Rackspace Hosting (RAX) 10-Q 2011 Q3 Quarterly report

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, 2011.

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (No Fee Required)

For the transition period from ______ to ______.

Commission file number 001-34143

RACKSPACE HOSTING, INC.

(Exact Name of Registrant as Specified in its Charter)

Delaware	74-3016523
(State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)

5000 Walzem Rd.

San Antonio, Texas 78218

(Address of principal executive offices, including Zip Code)

(210) 312-4000

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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 definition of “accelerated filer, large accelerated filer and a smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer R Accelerated filer o Non-accelerated filer o Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes o    No R

On October 31, 2011, 131,075,085 shares of the registrant’s Common Stock, $0.001 par value, were outstanding.

RACKSPACE HOSTING, INC.

TABLE OF CONTENTS

Part I - Financial Information
Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets as of December 31, 2010 and September 30, 2011 (unaudited)	3
	Unaudited Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2010 and 2011	4
	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2011	5
	Notes to the Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	36
Part II - Other Information
Item 1.	Legal Proceedings	37
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	57
Item 3.	Defaults Upon Senior Securities	57
Item 4.	Reserved	57
Item 5.	Other Information	57
Item 6.	Exhibits	58
Signatures		59

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, 2010			September 30, 2011
				(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	104,941		$	124,680
Accounts receivable, net of allowance for doubtful accounts and customer credits of $2,846 as of December 31, 2010 and $3,355 as of September 30, 2011	47,734			61,054
Income taxes receivable	4,397			—
Deferred income taxes	6,416			9,022
Prepaid expenses	16,738			29,175
Other current assets	5,219			3,304
Total current assets	185,445			227,235
Property and equipment, net	495,228			620,156
Goodwill	57,147			59,993
Intangible assets, net	9,675			10,385
Other non-current assets	14,082			52,908
Total assets	$	761,577		$	970,677
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	111,645		$	148,464
Current portion of deferred revenue	15,822			14,407
Current portion of obligations under capital leases	59,763			65,781
Current portion of debt	1,912			1,316
Total current liabilities	189,142			229,968
Non-current deferred revenue	2,927			3,365
Non-current obligations under capital leases	69,173			77,055
Non-current debt	879			—
Non-current deferred income taxes	35,238			66,115
Non-current deferred rent	14,595			22,187
Other non-current liabilities	10,760			20,938
Total liabilities	322,714			419,628
COMMITMENTS AND CONTINGENCIES
Stockholders' equity:
Common stock, $0.001 par value per share: 300,000,000 shares authorized; 126,950,468 shares issued and outstanding as of December 31, 2010; 131,014,249 shares issued and outstanding as of September 30, 2011	127			131
Additional paid-in capital	296,571			358,022
Accumulated other comprehensive loss	(12,416		)	(13,049		)
Retained earnings	154,581			205,945
Total stockholders’ equity	438,863			551,049
Total liabilities and stockholders’ equity	$	761,577		$	970,677

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands, except per share data)	2010			2011			2010			2011
Net revenue	$	199,710		$	264,572		$	565,829		$	741,803
Costs and expenses:
Cost of revenue	64,616			82,445			183,093			226,244
Sales and marketing	24,651			31,838			69,913			93,053
General and administrative	49,131			69,701			142,263			198,232
Depreciation and amortization	39,677			49,518			114,366			140,568
Total costs and expenses	178,075			233,502			509,635			658,097
Income from operations	21,635			31,070			56,194			83,706
Other income (expense):
Interest expense	(2,068		)	(1,531		)	(6,087		)	(4,544		)
Interest and other income (expense)	(1,263		)	(276		)	(264		)	(968		)
Total other income (expense)	(3,331		)	(1,807		)	(6,351		)	(5,512		)
Income before income taxes	18,304			29,263			49,843			78,194
Income taxes	6,495			9,281			17,024			26,830
Net income	$	11,809		$	19,982		$	32,819		$	51,364
Net income per share
Basic	$	0.09		$	0.15		$	0.26		$	0.40
Diluted	$	0.09		$	0.14		$	0.25		$	0.37
Weighted average number of shares outstanding
Basic	125,312			130,662			124,633			129,414
Diluted	133,439			138,453			132,824			137,751

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
(In thousands)	2010			2011
Cash Flows From Operating Activities
Net income	$	32,819		$	51,364
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization	114,366			140,568
Loss on disposal of equipment, net	569			357
Provision for bad debts and customer credits	2,976			4,462
Deferred income taxes	2,982			9,189
Deferred rent	4,171			8,271
Share-based compensation expense	19,537			21,188
Excess tax benefits from share-based compensation arrangements	—			(11,916		)
Changes in certain assets and liabilities
Accounts receivable	(9,074		)	(17,363		)
Income taxes receivable	4,352			4,397
Prepaid expenses and other current assets	(14,604		)	(10,091		)
Accounts payable and accrued expenses	12,982			38,215
Deferred revenue	(2,689		)	(1,096		)
All other operating activities	1,578			517
Net cash provided by operating activities	169,965			238,062
Cash Flows From Investing Activities
Purchases of property and equipment, net	(97,894		)	(202,784		)
Acquisitions, net of cash acquired	—			(952		)
Earn-out payments for acquisitions	(490		)	—
All other investing activities	(75		)	105
Net cash used in investing activities	(98,459		)	(203,631		)
Cash Flows From Financing Activities
Principal payments of capital leases	(37,947		)	(48,854		)
Principal payments of notes payable	(4,029		)	(1,476		)
Payments for debt issuance costs	—			(1,114		)
Payments of earn-out provisions for acquisitions	—			(2,900		)
Proceeds from employee stock plans	11,373			27,782
Excess tax benefits from share-based compensation arrangements	—			11,916
Net cash used in financing activities	(30,603		)	(14,646		)
Effect of exchange rate changes on cash and cash equivalents	229			(46		)
Increase in cash and cash equivalents	41,132			19,739
Cash and cash equivalents, beginning of period	125,425			104,941
Cash and cash equivalents, end of period	$	166,557		$	124,680
Supplemental cash flow information:
Acquisition of property and equipment by capital leases	$	54,767		$	62,755
Shares issued in business combinations	$	510		$	—
Cash payments for interest, net of amount capitalized	$	5,851		$	4,356
Cash payments for income taxes	$	15,761		$	15,417

See accompanying notes to the unaudited condensed consolidated financial statements.

