed for customers with rapidly growing infrastructure footprints who value the agility and elasticity of cloud along with the simplicity and cost-efficiency of colocation.

While these new offerings are still in the early stages, we believe that these new capabilities and features could drive future incremental demand.

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.

- 14 -


 
 
Three Months Ended
(Dollar amounts in thousands, except average monthly revenue per server)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
 
 
 
 
Growth
 
 
 
 
 
 
 
 
 
 
Dedicated cloud, net revenue
 
$
280,215

 
$
291,265

 
$
299,689

 
$
310,647

 
$
319,601

Public cloud, net revenue
 
$
108,421

 
$
116,838

 
$
121,358

 
$
130,465

 
$
140,175

Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

Revenue growth (year over year)
 
15.7
 %
 
15.6
 %
 
16.2
 %
 
17.4
 %
 
18.3
 %
Net upgrades (monthly average)
 
1.5
 %
 
1.1
 %
 
0.9
 %
 
1.5
 %
 
1.4
 %
Churn (monthly average)
 
-0.8
 %
 
-0.7
 %
 
-0.6
 %
 
-0.7
 %
 
-0.6
 %
Growth in installed base (monthly average) (1)
 
0.7
 %
 
0.4
 %
 
0.3
 %
 
0.8
 %
 
0.8
 %
Number of employees (Rackers) at period end
 
5,450

 
5,651

 
5,743

 
5,798

 
5,939

Number of servers deployed at period end
 
101,967

 
103,886

 
106,229

 
107,657

 
110,453

Average monthly revenue per server
 
$
1,290

 
$
1,322

 
$
1,336

 
$
1,375

 
$
1,405

Profitability
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Depreciation and amortization
 
$
80,753

 
$
87,683

 
$
87,805

 
$
90,559

 
$
98,307

Share-based compensation expense
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
$
3,453

 
$
3,877

 
$
3,791

 
$
4,127

 
$
4,175

Research and development
 
$
2,306

 
$
2,521

 
$
2,780

 
$
3,293

 
$
3,399

Sales and marketing
 
$
2,149

 
$
1,766

 
$
2,091

 
$
2,062

 
$
2,637

General and administrative
 
$
9,051

 
$
9,024

 
$
4,070

 
$
7,783

 
$
9,631

Total share-based compensation expense
 
$
16,959

 
$
17,188

 
$
12,732

 
$
17,265

 
$
19,842

Adjusted EBITDA (2)
 
$
125,474

 
$
132,028

 
$
139,661

 
$
141,711

 
$
158,662

Adjusted EBITDA margin
 
32.3
 %
 
32.4
 %
 
33.2
 %
 
32.1
 %
 
34.5
 %
Operating income margin
 
7.1
 %
 
6.7
 %
 
9.3
 %
 
7.7
 %
 
8.8
 %
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Effective tax rate
 
40.7
 %
 
22.7
 %
 
34.6
 %
 
33.0
 %
 
32.0
 %
Net operating profit after tax (NOPAT) (2)
 
$
16,463

 
$
20,992

 
$
25,587

 
$
22,704

 
$
27,549

NOPAT margin
 
4.2
 %
 
5.1
 %
 
6.1
 %
 
5.1
 %
 
6.0
 %
Capital efficiency and returns
 
 
 
 
 
 
 
 
 
 
Interest bearing debt
 
$
72,579

 
$
64,918

 
$
53,326

 
$
41,747

 
$
31,472

Stockholders' equity
 
$
988,708

 
$
1,055,412

 
$
1,100,012

 
$
1,171,197

 
$
1,223,772

Less: Excess cash
 
$
(223,359
)
 
$
(210,761
)
 
$
(263,309
)
 
$
(287,411
)
 
$
(294,307
)
Capital base
 
$
837,928

 
$
909,569

 
$
890,029

 
$
925,533

 
$
960,937

Average capital base
 
$
821,155

 
$
873,749

 
$
899,799

 
$
907,781

 
$
943,235

Capital turnover (annualized)
 
1.89

 
1.87

 
1.87

 
1.94

 
1.95

Return on capital (annualized) (2)
 
8.0
 %
 
9.6
 %
 
11.4
 %
 
10.0
 %
 
11.7
 %
Capital expenditures
 
 
 
 
 
 
 
 
 
 
Cash purchases of property and equipment
 
$
100,496

 
$
126,723

 
$
84,953

 
$
114,044

 
$
124,129

Non-cash purchases of property and equipment (3)
 
$
17,062

 
$
(4,116
)
 
$
15,741

 
$
(1,651
)
 
$
(6,706
)
Total capital expenditures
 
$
117,558

 
$
122,607

 
$
100,694

 
$
112,393

 
$
117,423

Customer gear
 
$
73,784

 
$
65,291

 
$
60,688

 
$
64,767

 
$
78,677

Data center build outs
 
$
12,441

 
$
22,524

 
$
10,963

 
$
13,767

 
$
14,825

Office build outs
 
$
6,700

 
$
14,860

 
$
9,212

 
$
6,857

 
$
3,464

Capitalized software and other projects
 
$
24,633

 
$
19,932

 
$
19,831

 
$
27,002

 
$
20,457

Total capital expenditures
 
$
117,558

 
$
122,607

 
$
100,694

 
$
112,393

 
$
117,423

Infrastructure capacity and utilization
 
 
 
 
 
 
 
 
 
 
Megawatts under contract at period end
 
60.0

 
60.0

 
58.1

 
58.1

 
58.1

Megawatts available for use at period end
 
46.9

 
46.9

 
45.3

 
45.4

 
45.4

Megawatts utilized at period end
 
27.0

 
27.4

 
28.1

 
29.0

 
29.9

Annualized net revenue per average Megawatt of power utilized
 
$
58,662

 
$
60,015

 
$
60,691

 
$
61,802

 
$
62,448


- 15 -


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

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, deferred rent and finance lease obligations for assets under construction)
 
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 increased from 8.0% for the three months ended September 30, 2013 to 11.7% for the three months ended September 30, 2014. This increase was primarily due to a 46% increase in income from operations between periods reflecting improved results driven by net revenue growth, partially offset by higher expenses. For further discussion of our operating results, see "Results of Operations" within this "Management's Discussion and Analysis of Financial Condition and Results of Operations." ROC was also positively impacted by a lower effective tax rate of 32.0% compared to 40.7% in the prior year period. These positive impacts were partially offset by a 15% increase in the average capital base between periods, as we continue to make infrastructure investments to support and enhance our growth opportunities. Return on assets increased from 4.6% for the three months ended September 30, 2013 to 6.1% for the three months ended September 30, 2014. This increase reflects our improved profitability as net income increased 58% between periods, partially offset by a 19% increase in average total assets.
 

- 16 -


See our reconciliation of the calculation of ROC to the calculation of return on assets in the table below: 
 
 
Three Months Ended
(In thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

Effective tax rate
 
40.7
%
 
22.7
%
 
34.6
%
 
33.0
%
 
32.0
%
Net operating profit after tax (NOPAT)
 
$
16,463

 
$
20,992

 
$
25,587

 
$
22,704

 
$
27,549

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
 
 
 
 
 
 
 
 
 
 
Total assets at period end
 
$
1,451,769

 
$
1,491,797

 
$
1,566,949

 
$
1,647,975

 
$
1,724,542

Less: Excess cash
 
(223,359
)
 
(210,761
)
 
(263,309
)
 
(287,411
)
 
(294,307
)
Less: Accounts payable and accrued expenses, accrued compensation and benefits, and income and other taxes payable
 
(213,268
)
 
(195,894
)
 
(224,423
)
 
(231,563
)
 
(244,397
)
Less: Deferred revenue (current and non-current)
 
(22,211
)
 
(26,530
)
 
(24,485
)
 
(23,248
)
 
(21,437
)
Less: Other non-current liabilities, deferred income taxes, deferred rent, and finance lease obligations for assets under construction
 
(155,003
)
 
(149,043
)
 
(164,703
)
 
(180,220
)
 
(203,464
)
Capital base
 
$
837,928

 
$
909,569

 
$
890,029

 
$
925,533

 
$
960,937

 
 
 
 
 
 
 
 
 
 
 
Average total assets
 
$
1,414,849

 
$
1,471,783

 
$
1,529,373

 
$
1,607,462

 
$
1,686,259

Average capital base
 
$
821,155

 
$
873,749

 
$
899,799

 
$
907,781

 
$
943,235

 
 
 
 
 
 
 
 
 
 
 
Return on assets (annualized)
 
4.6
%
 
5.7
%
 
6.7
%
 
5.6
%
 
6.1
%
Return on capital (annualized)
 
8.0
%
 
9.6
%
 
11.4
%
 
10.0
%
 
11.7
%

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 $33 million, or 26%, from the three months ended September 30, 2013 to the three months ended September 30, 2014. As a percentage of net revenue, Adjusted EBITDA increased from 32.3% for the three months ended September 30, 2013 to 34.5% for the three months ended September 30, 2014. The increase in Adjusted EBITDA margin was mainly due to improved operating results, as operating income margin also increased, from 7.1% for the three months ended September 30, 2013 to 8.8% for the three months ended September 30, 2014. Our improved operating results reflect an acceleration in revenue growth between periods, partially offset by higher expenses. For further discussion of our operating results, see "Results of Operations" within this "Management's Discussion and Analysis of Financial Condition and Results of Operations."


- 17 -


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

 
 
Three Months Ended
(Dollars in thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
 
 
 
 
 
 
 
 
 
 
 
Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

 
 
 
 
 
 
 
 
 
 
 
Income from operations
 
$
27,762

 
$
27,157

 
$
39,124

 
$
33,887

 
$
40,513

 
 
 
 
 
 
 
 
 
 
 
Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

   Plus: Income taxes
 
11,202

 
6,108

 
13,448

 
11,078

 
12,137

   Plus: Total other (income) expense
 
249

 
251

 
230

 
358

 
2,636

   Plus: Depreciation and amortization
 
80,753

 
87,683

 
87,805

 
90,559

 
98,307

   Plus: Share-based compensation expense
 
16,959

 
17,188

 
12,732

 
17,265

 
19,842

Adjusted EBITDA
 
$
125,474

 
$
132,028

 
$
139,661

 
$
141,711

 
$
158,662

 
 
 
 
 
 
 
 
 
 
 
Operating income margin
 
7.1
%
 
6.7
%
 
9.3
%
 
7.7
%
 
8.8
%
 
 
 
 
 
 
 
 
 
 
 
Adjusted EBITDA margin
 
32.3
%
 
32.4
%
 
33.2
%
 
32.1
%
 
34.5
%

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
 
Nine Months Ended
(In thousands)
September 30,
2013
 
September 30,
2014
 
September 30,
2013
 
September 30,
2014
Adjusted EBITDA
$
125,474

 
$
158,662

 
$
373,760

 
$
440,034

Non-cash deferred rent
3,801

 
1,928

 
9,285

 
6,297

Total capital expenditures
(117,558
)
 
(117,423
)
 
(349,482
)
 
(330,510
)
Cash payments for interest, net
(661
)
 
(360
)
 
(2,487
)
 
(1,312
)
Cash payments for income taxes, net
(2,605
)
 
(1,356
)
 
(12,355
)
 
(6,818
)
Adjusted free cash flow
$
8,451

 
$
41,451

 
$
18,721

 
$
107,691

 

- 18 -


Results of Operations

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

Consolidated Statements of Income:
 
 
Three Months Ended
(In thousands)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Net revenue
 
$
388,636

 
$
408,103

 
$
421,047

 
$
441,112

 
$
459,776

Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
127,404

 
133,821

 
140,417

 
145,051

 
142,954

Research and development
 
23,773

 
24,849

 
25,192

 
29,711

 
30,718

Sales and marketing
 
50,869

 
55,465

 
57,359

 
60,480

 
60,582

General and administrative
 
78,075

 
79,128

 
71,150

 
81,424

 
86,702

Depreciation and amortization
 
80,753

 
87,683

 
87,805

 
90,559

 
98,307

Total costs and expenses
 
360,874

 
380,946

 
381,923

 
407,225

 
419,263

Income from operations
 
27,762

 
27,157

 
39,124

 
33,887

 
40,513

Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(689
)
 