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RACKSPACE HOSTING, INC. AND SUBSIDIARIES—

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Company Overview 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 hosting solutions.  We provide IT as a service, managing web-based IT systems for small and medium-sized businesses as well as large enterprises.  We focus on providing a service experience for our customers, which we call Fanatical Support^®.

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

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

Basis of Consolidation

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

Basis of Presentation

The accompanying consolidated financial statements as of September 30, 2011, and for the three and nine months ended September 30, 2010 and 2011, are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all financial information and disclosures required by GAAP for complete financial statements, and certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted.  The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include normal recurring adjustments, necessary for a fair statement of our financial position as of September 30, 2011, our results of operations for the three and nine months ended September 30, 2010 and 2011, and our cash flows for the nine months ended September 30, 2010 and 2011.

These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto as of December 31, 2010 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 22, 2011.  The results of the three and nine months ended September 30, 2011 are not necessarily indicative of the results to be expected for the year ending December 31, 2011, or for any other interim period, or for any other future year.

Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation.

Significant Accounting Policies

The accompanying financial statements reflect the application of certain significant accounting policies. There have been no material changes to our significant accounting policies that are disclosed in our audited consolidated financial statements and notes thereto as of December 31, 2010, included in our Annual Report on Form 10-K.

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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 the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable and customer credits, property and equipment, fair values of intangible assets and goodwill, useful lives of intangible assets, fair value of stock options, contingencies, and income taxes, among others. We base our estimates on historical experience and on other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We engaged third-party valuation consultants to assist management in the purchase price allocation of significant acquisitions.

Recently Adopted Accounting Pronouncements

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

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

Recent Accounting Pronouncements Not Yet Adopted

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

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

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

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2. Earnings Per Share

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

	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands, except per share data)	2010		2011		2010		2011
Basic net income per share:
Net income	$	11,809	$	19,982	$	32,819	$	51,364
Weighted average shares outstanding:
Common stock	125,312		130,662		124,633		129,414
Number of shares used in per share computations	125,312		130,662		124,633		129,414
Earnings per share	$	0.09	$	0.15	$	0.26	$	0.40
Diluted net income per share:
Net income	$	11,809	$	19,982	$	32,819	$	51,364
Weighted average shares outstanding:
Common stock	125,312		130,662		124,633		129,414
Stock options, awards and employee share purchase plan	8,127		7,791		8,191		8,337
Number of shares used in per share computations	133,439		138,453		132,824		137,751
Earnings per share	$	0.09	$	0.14	$	0.25	$	0.37

We excluded 1.9 million and 1.6 million potential common shares from the computation of dilutive earnings per share for the three months ended September 30, 2010 and 2011, respectively, and 1.2 million and 1.1 million potential shares for the nine months ended September 30, 2010 and 2011, respectively, because the effect would have been anti-dilutive.

3. Cash and Cash Equivalents

Cash and cash equivalents consisted of:

(In thousands)	December 31, 2010		September 30, 2011
Cash deposits	$	64,201	$	83,938
Money market funds	40,740		40,742
Cash and cash equivalents	$	104,941	$	124,680

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

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

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4.  Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There is a three-tier fair value of 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.

There have been no material changes to the valuation techniques utilized in the fair value measurement of assets and liabilities presented on our balance sheet as disclosed in our Form 10-K for the year ended December 31, 2010.

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

	December 31, 2010
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Assets/Liabilities at Fair Value
Assets:
Money market funds (1)	$	40,740	$	—	$	—	$	40,740
Rabbi trust (2)	795		—		—		795
Total	$	41,535	$	—	$	—	$	41,535
Liabilities:
Deferred compensation (3)	$	754	$	—	$	—	$	754
Total	$	754	$	—	$	—	$	754

	September 30, 2011
(In thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Assets/Liabilities at Fair Value
Assets:
Money market funds (1)	$	40,742	$	—	$	—	$	40,742
Rabbi trust (2)	264		—		—		264
Total	$	41,006	$	—	$	—	$	41,006
Liabilities:
Deferred compensation (3)	$	225	$	—	$	—	$	225
Total	$	225	$	—	$	—	$	225

(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.

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5. Property and Equipment, net

Property and equipment consisted of: 

(In thousands)	Estimated Useful Lives				December 31, 2010			September 30, 2011
Computers, software and equipment	1	-	5	years	$	668,691		$	841,402
Furniture and fixtures	7	years			25,140			28,922
Buildings and leasehold improvements	2	-	30	years	141,506			174,739
Land					13,860			13,860
Property and equipment, at cost					849,197			1,058,923
Less accumulated depreciation and amortization					(422,716		)	(537,294		)
Work in process					68,747			98,527
Property and equipment, net					$	495,228		$	620,156

Depreciation and leasehold amortization expense, not including amortization expense for intangible assets, was $38.2 million and $48.5 million for the three months ended September 30, 2010 and 2011, respectively, and $109.7 million and $136.8 million for the nine months ended September 30, 2010 and 2011, respectively.

At December 31, 2010, the work in process balance consisted of build outs of $35.7 million for office facilities, $21.3 million for data centers (of which $13.3 million relates to a vendor fee for data center design services), and $11.7 million for capitalized software and other projects.  At September 30, 2011, the work in process balance consisted of build outs of $50.5 million for office facilities, $23.3 million for data centers (of which $17.0 million relates to a vendor fee for data center design services), and $24.7 million for capitalized software and other projects.

Capitalized interest was $0.2 million for the three months ended September 30, 2010 and $0.5 million for the nine months ended September 30, 2010. There has been no interest capitalized in 2011. 

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6. Business Combinations and Goodwill

In January 2011, we acquired a company to bolster our service delivery capabilities around OpenStack. The acquisition, which was accounted for using the acquisition method, included an initial cash payment, additional cash payments due on the first and second anniversaries of the closing date and cash or stock to be paid upon the achievement of certain earn-out provisions. The composition of the payment of the earn-out provisions between cash and stock is at our discretion. The purchase price was allocated based on the estimated fair values of the individual assets acquired and liabilities assumed at the date of acquisition, and after the completion of our final tax review during the three months ended September 30, 2011, we determined the allocation of the purchase price was final. The fair value of the contingent consideration as of September 30, 2011 was $2.2 million, all of which is classified as short-term within accounts payable and accrued expenses. The condensed consolidated statements of income include the results of operations for the acquired company commencing on January 26, 2011.