(656
)
 
(495
)
 
(529
)
 
(445
)
Interest and other income (expense)
 
440

 
405

 
265

 
171

 
(2,191
)
Total other income (expense)
 
(249
)
 
(251
)
 
(230
)
 
(358
)
 
(2,636
)
Income before income taxes
 
27,513

 
26,906

 
38,894

 
33,529

 
37,877

Income taxes
 
11,202

 
6,108

 
13,448

 
11,078

 
12,137

Net income
 
$
16,311

 
$
20,798

 
$
25,446

 
$
22,451

 
$
25,740

 
 Consolidated Statements of Income, as a Percentage of Net Revenue:
 
 
 
Three Months Ended
(Percent of net revenue)
 
September 30,
2013
 
December 31,
2013
 
March 31,
2014
 
June 30,
2014
 
September 30,
2014
Net revenue
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
 
 
 
 
 
 
Cost of revenue
 
32.8
 %
 
32.8
 %
 
33.3
 %
 
32.9
 %
 
31.1
 %
Research and development
 
6.1
 %
 
6.1
 %
 
6.0
 %
 
6.7
 %
 
6.7
 %
Sales and marketing
 
13.1
 %
 
13.6
 %
 
13.6
 %
 
13.7
 %
 
13.2
 %
General and administrative
 
20.1
 %
 
19.4
 %
 
16.9
 %
 
18.5
 %
 
18.9
 %
Depreciation and amortization
 
20.8
 %
 
21.5
 %
 
20.9
 %
 
20.5
 %
 
21.4
 %
Total costs and expenses
 
92.9
 %
 
93.3
 %
 
90.7
 %
 
92.3
 %
 
91.2
 %
Income from operations
 
7.1
 %
 
6.7
 %
 
9.3
 %
 
7.7
 %
 
8.8
 %
Other income (expense):
 
 
 
 
 
 
 
 
 
 
Interest expense
 
(0.2
)%
 
(0.2
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
Interest and other income (expense)
 
0.1
 %
 
0.1
 %
 
0.1
 %
 
0.0
 %
 
(0.5
)%
Total other income (expense)
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.1
)%
 
(0.6
)%
Income before income taxes
 
7.1
 %
 
6.6
 %
 
9.2
 %
 
7.6
 %
 
8.2
 %
Income taxes
 
2.9
 %
 
1.5
 %
 
3.2
 %
 
2.5
 %
 
2.6
 %
Net income
 
4.2
 %
 
5.1
 %
 
6.0
 %
 
5.1
 %
 
5.6
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

- 19 -


Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013
 
Net Revenue

Net revenue increased $71 million, or 18%, primarily due to both new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased 14% while net revenue for public cloud increased 29%. Overall, our installed base grew at a monthly average rate of 0.8% in the three months ended September 30, 2014, compared to 0.7% in the three months ended September 30, 2013.

Contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the three months ended September 30, 2014 would have been approximately $8 million lower had foreign exchange rates remained constant from the prior year.
  
Cost of Revenue

Cost of revenue increased $16 million, or 12%. Of this increase, $12 million was attributable to employee-related expenses, such as salaries, benefits and incentive compensation, driven by an increase in headcount to support business growth. Data center costs increased $3 million due to higher maintenance and bandwidth expenses. License costs increased $1 million, as higher expenses of $8 million related to our growth were mostly offset by a $7 million benefit related to a refund of sales tax paid on previous license purchases. As a percentage of net revenue, cost of revenue decreased 170 basis points, from 32.8% in the three months ended September 30, 2013 to 31.1% in the three months ended September 30, 2014. Of the 170 basis point decline, the sales tax refund of $7 million represented 150 basis points.

Research and Development Expenses

Research and development expenses increased $7 million, or 29%, due to increased employee-related expenses, such as salaries, benefits and incentive compensation. We have invested in additional headcount to support research and development activities to enhance our existing offerings and develop new products and services.

Sales and Marketing Expenses

Sales and marketing expenses increased $10 million, or 19%. Employee-related expenses increased $6 million primarily due to increased headcount and higher sales commissions consistent with our revenue growth. The remaining increase was primarily due to increased spending on marketing and promotional activities such as online advertising, customer events and sponsorships.

General and Administrative Expenses

General and administrative expenses increased $9 million, or 11%. Included in general and administrative expenses was $3 million of expenses, primarily legal and other professional fees, incurred in connection with a formal evaluation by our Board of Directors of the Company's long-term strategic alternatives during the three months ended September 30, 2014. Employee-related expenses increased $6 million, due mainly to increased headcount and salaries. Internal software support and maintenance expenses increased $2 million to support the growth of our business. Offsetting these increases was a $3 million decrease in professional and consulting fees and a benefit from the reversal of a previously recorded sales and use tax accrual. As a percentage of net revenue, general and administrative expenses decreased 120 basis points, from 20.1% in the three months ended September 30, 2013 to 18.9% in the three months ended September 30, 2014.

Depreciation and Amortization Expense

Depreciation and amortization expense increased $18 million, or 22%. During the three months ended September 30, 2014, we recorded a $4 million abandonment charge related to an unimproved portion of our corporate headquarters' building that we intend to demolish and redevelop. The remaining increase was due to an increase in property and equipment to support the growth of our business, which included increases in customer gear and internally developed and purchased software. As a percentage of net revenue, depreciation and amortization expenses increased 60 basis points, from 20.8% in the three months ended September 30, 2013 to 21.4% in the three months ended September 30, 2014. The headquarters building abandonment charge represented 90 basis points of the change between periods.




- 20 -


Other Income (Expense)

Other expense was $2.6 million and $0.2 million for the three months ended September 30, 2014 and 2013, respectively. The increase in other expense of $2.4 million between periods was driven by the unfavorable impact of foreign exchange rate movements and increased accretion expense related to our asset retirement obligations.

Income Taxes

Our effective tax rate decreased from 40.7% for the three months ended September 30, 2013 to 32.0% for the three months ended September 30, 2014 due primarily to Research and Development tax incentives in the State of Texas and a higher portion of earnings being generated outside the U.S. where earnings are generally taxed at lower rates. 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.

Net Income

Net income increased $9 million, or 58%, driven by higher net revenue and the positive impact of a lower effective tax rate, partially offset by higher expenses as we continue to make investments to support future growth. Net income per diluted share was $0.18 in the three months ended September 30, 2014, an increase of $0.07 from the same period of 2013.


- 21 -


Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 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.
Consolidated Statements of Income:
 
 
Nine Months Ended
(In thousands)
 
September 30,
2013
 
September 30,
2014
Net revenue
 
$
1,126,683

 
$
1,321,935

Costs and expenses:
 
 
 
 
Cost of revenue
 
358,672

 
428,422

Research and development
 
65,364

 
85,621

Sales and marketing
 
152,952

 
178,421

General and administrative
 
218,392

 
239,276

Depreciation and amortization
 
225,324

 
276,671

Total costs and expenses
 
1,020,704

 
1,208,411

Income from operations
 
105,979

 
113,524

Other income (expense):
 
 
 
 
Interest expense
 
(2,462
)
 
(1,469
)
Interest and other income (expense)
 
336

 
(1,755
)
Total other income (expense)
 
(2,126
)
 
(3,224
)
Income before income taxes
 
103,853

 
110,300

Income taxes
 
37,914

 
36,663

Net income
 
$
65,939

 
$
73,637


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

 
 
Nine Months Ended
(Percent of net revenue)
 
September 30,
2013
 
September 30,
2014
Net revenue
 
100.0
 %
 
100.0
 %
Costs and expenses:
 
 
 
 
Cost of revenue
 
31.8
 %
 
32.4
 %
Research and development
 
5.8
 %
 
6.5
 %
Sales and marketing
 
13.6
 %
 
13.5
 %
General and administrative
 
19.4
 %
 
18.1
 %
Depreciation and amortization
 
20.0
 %
 
20.9
 %
Total costs and expenses
 
90.6
 %
 
91.4
 %
Income from operations
 
9.4
 %
 
8.6
 %
Other income (expense):
 
 
 
 
Interest expense
 
(0.2
)%
 
(0.1
)%
Interest and other income (expense)
 
0.0
 %
 
(0.1
)%
Total other income (expense)
 
(0.2
)%
 
(0.2
)%
Income before income taxes
 
9.2
 %
 
8.3
 %
Income taxes
 
3.4
 %
 
2.8
 %
Net income
 
5.9
 %
 
5.6
 %
Due to rounding, totals may not equal the sum of the line items in the table above.

- 22 -


Net Revenue

Net revenue increased $195 million, or 17%, primarily due to both new customers and incremental services rendered to existing customers. Net revenue for dedicated cloud increased 12% while net revenue for public cloud increased 31%. Overall, our installed base grew at a monthly average rate of 0.6% in the nine months ended September 30, 2014, compared to 0.5% in the nine months ended September 30, 2013.

Contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the functional currencies of our foreign operations. Net revenue for the nine months ended September 30, 2014 would have been approximately $25 million lower had foreign exchange rates remained constant from the prior year.
  
Cost of Revenue

Cost of revenue increased $70 million, or 19%. Of this increase, $38 million was attributable to employee-related expenses, such as salaries, benefits and incentive compensation, driven by an increase in headcount to support business growth. License costs increased $18 million, as higher expenses of $25 million related to our growth were partially offset by a $7 million benefit related to a refund of sales tax paid on previous license purchases. Data center costs increased $19 million, mostly related to rent, maintenance and utilities. As a percentage of net revenue, cost of revenue increased 60 basis points, from 31.8% in the nine months ended September 30, 2013 to 32.4% in the nine months ended September 30, 2014. This change was primarily driven by increases of 50 basis points for employee-related expenses and 90 basis points for higher license expense, partially offset by 50 basis points related to the sales tax refund.

Research and Development Expenses

Research and development expenses increased $20 million, or 31% due to increased employee-related expenses, such as salaries, benefits and incentive compensation. We have invested in additional headcount to support research and development activities to enhance our existing offerings and develop new products and services.

Sales and Marketing Expenses

Sales and marketing expenses increased $25 million, or 17%. Employee-related expenses increased $19 million primarily due to increased headcount and higher sales commissions consistent with our revenue growth. The remaining increase was primarily due to increased spending on marketing and promotional activities such as online advertising, customer events and sponsorships, partially offset by a decrease in print advertising.

General and Administrative Expenses

General and administrative expenses increased $21 million, or 10%. Included in general and administrative expenses was $3 million of expenses, primarily legal and other professional fees, incurred in connection with a formal evaluation by our Board of Directors of the Company's long-term strategic alternatives during the nine months ended September 30, 2014. Employee-related expenses increased $12 million, primarily due to increased headcount, salaries and contract labor, partially offset by a decrease in share-based compensation expense resulting from certain executive forfeitures. Internal software support and maintenance expenses increased $4 million, to support the growth of the business. General and administrative expenses decreased as a percentage of net revenue, from 19.4% in the nine months ended September 30, 2013 to 18.1% in the nine months ended September 30, 2014, primarily due to the forfeiture of certain executive stock grants and slower hiring relative to revenue growth.
 
Depreciation and Amortization Expense

Depreciation and amortization expense increased $51 million, or 23%. During the nine months ended September 30, 2014, we recorded a $4 million abandonment charge related to an unimproved portion of our corporate headquarters' building that we intend to demolish and redevelop. The remaining increase was due to an increase in property and equipment to support the growth of our business, which included increases in customer gear and internally developed and purchased software. Depreciation and amortization expenses increased as a percentage of net revenue, from 20.0% in the nine months ended September 30, 2013 to 20.9% in the nine months ended September 30, 2014. The headquarters building abandonment charge represented 30 basis points of the increase between periods.