In December 2010, we acquired a company and accounted for the transaction using the acquisition method. During the three months ended March 31, 2011, we recorded a measurement period adjustment to reflect changes in the estimated fair value of deferred tax assets related to the acquisition. This adjustment resulted from our final review of certain tax matters relating to the transaction and did not result from intervening events subsequent to the acquisition date. Upon the final completion of an independent appraisal and all other evaluations during the three months ended March 31, 2011, we determined the allocation of the purchase price was final. Beginning in the second quarter of 2011, the associated earn-out payments are no longer contingent upon achievement of certain provisions, and the full amount is scheduled to be paid in six equal installments, the first two of which were paid in the third quarter of 2011. The composition of the payout between cash and stock is at our discretion. As of September 30, 2011, the amount of the liability recorded was $6.4 million.

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

(In thousands)
December 31, 2010	$	57,147
Measurement period adjustments	149
Acquisition	2,697
September 30, 2011	$	59,993

7. Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses consisted of: 

(In thousands)	December 31, 2010		September 30, 2011
Trade payables	$	30,603	$	40,444
Accrued compensation and benefits	26,855		40,729
Income and other taxes payable	19,814		21,841
Vendor accruals	22,503		28,540
Other liabilities	11,870		16,910
Accounts payable and accrued expenses	$	111,645	$	148,464

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8. Debt

Debt outstanding consisted of:

(In thousands)	December 31, 2010			September 30, 2011
Notes payable	$	2,791		$	1,316
Total debt	2,791			1,316
Less current portion of debt	(1,912		)	(1,316		)
Total non-current debt	$	879		$	—

Revolving Credit Facility

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

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

As of September 30, 2011, there was no amount outstanding under the facility except for an outstanding letter of credit of $0.4 million, resulting in $199.6 million being available for future borrowings. As of the same date, we were in compliance with all of the covenants under our facility.

9. Commitments and Contingencies

Legal Proceedings

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

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10. Share-Based Compensation

In January 2011, an additional 5.8 million shares became available for future grants pursuant to the automatic share reserve increase or “evergreen” provision under our Amended and Restated 2007 Long-Term Incentive Plan.  As of September 30, 2011, the total number of shares authorized under all of our plans was 54.3 million shares, of which approximately 12.9 million shares were available for future grants.

Outstanding stock awards were as follows: 

	December 31, 2010	September 30, 2011
Restricted stock units	2,869,832	3,450,978
Stock options	15,551,009	12,888,089
Total outstanding awards	18,420,841	16,339,067

The following table summarizes our restricted stock unit activity for the nine months ended September 30, 2011:

	Number of Units	Weighted Average Grant Date Fair Value
Outstanding at December 31, 2010	2,869,832	$	9.23
Granted	833,941	$	36.10
Released	(175,391)	$	18.97
Cancelled	(77,404)	$	24.65
Outstanding at September 30, 2011	3,450,978	$	14.85
Expected to vest after September 30, 2011*	3,218,214	$	9.09

*Includes reduction of shares outstanding due to estimated forfeitures

There have been two types of restricted stock units (RSUs) granted in 2011.  The first type vests as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date.  Stock-based compensation expense for these service-vesting RSUs is measured based on the closing fair market value of the company’s common stock on the date of grant and is recognized ratably over the service period.  The second type was granted to members of our executive team. The vesting of these RSUs is dependent upon the company’s total shareholder return (TSR) on its common stock for a 3-year performance period as compared to the components of the NASDAQ Internet Index over this same period. In addition, the company’s TSR must be positive for vesting to occur.  Stock-based compensation expense for this type of RSU is measured using a Monte Carlo pricing method and is recognized ratably over the vesting period.

As of September 30, 2011, there was $40.1 million of total unrecognized compensation cost related to non-vested RSUs that we have granted, which will be amortized using the straight-line method over a remaining weighted average period of 2.1 years.

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The following table summarizes the stock option activity for the nine months ended September 30, 2011: 

	Number of Shares	Weighted Average Exercise Price		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2010	15,551,009	$	8.45	6.84	$	356,993
Granted	1,918,428	$	37.35
Exercised	(3,865,896)	$	7.08
Cancelled	(715,452)	$	14.68
Outstanding at September 30, 2011	12,888,089	$	12.83	6.17	$	280,460
Vested and exercisable at September 30, 2011	7,180,137	$	6.16	5.49	$	200,931
Vested and exercisable at September 30, 2011 and expected to vest thereafter*	12,418,883	$	12.37	6.14	$	275,608

*Includes reduction of shares outstanding due to estimated forfeitures

The stock options granted in 2011 vest as the employee continues to be employed with us, in four equal installments, on each of the first, second, third and fourth anniversaries of the grant date and have a term of 7 years.

The total pre-tax intrinsic value of the stock options exercised during the three months ended September 30, 2010 and 2011 was $17.2 million and $16.9 million, respectively, and $32.8 million and $121.0 million for the nine months ended September 30, 2010 and 2011, respectively.

The following table presents the assumptions used to estimate the fair values of the stock options granted in the periods presented:

	Three Months Ended September 30,		Nine Months Ended September 30,
	2010	2011	2010	2011
Expected stock volatility	55% - 56%	57%	55% - 56%	56% - 57%
Expected dividend yield	0.0%	0.0%	0.0%	0.0%
Risk-free interest rate	1.44% - 1.76%	0.85%	1.44% - 2.79%	0.85% - 2.35%
Expected life	4.75 - 6.25 years	4.75 years	4.75 - 6.25 years	4.75 years
Weighted average grant date fair value of options granted during the period	$9.08	$16.87	$9.82	$17.99

As of September 30, 2011, there was $50.6 million of total unrecognized compensation cost related to non-vested stock options that we have granted, which will be amortized using the straight line method over a weighted average period of 2.6 years.

Share-based compensation expense was recognized as follows: 

	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2010			2011			2010			2011
Cost of revenue	$	1,305		$	1,005		$	3,437		$	3,173
Sales and marketing	1,209			864			3,189			1,474
General and administrative	4,669			5,526			12,911			16,541
Pre-tax share-based compensation	7,183			7,395			19,537			21,188
Less: Income tax benefit	(2,549		)	(2,323		)	(6,673		)	(7,270		)
Total share-based compensation expense, net of tax	$	4,634		$	5,072		$	12,864		$	13,918

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11. 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.

During the quarter ended September 30, 2011, Rackspace US, Inc. sold certain intellectual property to a wholly-owned offshore subsidiary in a taxable transaction.  As a result of the transaction, an asset of $39.3 million (of which $37.2 million was recorded in Other non-current assets) was recorded and will be amortized through income tax expense over the lives of the applicable intellectual property. Although the transaction was taxable, the resulting gain was entirely offset against existing net operating losses, including excess stock compensation deductions. Thus, there was no cash tax impact from the sale of the intellectual property.

 We expect a taxable profit in the U.S. and U.K. for the full year 2011, and therefore we anticipate utilizing benefits of tax deductions related to stock compensation in 2011.  As a result, we have recognized an income tax receivable or excess tax benefit in the U.S. and U.K. during the current period.

The following table provides a roll forward of our balance of unrecognized tax benefits, excluding accrued interest.

(In thousands)
December 31, 2010	$	2,456
Additions based on tax positions related to the current year	12,944
Additions for tax positions of prior years	1,228
Reductions for tax positions of prior years	—
Settlements	—
September 30, 2011	$	16,628

As of September 30, 2011, approximately $1.9 million of these unrecognized tax benefits, if recognized, would favorably impact our effective tax rate in any future period. Also included in the balance of unrecognized tax benefits at September 30, 2011 are liabilities of $12.6 million that, if recognized, would be recorded as an adjustment to other current and non-current assets.

12. Comprehensive Income

Total comprehensive income was as follows: 

	Three Months Ended September 30,					Nine Months Ended September 30,
(In thousands)	2010		2011			2010			2011
Net income	$	11,809	$	19,982		$	32,819		$	51,364
Derivative instrument, net of deferred taxes of $(158) for the three months ended September 30, 2010, and $(465) for the nine months ended September 30, 2010.	294		—			864			—
Foreign currency cumulative translation adjustment, net of taxes of $(274) and $193 for the three months ended September 30, 2010 and 2011, and $237 and $(52) for the nine months ended September 30, 2010 and 2011.	4,965		(3,502		)	(1,624		)	(633		)
Total other comprehensive income (loss)	5,259		(3,502		)	(760		)	(633		)
Total comprehensive income	$	17,068	$	16,480		$	32,059		$	50,731

(In thousands)	Accumulated other comprehensive loss
Balance at December 31, 2010	$	(12,416	)
Foreign currency cumulative translation adjustment, net of taxes	(633		)
Balance at September 30, 2011	$	(13,049	)

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13. Segment Information

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

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

	Three Months Ended September 30,				Nine Months Ended September 30,
(In thousands)	2010		2011		2010		2011
United States	$	149,637	$	198,250	$	423,038	$	554,754
International	50,073		66,322		142,791		187,049
Total net revenue	$	199,710	$	264,572	$	565,829	$	741,803

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

(In thousands)	December 31, 2010		September 30, 2011
United States	$	395,318	$	481,971
International	99,910		138,185
Total property and equipment, net	$	495,228	$	620,156

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

References to “we,” “our,” “our company,” “us,” “the company,” “Rackspace Hosting,” or “Rackspace” refer to Rackspace Hosting, Inc. and its consolidated subsidiaries.We have made forward-looking statements in this Quarterly Report on Form 10-Q that are subject to risks and uncertainties. Forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section21E 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 reportare based on our management’s beliefs and assumptions and on information currently available to our management. In some cases, you can identify forward-looking statements by terms such as “anticipates,” “aspires,” “believes,” “can,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will” or “would” or the negative of these terms and similar expressions intended to identify forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance, time frames or achievements to be materially different from any future results, performance, time frames or achievements expressed or implied by the forward-looking statements. We discuss many of these risks, uncertainties and other factors in this document in greater detail under the heading “Risk Factors.”We believe it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. The risks described in “Risk Factors” included in this report, as well as any other cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of the events described in “Risk Factors” and elsewhere in this report could harm our business.

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

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

Overview of our Business

We are the world’s leading specialist in the hosting and cloud computing industry. Our growth is the result of our commitment to serving our customers, known as Fanatical Support^®, and our exclusive focus on hosting and cloud computing. We have been successful in attracting and retaining thousands of customers and in growing our business. We are a pioneer in an emerging category, hybrid hosting, which combines the benefits of both traditional dedicated hosting and cloud computing. We are committed to maintaining our service-centric focus, and we will follow our vision to be considered one of the world’s greatest service companies.

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

We sell our services to small and medium-sized businesses as well as large enterprises. For the first nine months of 2011, 25.2% of our net revenue was generated by our operations outside of the U.S., mainly from the U.K. Additionally, we operate a Hong Kong data center and sales office. Our growth strategy includes, among other strategies, targeting international customers as we plan to expand our activities in continental Europe and Asia. For the first nine months of 2011, no individual customer accounted for greater than 2% of our net revenue.

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Product and Service Offerings

A focus in our growth strategy is to build our product portfolio to include higher service levels and additional capabilities. We are investing heavily in this strategy and creating new technologies to help businesses leverage the benefits of the Cloud. Hosted virtual desktop, our managed Cloud service, the U.K. Cloud, and Cloud Load Balancers are a few of the recent examples of new capabilities we have developed that are available in the market today that make us more competitive, drive revenue growth, and improve returns.