- 23 -


Other Income (Expense)

Other expense was $3.2 million and $2.1 million for the nine months ended September 30, 2014 and 2013, respectively. The increase in other expense of $1.1 million between periods was driven by the unfavorable impact of foreign exchange rate movements and increased accretion expense related to our asset retirement obligations, partially offset by lower interest expense related to a reduction in outstanding interest-bearing debt.

Income Taxes

Our effective tax rate decreased from 36.5% for the nine months ended September 30, 2013 to 33.2% for the nine months ended September 30, 2014 due primarily to Research and Development tax incentives in the State of Texas and a higher portion of earnings being generated outside the U.S. where earnings are generally taxed at lower rates. 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.

Net Income

Net income was $74 million in the nine months ended September 30, 2014, an increase of $8 million, or 12%, from the same period of 2013. Higher net revenue and the positive impact of a lower effective tax rate were mostly offset by increased expenses as we continue to make investments to support future growth. Net income per diluted share was $0.51 in the nine months ended September 30, 2014, an increase of $0.05 from the same period of 2013.

Liquidity and Capital Resources

At September 30, 2014, we held $349 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, secondly on the liquidity of our investments, and finally on maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation, or “FDIC,” insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

Of our cash and cash equivalents at September 30, 2014, $141 million was held by our foreign subsidiaries. If these funds are repatriated, we must accrue and pay taxes on such funds; however, we do not currently intend to repatriate these funds because we believe cash available in the U.S. is sufficient to meet our domestic operating and capital needs. As we expand our business on a global basis, we may transfer additional cash to our foreign entities.

We have vendor-financed arrangements in the form of leases and notes payable with our major vendors that permit us to finance our purchases of data center equipment. While we believe our borrowings from these arrangements will continue to be available, we have shifted our current strategy and now pay cash for most of our equipment purchases rather than financing them through these arrangements. Additionally, we have entered into certain real estate development and lease arrangements with independent real estate developers to design, construct and lease certain real estate projects that result in capital and finance lease obligations. As of December 31, 2013 and September 30, 2014, we had $65 million and $99 million outstanding with respect to these arrangements. 
    

- 24 -


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 September 30, 2014, 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 September 30, 2014, there were no outstanding borrowings under the revolving credit facility.

Capital Expenditure Requirements

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.
 
Cash Flows

The following table sets forth a summary of certain cash flow information for the periods indicated: 
 
 
Nine Months Ended September 30,
(In thousands)
 
2013
 
2014
Cash provided by operating activities
 
$
334,542

 
$
391,624

Cash used in investing activities
 
$
(333,884
)
 
$
(321,181
)
Cash provided by (used in) financing activities
 
$
(22,138
)
 
$
20,676


Operating Activities
 
Net cash provided by operating activities is primarily a function of our profitability, the amount of non-cash charges included in our profitability, and our working capital management. Net cash provided by operating activities increased $57 million, or 17%, from the first nine months of 2013 compared to the first nine months of 2014

Net income adjusted for the impact of non-cash items such as depreciation and amortization expense, share-based compensation expense and excess tax benefits from share-based compensation arrangements decreased $5 million in the first nine months of 2014 compared to the same period of 2013. Net income increased $8 million from the first nine months of 2013 to the first nine months of 2014. A summary of the significant changes in non-cash adjustments is as follows:

Depreciation and amortization expense increased by $51 million, due mainly to purchases of customer gear and computer software (internally developed technology).

The change in deferred income taxes in the first nine months of 2014 reduced cash from operating activities by $30 million, compared to a contribution of $10 million for the first nine months of 2013. This change is primarily due to a reduction in deferred tax liabilities related to depreciation and amortization expense.

Excess tax benefits from share-based compensation arrangements reduced cash from operating activities by $45 million during the first nine months of 2014, compared to a reduction of $17 million in the same period of 2013. We recognize an excess tax benefit from the exercise of stock options to the extent it will reduce our current income tax payable. The cash retained as a result of excess tax benefits is classified as a cash inflow from financing activities, with the corresponding cash outflow presented as an operating activity.


- 25 -


Net changes in certain assets and liabilities contributed $56 million to cash from operating activities during the first nine months of 2014 compared to a cash outflow of $15 million during the same period of 2013, resulting in an increase of $71 million between periods. Of this increase, the change in cash inflows from accounts payable and accrued expenses between periods represented $67 million. This includes an increase in income taxes payable as we expect a taxable profit in the U.S. and U.K. for 2014, before consideration of excess tax benefits. As described above, the cash impact from excess tax benefits is presented separately as a financing activity. The timing of payments for trade payables also contributed to the change.

Investing Activities

Net cash used in investing activities primarily consists of capital expenditures to meet the demands of our growing customer base. Our main investing activities consist of purchases of IT equipment for our data center infrastructure; furniture, equipment and leasehold improvements to support our operations; and capitalized payroll costs related to software development. Our net cash used in investing activities decreased $13 million, or 4%, from the first nine months of 2013 compared to the first nine months of 2014, primarily due to a decrease in cash purchases of property and equipment of $3 million and a $6 million decrease related to cash paid for acquisitions.
 
Financing Activities
 
Net cash used in financing activities was $22 million during the first nine months of 2013 compared to net cash provided by financing activities of $21 million during the first nine months of 2014, a change of $43 million. This change is primarily related to a $19 million decrease in principal payments of capital and financing leases, the receipt of $6 million from the Texas Enterprise Fund grant, an increase in proceeds from employee stock plans of $3 million, and an increase in excess tax benefits from share-based compensation arrangements of $28 million. These decreases in cash used in financing activities were partially offset by a $14 million cash outflow related to treasury stock purchases. The Company withheld shares related to the vesting of certain restricted stock units in lieu of employees paying withholding taxes, and we subsequently retired these shares prior to March 31, 2014.

Subsequent Event

On November 6, 2014, the Company's Board of Directors authorized the repurchase of up to $500.0 million of our common stock over the next two years.