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

Key Metrics

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

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	Three Months Ended
	(Unaudited)
(Dollar amounts in thousands, except annualized net revenue per average technical square foot)	September 30, 2010			December 31, 2010			March 31, 2011			June 30, 2011			September 30, 2011
Growth
Managed hosting, net revenue	$	172,947		$	183,311		$	192,895		$	204,275		$	213,899
Cloud, net revenue	$	26,763		$	31,415		$	37,107		$	42,954		$	50,673
Net revenue	$	199,710		$	214,726		$	230,002		$	247,229		$	264,572
Revenue growth (year over year)	23.0		%	26.7		%	28.6		%	32.0		%	32.5		%
Net upgrades (monthly average)	1.6		%	1.6		%	1.8		%	1.8		%	1.8		%
Churn (monthly average)	-1.1		%	-1.0		%	-0.9		%	-0.9		%	-0.9		%
Growth in installed base (monthly average) (2)	0.5		%	0.6		%	0.9		%	0.9		%	0.9		%
Number of customers at period end (3)	118,732			130,291			142,441			152,578			161,422
Number of employees (Rackers) at period end	3,130			3,262			3,492			3,712			3,799
Number of servers deployed at period end	63,996			66,015			70,473			74,028			78,717
Profitability
Income from operations	$	21,635		$	23,408		$	23,983		$	28,653		$	31,070
Depreciation and amortization	$	39,677		$	41,529		$	44,098		$	46,952		$	49,518
Share-based compensation expense
Cost of revenue	$	1,305		$	1,223		$	1,412		$	756		$	1,005
Sales and marketing (4)	$	1,209		$	1,052		$	1		$	609		$	864
General and administrative	$	4,669		$	4,812		$	6,397		$	4,618		$	5,526
Total share-based compensation expense	$	7,183		$	7,087		$	7,810		$	5,983		$	7,395
Adjusted EBITDA (1)	$	68,495		$	72,024		$	75,891		$	81,588		$	87,983
Adjusted EBITDA margin	34.3		%	33.5		%	33.0		%	33.0		%	33.3		%
Operating income margin	10.8		%	10.9		%	10.4		%	11.6		%	11.7		%
Income from operations	$	21,635		$	23,408		$	23,983		$	28,653		$	31,070
Effective tax rate	35.5		%	37.2		%	38.3		%	33.8		%	31.7		%
Net operating profit after tax (NOPAT) (1)	$	13,955		$	14,700		$	14,798		$	18,968		$	21,221
NOPAT margin	7.0		%	6.8		%	6.4		%	7.7		%	8.0		%
Capital efficiency and returns
Interest bearing debt	$	180,177		$	131,727		$	134,905		$	138,841		$	144,152
Stockholders' equity	$	413,237		$	438,863		$	478,307		$	511,843		$	551,049
Less: Excess cash	$	(142,592	)	$	(79,174	)	$	(106,268	)	$	(102,358	)	$	(92,931	)
Capital base	$	450,822		$	491,416		$	506,944		$	548,326		$	602,270
Average capital base	$	446,323		$	471,119		$	499,180		$	527,635		$	575,298
Capital turnover (annualized)	1.79			1.82			1.84			1.87			1.84
Return on capital (annualized) (1)	12.5		%	12.5		%	11.9		%	14.4		%	14.8		%
Capital expenditures
Purchases of property and equipment, net	$	29,222		$	46,884		$	57,651		$	74,754		$	70,379
Vendor-financed equipment purchases	$	23,208		$	16,596		$	19,009		$	20,567		$	23,179
Total capital expenditures	$	52,430		$	63,480		$	76,660		$	95,321		$	93,558
Customer gear	$	36,219		$	38,052		$	46,300		$	48,777		$	53,643
Data center build outs	$	6,162		$	9,754		$	9,173		$	17,491		$	16,715
Office build outs	$	1,271		$	5,145		$	2,957		$	14,074		$	8,806
Capitalized software and other projects	$	8,778		$	10,529		$	18,230		$	14,979		$	14,394
Total capital expenditures	$	52,430		$	63,480		$	76,660		$	95,321		$	93,558
Infrastructure capacity and utilization
Technical square feet of data center space at period end (5)	177,148			180,173			181,848			198,868			227,988
Annualized net revenue per average technical square foot	$	4,602		$	4,807		$	5,083		$	5,195		$	4,959
Utilization rate at period end	68.9		%	72.0		%	76.7		%	72.9		%	69.0		%

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

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

(3) Customers continue to be counted on an account basis, and therefore a customer with more than one account with us would be included as more than one customer. Furthermore, amounts include SaaS customers for Jungle Disk using a Rackspace storage solution. Jungle Disk customers using a third-party storage solution are excluded.

(4) During the three months ended March 31, 2011, share-based compensation expense within Sales and Marketing was positively impacted by the reversal of previously recorded expense related to terminated employees. The offset of the reversal was a true-up of the forfeiture rate across Cost of Revenue and General and Administrative expenses for options that fully vested within the quarter, negatively impacting these categories.

(5) Technical square footage as of September 30, 2011 excludes 36,260 square feet for unused portions of our data center facilities.

In the table above, we continue to define technical square feet of data center space as space that can be utilized to support IT equipment.  With respect to square footage and utilization, for data centers that are not yet fully utilized we include square footage and power capacity based on the agreed upon schedule in the lease agreement.  For example, if the agreement has 10 phases and we are in phase five, we include 50% of the total square footage and power capacity called for in the lease agreement. As a result of our strategy to continue leasing data centers, beginning in the first quarter of 2012, we will modify the way we measure and report utilization to better reflect available capacity with a leasing model.

Non-GAAP Financial Measures

Return on Capital (ROC) (Non-GAAP financial measure)

We define Return on Capital as follows: ROC = Net operating profit after tax (NOPAT) / Average capital base

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

Average capital base = Average of (Interest bearing debt + stockholders’ equity – excess cash) = Average of (Total assets – excess cash – accounts payables and accrued expenses – deferred revenue – other non-current liabilities, deferred income taxes, and deferred rent)

Year-to-date average balances are based on an average calculated using the quarter end balances at the beginning of the period and all other quarter ending balances included in the period.

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

We believe that ROC is an important metric for investors in evaluating our company’s performance. ROC relates to after-tax operating profits with the capital that is placed into service. It is therefore a performance metric that incorporates both the Statement of Income and the Balance Sheet.  ROC measures how successfully capital is deployed within a company.

Note that ROC is not a measure of financial performance under GAAP and should not be considered a substitute for return on assets, which we consider to be the most directly comparable GAAP measure. ROC has limitations as an analytical tool, and when assessing our operating performance, you should not consider ROC in isolation, or as a substitute for other financial data prepared in accordance with GAAP. Other companies may calculate ROC differently than we do, limiting its usefulness as a comparative measure.

ROC increased from 12.5% for the three months ended September 30, 2010 to 14.8% for the three months ended September 30, 2011, primarily due to a reduction of operating costs as a percentage of revenue and a lower tax rate, partially offset by growth in our capital base.  Included in the average capital base are capital expenditures of $32.3 million and $59.3 million related to the build-out of our corporate and international headquarters and data centers, respectively, since the beginning of the third quarter of 2010.

Return on assets increased from 6.4% for the three months ended September 30, 2010 to 8.6% for the three months ended September 30, 2011. This increase was primarily due to operating expenses decreasing as a percentage of revenue, as well as a lower tax rate, partially offset by growth in our asset base due to the purchase of property and equipment to support the growth of our business.

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

	Three Months Ended
(In thousands)	September 30, 2010			December 31, 2010			March 31, 2011			June 30, 2011			September 30, 2011
Income from operations	$	21,635		$	23,408		$	23,983		$	28,653		$	31,070
Effective tax rate	35.5		%	37.2		%	38.3		%	33.8		%	31.7		%
Net operating profit after tax (NOPAT)	$	13,955		$	14,700		$	14,798		$	18,968		$	21,221
Net income	$	11,809		$	13,539		$	13,821		$	17,561		$	19,982
Total assets at period end	$	760,198		$	761,577		$	831,414		$	887,576		$	970,677
Less: Excess cash	(142,592		)	(79,174		)	(106,268		)	(102,358		)	(92,931		)
Less: Accounts payable and accrued expenses	(101,427		)	(111,645		)	(132,308		)	(145,609		)	(148,464		)
Less: Deferred revenue (current and non-current)	(16,685		)	(18,749		)	(19,149		)	(18,687		)	(17,772		)
Less: Other non-current liabilities, deferred income taxes, and deferred rent	(48,672		)	(60,593		)	(66,745		)	(72,596		)	(109,240		)
Capital base	$	450,822		$	491,416		$	506,944		$	548,326		$	602,270
Average total assets	$	740,328		$	760,888		$	796,496		$	859,495		$	929,127
Average capital base	$	446,323		$	471,119		$	499,180		$	527,635		$	575,298
Return on assets (annualized)	6.4		%	7.1		%	6.9		%	8.2		%	8.6		%
Return on capital (annualized)	12.5		%	12.5		%	11.9		%	14.4		%	14.8		%

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Adjusted EBITDA (Non-GAAP financial measure)

We use Adjusted EBITDA as a supplemental measure to review and assess our performance.  We define Adjusted EBITDA as Net income, plus income taxes, total other (income) expense, depreciation and amortization, and non-cash charges for share-based compensation.

Adjusted EBITDA is a metric that is used in our industry by the investment community for comparative and valuation purposes. We disclose this metric in order to support and facilitate the dialogue with research analysts and investors.

Note that Adjusted EBITDA is not a measure of financial performance under GAAP and should not be considered a substitute for operating income, which we consider to be the most directly comparable GAAP measure. Adjusted EBITDA has limitations as an analytical tool, and when assessing our operating performance, you should not consider Adjusted EBITDA in isolation, or as a substitute for net income or other consolidated income statement data prepared in accordance with GAAP.  Other companies may calculate Adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure.

Adjusted EBITDA increased$19.5 million, or 28.5%, from $68.5 million in the three months ended September 30, 2010 to $88.0 million in the three months ended September 30, 2011.  Adjusted EBITDA as a percentage of revenue decreased from 34.3% for the three months ended September 30, 2010 to 33.3% for the three months ended September 30, 2011.  The primary driver of the decrease in Adjusted EBITDA percentage was an increase in General and Administrative expenses as a percentage of revenue, partially offset by decreases in Cost of Revenue and Sales and Marketing expenses as a percentage of revenue.  Also impacting our results were changes in non-cash deferred rent and non-equity incentive compensation. Non-cash rent increased from $1.0 million in the three months ended September 30, 2010 to $2.5 million in the three months ended September 30, 2011.  Overall, non-equity incentive compensation increased$8.8 million due to an increase in the payout percentage and increased headcount.

Employee non-equity incentive compensation through our current non-equity incentive plan, in effect since January 1, 2009, is dependent upon the financial results of the company in relation to a pre-set target level that is set at the beginning of each quarter. Thus, favorable financial performance in comparison to the pre-set target level is partially offset by increased non-equity incentive compensation expense.  If company achievement of the pre-set target results in a 10% increase in the non-equity incentive compensation percentage payout, this would increase total non-equity incentive compensation by approximately $0.6 million on an after-tax basis and increase net income by $0.6 million.  Company achievement resulting in a 10% decrease in the non-equity incentive compensation percentage payout would decrease total non-equity incentive compensation by approximately $0.6 million on an after-tax basis and decrease net income by $0.6 million. Additionally, the Compensation Committee has the discretion to increase or decrease a payout under the plan at any time in the event that it determines that circumstances warrant adjustment or to pay bonuses outside of the plan.

Income from operations has been favorably impacted by decreases in our Cost of Revenue and Depreciation and Amortization expenses as a percentage of revenue. Our operating income margin increased from 10.8% for the three months ended September 30, 2010 to 11.7% for the three months ended September 30, 2011.

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See our Adjusted EBITDA reconciliation below. 

	Three Months Ended
(Dollars in thousands)	September 30, 2010			December 31, 2010			March 31, 2011			June 30, 2011			September 30, 2011
Net revenue	$	199,710		$	214,726		$	230,002		$	247,229		$	264,572
Income from operations	$	21,635		$	23,408		$	23,983		$	28,653		$	31,070
Net income	$	11,809		$	13,539		$	13,821		$	17,561		$	19,982
Plus: Income taxes	6,495			8,029			8,593			8,956			9,281
Plus: Total other (income) expense	3,331			1,840			1,569			2,136			1,807
Plus: Depreciation and amortization	39,677			41,529			44,098			46,952			49,518
Plus: Share-based compensation expense	7,183			7,087			7,810			5,983			7,395
Adjusted EBITDA	$	68,495		$	72,024		$	75,891		$	81,588		$	87,983
Operating income margin	10.8		%	10.9		%	10.4		%	11.6		%	11.7		%
Adjusted EBITDA margin	34.3		%	33.5		%	33.0		%	33.0		%	33.3		%

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Adjusted Free Cash Flow (Non-GAAP financial measure)

We define Adjusted Free Cash Flow as Adjusted EBITDA plus non-cash deferred rent, less total capital expenditures (including vendor-financed equipment purchases), cash payments for interest, net, and cash payments for income taxes, net.