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.
 
Critical Accounting Policies and Estimates
  
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 3, 2014 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates.” 

Recent Accounting Pronouncements Not Yet Adopted

For a description of accounting pronouncements recently issued but not yet adopted, see "Notes to the Unaudited Condensed Consolidated Financial Statements - Note 1. Company Overview, Basis of Presentation, and Summary of Significant Accounting Policies."

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
There have been no significant changes to our market risks since December 31, 2013. 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, 2013.


- 26 -


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 identified the material weakness described below and solely based on that material weakness, concluded that, as of the Evaluation Date, our disclosure controls and procedures were not effective as of September 30, 2014.

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

To remediate this material weakness, in the first quarter of 2014 we began to enhance our process around identifying and reviewing complex real estate development and lease agreements by (i) formalizing the process of timely identifying the origination of transactions with development and lease arrangements; (ii) implementing more comprehensive procedures for the accounting review of such transactions; (iii) creating a formal checklist of accounting provisions to be considered and evaluated during the review process; (iv) creating specific documentation standards of how accounting provisions were identified, considered and concluded upon and (v) developing more robust review standards. During the second and third quarter of 2014, we further enhanced our process and have implemented new internal controls surrounding the identification and accounting review of complex real estate development and lease agreements. However, we have not yet been able to conclude upon the effectiveness of these new controls as of September 30, 2014. As such, we do not consider the material weakness to be remediated.

Notwithstanding this material weakness, our chief executive officer and chief financial officer have each concluded that the consolidated financial statements included in this Form 10-Q present fairly, in all material respects, the financial position, results of operations and cash flows of our company and its subsidiaries in conformity with accounting principles generally accepted in the United States of America.

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.

- 27 -



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. While we implemented remedial procedures during 2014, we cannot yet conclude that such procedures were effective as of September 30, 2014.

- 28 -


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 May 29, 2012, Clouding IP, LLC filed a complaint against us in the United States District Court for the District of Delaware. The complaint alleged, among other things, infringement of the following 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 sought monetary damages and costs. The parties reached a settlement of the case, and on November 3, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

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 alleged, 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 sought injunctive relief, monetary damages, costs, and attorney's fees. The parties reached a settlement of the case, and on October 20, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

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 alleged, 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. The parties reached a settlement of the case, and on November 6, 2014, all claims were dismissed with prejudice. This settlement did not have a material impact on our financial position or results of operations.

On March 18, 2014, Selene Communications Technologies, 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 two patents: U.S. Patent No. 6,363,377 purporting to cover a “Search Data Processor” and U.S. Patent No. 7,143,444 purporting to cover an “Application-Layer Anomaly and Misuse Detection.” The plaintiff seeks injunctive relief, monetary damages and costs. We dispute the allegations of wrongdoing and intend to vigorously defend ourselves in this matter.

We cannot predict the impact, if any, that any of the continuing outstanding 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.


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ITEM 1A – RISK FACTORS

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

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Any future service interruptions could:
 
Cause our customers to seek damages for losses incurred;
Require us to replace existing equipment or add redundant facilities;
Affect our reputation as a reliable provider of hosting services;
Cause existing customers to cancel or elect to not review their contracts; or
Make it more difficult for us to attract new customers.
Any of these events could materially increase our expenses or reduce our revenue, which would have a material adverse effect on our operating results.

If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer.
 
Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way our services are marketed and delivered. The adoption of new technologies, a change in industry standards or introduction of more attractive products or services could make some or all of our offerings less desirable or even obsolete. These potential changes are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by forecasting customer demands; improving the performance, features, and reliability of our products and services; and modifying our business strategies accordingly. We cannot guarantee that we will be able to identify the emergence of all of these new service alternatives successfully, modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes.

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

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

We could also incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. For example, our data center infrastructure could require improvements due to (i) the development of new systems to deliver power to or eliminate heat from the servers we house, (ii) the development of new server technologies that require levels of critical load and heat removal that our facilities are not designed to provide, or (iii) a fundamental change in the way in which we deliver services. We may not be able to timely adapt to changing technologies, if at all. Our ability to sustain and grow our business would suffer if we fail to respond to these changes in a timely and cost-effective manner.


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Finally, even if we succeed in adapting to a new technology or the changing industry standard and developing attractive products and services and successfully bringing them to market, there is no assurance that our use of the new technology or standard or our introduction of the new products or services would have a positive impact on our financial performance and could even result in lower revenue, lower margins and/or higher costs and therefore could negatively impact our financial performance. For example, our cloud platform launch featured the release of several key products. While we believe that these capabilities and features drive future incremental demand, there are certain risks associated with such a significant product transition and platform shift. We believe these risks could adversely impact our ability to execute on our growth strategy and therefore capitalize on the current market opportunity, both in the short and long term. They include: (i) the non-acceptance by current and prospective customers of our new hybrid cloud platform and product set; (ii) increasing competition in our industry by competitors that have greater financial, technical, and marketing resources, larger customer bases, longer operating histories, greater brand recognition, more established relationships in the industry, and the ability to acquire competitors and suppliers to increase their market presence and vertical reach capabilities; (iii) new pricing strategies that may include lowering price points for cloud products and services to recognize increasing technological efficiencies and offering discounted usage and volume-based pricing for our cloud products to significant cloud customers; (iv) the adoption of OpenStack as the ubiquitous open source cloud computing platform standard for public and private clouds, which could be negatively impacted by a delay in product releases; and (v) unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we serve.

Our failure to provide platforms, products and services to compete with new technologies or the obsolescence of our platforms, products or services would likely lead us to lose current and potential customers or cause us to incur substantial costs by attempting to catch our offerings up to the changed environment.


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We may not be able to compete successfully against current and future competitors.
 
The market for cloud computing is highly competitive. We expect to face intense competition from our existing competitors as well as additional competition from new market entrants in the future as the actual and potential market for hosting and cloud computing continues to grow.
 
Our current and potential competitors vary by size, service offerings and geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:
 
In-house and Colocation solutions with a colocation partner such as AT&T, Equinix, CenturyLink and other telecommunications companies;
IT outsourcing providers such as CSC, Hewlett-Packard, and IBM;
Cloud computing providers such as AT&T, British Telecom, CenturyLink, Red Hat, IBM, 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 Taylor Rhodes, our Chief Executive Officer and President. We do not have long-term employment agreements with several members of our senior management team, including Mr. Rhodes.

We have been accused of infringing the proprietary rights of others and may be accused of infringing on the proprietary rights of others in the future, which could subject us to costly and time consuming litigation and require us to discontinue services that infringe the rights of others.

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

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

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

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


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

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.
 
We believe that our success depends on our ability to provide customers with quality service that not only meets our stated commitments, but meets and then exceeds customer service expectations. We refer to this high quality of customer service as Fanatical Support. If we are unable to provide customers with quality customer support in a variety of areas, we could face customer dissatisfaction, dilution of our brand, weakening of our main market differentiator, decreased overall demand for our services, and loss of revenue. In addition, our inability to meet customer service expectations may damage our reputation and could consequently limit our ability to retain existing customers and attract new customers, which would adversely affect our ability to generate revenue and negatively impact our operating results.
 
Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.
 
Customer contracts for our managed dedicated hosting services typically have initial terms of one to two years which, unless terminated, may be renewed or automatically extended on a month-to-month basis. Our customers have no obligation to renew their services after their initial contract periods expire on these contracts. In addition, many of our other services and products, including most of our public cloud products and services, are generally provided on a month-to-month basis and do not have an extended initial term at all. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.
 
Customers with mission-critical applications could potentially expose us to lawsuits for their lost profits or damages, which could impair our financial condition.
 
Because our services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot be assured that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may exceed our liability insurance coverage by unknown but significant amounts, which could materially impair our financial condition.


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

In addition, our activities with these open source projects could subject us to additional risks of litigation, including indirect infringement claims based on third-party contributors because of our participation in these projects.
 
We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.
 
We rely primarily on patent, copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies. We cannot be assured that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We currently have patents issued and patent applications pending in the U.S. and the European Union. Our patent applications may be challenged and/or ultimately rejected, and our issued patents may be contested, circumvented, found unenforceable or invalidated.
 
We endeavor to enter into agreements with our employees, contractors, and parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. We may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed. 

In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the U.S. Despite the measures taken by us, it may be possible for a third party to copy or otherwise obtain and use our technology and information without authorization. Policing unauthorized use of our proprietary technologies and other intellectual property and our services is difficult, and litigation could become necessary in the future to enforce our intellectual property rights. Any litigation could be time consuming and expensive to prosecute or resolve, result in substantial diversion of management attention and resources, and harm our business, financial condition, and results of operations.


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

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

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

The costs of construction, leasing, and maintenance of our data centers constitute a significant portion of our capital and operating expenses. In order to manage growth and ensure adequate capacity for new and existing customers while minimizing unnecessary excess capacity costs, we continuously evaluate our short and long-term data center capacity requirements. If we overestimate the demand for our services and therefore secure excess data center capacity, our operating margins could be materially reduced, which would materially impair our profitability. If we underestimate our data center capacity requirements, we may not be able to service the expanding needs of our existing customers and may be required to limit new customer acquisition, which may materially impair our revenue growth.

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

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

We currently intend to continue to lease from data center operators, but we could be forced to re-evaluate those plans depending on the availability and cost of data center facilities, the ability to impact and control certain design aspects of the data center and economic conditions affecting the data center operator's ability to add additional facilities.
 
We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.
 
We do not own the facilities occupied by our current data centers but occupy them pursuant to commercial leasing arrangements. The initial terms of our main existing data center leases expire over the next 20 years. Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required or choose to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.
 
Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.


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We have identified a material weakness in our internal control over financial reporting which could, if not remediated, result in material misstatements in our financial statements.

Although we have concluded that our consolidated financial statements as of December 31, 2013, and the interim consolidated financial statements as of September 30, 2014, present fairly, in all material respects, the financial position, results of operations and cash flow of our company and its subsidiaries in conformity with generally accepted accounting principles, we have identified a material weakness in internal control over financial reporting related to the controls around our accounting review of complex real estate development and lease arrangements. Under standards established by the Public Company Accounting Oversight Board, a material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected and corrected on a timely basis. See Item 4, "Controls and Procedures."

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

We rely on a number of third-party providers for data center space, equipment, maintenance and other services, and the loss of, or problems with, one or more of these providers may impede our growth or cause us to lose customers.
 
We rely on third-party providers to supply data center space, equipment and maintenance. For example, we lease data center space from third-party landlords, lease or purchase equipment from equipment providers, and source equipment maintenance through third parties. While we have entered into various agreements for the lease of data center space, equipment, maintenance and other services, the third party could fail to live up to the contractual obligations under those agreements. For example, a data center landlord may fail to adequately maintain its facilities or provide an appropriate data center infrastructure for which it is responsible. If that were to happen, we would not likely be able to deliver the services to our customers that we have agreed to provide according to our standards or at all. Additionally, if the third parties that we rely on do fail to deliver on their obligations, our customers may lose confidence in our company, which would make it likely that we would not able to retain those customers, and therefore negatively impede our growth and financial results.
 
We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.
 
We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software or inadequate or delayed support by the third party could result in errors or a failure of our service, which could harm our operating results by adversely affecting our revenue or operating costs.
 
We engage and rely on third-party consultants who may fail to provide effective guidance or solutions, which could result in increased costs and loss of business opportunity.
 
We engage third-party consultants who provide us with guidance and solutions relating to everything from overall corporate strategy to data center operations to employee engagement. We engage these parties based on our perception of their expertise and ability to provide valuable insight or solutions in the areas that we believe need to be addressed in our business. However, these consultants may provide us with ineffective or even harmful guidance or solutions, which, if followed or implemented, could result in a loss of resources, operational failures or a loss of critical business opportunities.
 

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Increased energy costs, power outages, and limited availability of electrical resources may adversely affect our operating results.
 