We believe that Adjusted Free Cash Flow is an important metric for investors in evaluating how a company is currently using cash generated and may indicate its ability to generate cash that can potentially be used by the business for capital investments, acquisitions, reduction of debt, payment of dividends, etc. Note that Adjusted Free Cash Flow is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.

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

	Three Months Ended			Nine Months Ended
(In thousands)	September 30, 2011			September 30, 2011
Adjusted EBITDA	$	87,983		$	245,462
Non-cash deferred rent	2,457			8,271
Total capital expenditures	(93,558		)	(265,539		)
Cash payments for interest, net	(1,541		)	(4,237		)
Cash payments for income taxes, net	(781		)	(10,525		)
Adjusted free cash flow	$	(5,440	)	$	(26,568	)

Net Leverage (Non-GAAP financial measure)

We define Net Leverage as Net Debt divided by Adjusted EBITDA (trailing twelve months). We believe that Net Leverage is an important metric for investors in evaluating a company’s liquidity. Note that Net Leverage is not a measure of financial performance under GAAP and may not be comparable to similarly titled measures reported by other companies.

See our Net Leverage calculation below. 

(Dollars in thousands)	As of
	September 30, 2011
Obligations under capital leases	$	142,836
Debt	1,316
Total debt	$	144,152
Less: Cash and cash equivalents	(124,680		)
Net debt	$	19,472
Adjusted EBITDA (trailing twelve months)	$	317,486
Net leverage	0.06			x

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Results of Operations

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

Consolidated Statements of Income (Unaudited):

	Three Months Ended
(In thousands)	September 30, 2010			December 31, 2010			March 31, 2011			June 30, 2011			September 30, 2011
Net revenue	$	199,710		$	214,726		$	230,002		$	247,229		$	264,572
Costs and expenses:
Cost of revenue	64,616			66,747			69,742			74,057			82,445
Sales and marketing	24,651			26,294			29,738			31,477			31,838
General and administrative	49,131			56,748			62,441			66,090			69,701
Depreciation and amortization	39,677			41,529			44,098			46,952			49,518
Total costs and expenses	178,075			191,318			206,019			218,576			233,502
Income from operations	21,635			23,408			23,983			28,653			31,070
Other income (expense):
Interest expense	(2,068		)	(1,897		)	(1,491		)	(1,522		)	(1,531		)
Interest and other income (expense)	(1,263		)	57			(78		)	(614		)	(276		)
Total other income (expense)	(3,331		)	(1,840		)	(1,569		)	(2,136		)	(1,807		)
Income before income taxes	18,304			21,568			22,414			26,517			29,263
Income taxes	6,495			8,029			8,593			8,956			9,281
Net income	$	11,809		$	13,539		$	13,821		$	17,561		$	19,982

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

	Three Months Ended
(Percent of net revenue)	September 30, 2010		December 31, 2010		March 31, 2011		June 30, 2011		September 30, 2011
Net revenue	100.0	%	100.0	%	100.0	%	100.0	%	100.0	%
Costs and expenses:
Cost of revenue	32.4	%	31.1	%	30.3	%	30.0	%	31.2	%
Sales and marketing	12.3	%	12.2	%	12.9	%	12.7	%	12.0	%
General and administrative	24.6	%	26.4	%	27.1	%	26.7	%	26.3	%
Depreciation and amortization	19.9	%	19.3	%	19.2	%	19.0	%	18.7	%
Total costs and expenses	89.2	%	89.1	%	89.6	%	88.4	%	88.3	%
Income from operations	10.8	%	10.9	%	10.4	%	11.6	%	11.7	%
Other income (expense):
Interest expense	-1.0	%	-0.9	%	-0.6	%	-0.6	%	-0.6	%
Interest and other income (expense)	-0.6	%	0.0	%	0.0	%	-0.2	%	-0.1	%
Total other income (expense)	-1.7	%	-0.9	%	-0.7	%	-0.9	%	-0.7	%
Income before income taxes	9.2	%	10.0	%	9.7	%	10.7	%	11.1	%
Income taxes	3.3	%	3.7	%	3.7	%	3.6	%	3.5	%
Net income	5.9	%	6.3	%	6.0	%	7.1	%	7.6	%

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

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Third Quarter 2011 Overview

The highlights and significant events of the three months ended September 30, 2011 and the impact on our operating results compared to the three months ended June 30, 2011 were as follows:

Net Revenue

Net revenue increased$17.4 million, or 7.0%, from $247.2 million in the three months ended June 30, 2011 to $264.6 million in the three months ended September 30, 2011.  The market for hosting services continues to be highly competitive, and we face competition from existing competitors as well as new market entrants.  However, we continue to grow our dedicated hosting and cloud computing service offerings and believe that this full portfolio of hosting services positions us to benefit from increased IT spending in the future. During the third quarter, we experienced an unfavorable revenue impact due to a strengthening U.S. dollar relative to the pound sterling, which resulted in a decrease to revenue of approximately $0.8 million, or 0.3%, for the three months ended September 30, 2011 compared to the three months ended June 30, 2011, with minimal impact to our margins as the majority of customers are invoiced, and substantially all of our expenses associated with these customers are paid, by us or our subsidiaries in the functional currency of our company or our subsidiaries.

Cost of Revenue

Our cost of revenue was $74.1 million for the three months ended June 30, 2011 and $82.4 million for the three months ended September 30, 2011, an increase of $8.3 million, or 11.2%.  Of this increase, $3.6 million was attributable to an increase in employee-related expenses. Total compensation increased as a result of salary increases and the hiring of additional personnel as well as an increase in non-equity incentive compensation. The cost increase was further attributable to increases in license costs of $1.2 million, data center costs of $1.3 million related to power and rent, and consulting fees of $0.9 million related to data center assessments and improvements. The remaining variance was due to small changes in other cost of revenue expenses.