Our data centers are susceptible to increased regional, national or international costs of power and to electrical power outages. Our customer contracts do not allow us to pass on any increased costs of energy to our customers, which could affect our operating margins. Increases in our power costs could impact our operating results and financial condition. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Increased Internet bandwidth costs and network failures may adversely affect our operating results.
 
Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.
 
As our customer base grows and their usage of telecommunications capacity increases, we will be required to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.
 

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We could be required to repay substantial amounts of money to certain state and local governments if we lose tax exemptions or grants previously awarded to us, which could adversely affect our operating results.
 
In August 2007, we entered into an agreement with the State of Texas (Texas Enterprise Fund Grant) under which we may receive up to $22 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest. On July 27, 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements. Under the amendment, the grant has been divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a Job Target of 1,225 new jobs by December 2012 (in addition to the 1,436 jobs in place as of August 1, 2007, for a total of 2,661 jobs in Texas). We received the initial installment of $5 million from the State of Texas in September 2007, and, after achieving the Job Target, we received the remaining $3.5 million in March 2012. These amounts were recorded as non-current liabilities. The remaining three tranches are at our option. We can draw an additional $13.5 million in the aggregate, based on the following amounts and milestones: $5.5 million if we create a total of 2,100 new jobs in Texas, another $5.25 million if we create a total of 3,000 new jobs in Texas, and $2.75 million more if we create a total of 4,000 new jobs in Texas. We have met the required employment level of the second tranche and received the related $5.5 million of funding in March 2014. We are responsible for maintaining all of the jobs used in calculating these disbursements 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 September 30, 2014, there was no outstanding indebtedness under our credit facility other than immaterial outstanding letters of credit.
 
We also have substantial equipment and other lease obligations. The principal balance of these capital lease obligations totaled approximately $31.3 million as of September 30, 2014. The payment obligations under the equipment leases are generally secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

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


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We are exposed to commodity and market price risks that have the potential to substantially influence our profitability and liquidity.
 
We are a large consumer of power. During the first nine months of 2014, we expensed approximately $23.4 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations and changes in energy prices. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically tracked the general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. We periodically evaluate the advisability of entering into fixed-price utilities contracts and have entered into certain fixed-price utilities contracts for some of our power consumption. If we choose not to enter into a fixed-price contract, we expose our cost structure to this commodity price risk. If we do choose to enter into a fixed-price contract, we lose the opportunity to reduce our power costs if the price for power falls below the fixed cost.  

Our main credit facility is a revolving line of credit with a base rate determined by variable market rates, including the Prime Rate and the London Interbank Offered Rate (LIBOR). These market rates of interest are fluctuating and expose our interest expense to risk. At this point, our credit agreement does not obligate us to hedge any interest rate risk with any instruments, such as interest rate swaps or interest rate options, and we do not have any such instruments in place. As we borrow, 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 September 30, 2014, 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 revenue to our business, and we benefit from our association with them. The loss of these participants could adversely affect our business.
 
Our referral and reseller partners drive revenue to our business. Most of these partners offer services that are complementary to our services; however, some may actually compete with us in one or more of our product or service offerings. These network partners may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own services rather than ours, which could cause our revenue to decline.
 
Also, we derive tangible and intangible benefits from our association with some of our network partners, particularly high profile partners that reach a large number of companies through the Internet. If a substantial number of these partners terminate their relationship with us, our business could be adversely affected.
 

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Our acquisitions may divert our management’s attention, result in dilution to our stockholders and consume resources that are necessary to sustain our business.
 
We have made acquisitions, and, if appropriate opportunities present themselves, we may make additional acquisitions or investments or enter into joint ventures or strategic alliances with other companies. Risks commonly encountered in such transactions include:
 
The difficulty of assimilating the operations and personnel of the combined companies;
The potential post-acquisition loss of personnel acquired through an acquisition;
The risk that we may not be able to integrate the acquired services or technologies with our current services, products, and technologies;
The potential disruption of our ongoing business;
The diversion of management attention from our existing business;
The inability of management to maximize our financial and strategic position through the successful integration of the acquired businesses;
Difficulty in maintaining controls, procedures, and policies;
The impairment of relationships with employees, suppliers, and customers as a result of any integration;
The loss of an acquired base of customers and accompanying revenue; and
The assumption of leased facilities, other long-term commitments or liabilities that could have a material adverse impact on our profitability and cash flow.
As a result of these potential problems and risks, businesses that we may acquire or invest in may not produce the revenue, earnings, or business synergies that we anticipated. In addition, there can be no assurance that any potential transaction will be successfully identified and completed or that, if completed, the acquired business or investment will generate sufficient revenue to offset the associated costs or other potential harmful effects on our business.

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

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Risks Related to the Ownership of Our Common Stock
 
The trading price of our common stock may be volatile.
 
The market price of our common stock has been highly volatile and could be subject to wide fluctuations in response to, among other things, the risk factors described in this periodic report, operating results that do not meet the market analyst expectations, and other factors beyond our control, such as stock market volatility and fluctuations in the valuation of companies perceived by investors to be comparable to us. For example, between December 31, 2013 and September 30, 2014, the closing trading price of our common stock was very volatile, ranging between $26.28 and $40.36 per share, including single-day increases of up to 17.7% and declines up to 19.1%. 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 6 – EXHIBITS
 
Exhibit Number
 
 Description
10.1*
 
Amended and Restated Employment Agreement between Rackspace US, Inc. and William Taylor Rhodes, dated September 16, 2014
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 November 10, 2014.


Rackspace Hosting, Inc.

Date:
November 10, 2014
 
By:
 
/s/ Karl Pichler
 
 
 
 
 
Karl Pichler
 
 
 
 
 
Chief Financial Officer and Treasurer
 
 
 
 
 
(Principal Financial Officer)

Date:
November 10, 2014
 
By:
 
/s/ Joseph Saporito
 
 
 
 
 
Joseph Saporito
 
 
 
 
 
Chief Accounting Officer
 
 
 
 
 
(Principal Accounting Officer)


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