Sales and Marketing Expenses

Our sales and marketing expenses were $31.5 million for the three months ended June 30, 2011 and $31.8 million for the three months ended September 30, 2011, an increase of $0.3 million, or 1.0%. Of this increase, $1.1 million was attributable to an increase in employee-related expenses. Total compensation increased as a result of salary increases, a slight increase in commissions and increased share-based compensation expense as well as the hiring of additional sales and marketing personnel. The increase in employee-related expenses was partially offset by small decreases in marketing programs and other sales and marketing expenses.

General and Administrative Expenses

Our general and administrative expenses were $66.1 million for the three months ended June 30, 2011 and $69.7 million for the three months ended September 30, 2011, an increase of $3.6 million, or 5.4%. Of this increase, $4.3 million was attributable to employee-related expenses.  Total compensation increased as a result of salary increases, the hiring of additional personnel and increases in non-equity incentive compensation and shared-based compensation expense, partially offset by a decrease in payroll taxes from decreased stock option exercise activity. Also contributing to the change were increases in internal software and maintenance costs of $0.4 million, partially offset by decreases in professional fees of $0.4 million, travel of $0.7 million, and bad debt expense of $0.3 million. The remaining variance was due to small changes in other general and administrative expenses.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $47.0 million for the three months ended June 30, 2011 and $49.5 million for the three months ended September 30, 2011, an increase of $2.5 million, or 5.3%. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build outs and internally developed and purchased software.

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Net Income and Net Income per Share

Net income was $17.6 million, or $0.13 per share on a diluted basis, for the three months ended June 30, 2011 compared to net income of $20.0 million, or $0.14 per share on a diluted basis, for the three months ended September 30, 2011. The increase in net income was mainly due to revenue growth.  Additionally, each of our expense categories decreased as a percentage of revenue except for cost of revenue.  Additionally, net income was positively impacted by a decrease in our effective tax rate from 33.8% in the three months ended June 30, 2011 to 31.7% in the three months ended September 30, 2011 due to a change in the geographical distribution of our income and a change in the U.K. statutory tax rate from 27% to 26%. 

Three Months EndedSeptember 30, 2010 and September 30, 2011

Net Revenue

Our net revenue was $199.7 million for the three months ended September 30, 2010 and $264.6 million for the three months ended September 30, 2011, an increase of $64.9 million, or 32.5%.  The increase in net revenue was primarily due to an increased volume of services provided, resulting from an increasing number of new customers and incremental services rendered to existing customers.  Also contributing to the revenue increase was the favorable impact of a weaker U.S. dollar relative to the pound sterling for the three months ended September 30, 2011 compared to the three months ended September 30, 2010.  Net revenue for the three months ended September 30, 2011 would have been approximately $2.4 millionlower had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.

Cost of Revenue

Our cost of revenue was $64.6 million for the three months ended September 30, 2010 and $82.4 million for the three months ended September 30, 2011, an increase of $17.8 million, or 27.6%. Of this increase, $10.0 million was attributable to employee-related expenses due to an increase in salaries and benefits of $6.9 million, and an increase in non-equity incentive compensation of $3.4 million, partially offset by a decrease in share-based compensation expense of $0.3 million. These increases are primarily due to additional headcount, salary increases and a higher percentage attainment against the preset target for non-equity incentive compensation.  The cost increase was further attributable to an increase in license costs of $3.5 million, an increase in data center costs of $4.6 million related to power and rent, an increase in maintenance of $0.9 million, partially offset by a decrease in consulting fees primarily related to data center assessments and improvements of $2.2 million.  The remaining variance was due to small changes in other cost of revenue expenses.

Sales and Marketing Expenses

Our sales and marketing expenses were $24.7 million for the three months ended September 30, 2010 and $31.8 million for the three months ended September 30, 2011, an increase of $7.1 million, or 28.7%. Of this increase, $4.5 million was attributable to employee-related expenses due to an increase in salaries and benefits of $4.2 million, increases in non-equity incentive compensation of $0.3 million and commissions of $0.3 million, partially offset by a decrease in share-based compensation expense of $0.3 million. Total compensation increased as a result of salary increases and the hiring of additional sales and marketing personnel as well as the impact of higher commissions associated with increased sales.  Advertising and Internet-related marketing expenditures increased $2.5 million, and consulting fees increased $0.2 million. The remaining variance was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

Our general and administrative expenses were $49.1 million for the three months ended September 30, 2010 and $69.7 million for the three months ended September 30, 2011, an increase of $20.6 million, or 42.0%. Of this increase, $15.3 million was attributable to employee-related expenses due to increases in salaries and benefits of $9.3 million, non-equity incentive compensation of $5.1 million and share-based compensation expense of $0.9 million.  These increases are primarily due to additional headcount, salary increases and a higher non-equity incentive compensation payout percentage. Professional fees and legal expenses increased $1.5 million primarily as a result of increased consulting expenses related to tax, legal and general consulting services, and internal software and maintenance costs increased $1.6 million. In addition, travel and other employee related expenses such as recruiting fees and relocation increased $0.7 million primarily due to a general increase in hiring during the three months ended September 30, 2011, partially offset by a $0.5 million decrease in bad debt expense. We also experienced an increase in merchant credit card fees of $0.7 million due to higher volume of sales in the third quarter of 2011.  The remaining variance was due to small changes in other general and administrative expenses.

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Depreciation and Amortization Expense

Our depreciation and amortization expense was $39.7 million for the three months ended September 30, 2010 and $49.5 million for the three months ended September 30, 2011, an increase of $9.8 million, or 24.7%. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build outs and internally developed and purchased software.

Other Income (Expense)

Our interest expense was $2.1 million for the three months ended September 30, 2010 and $1.5 million for the three months ended September 30, 2011, a decrease of $0.6 million, or 28.6%.  This decrease was primarily due to the decreased level of indebtedness. Interest expense was partially offset by capitalized interest of $0.2 million for the three months ended September 30, 2010. There has been no interest capitalized in 2011.

Interest and other income (expense) was $(1.3) million for the three months ended September 30, 2010 and $(0.3) million for the three months ended September 30, 2011.  The three months ended September 30, 2010, included foreign currency losses of $1.4 million compared to foreign currency losses of $0.1 million in the three months ended September 30, 2011.

Income Taxes

Our effective tax rate decreased from 35.5% for the three months ended September 30, 2010 to 31.7% for the three months ended September 30, 2011, primarily due to a change in the geographical distribution of our income and a change in the U.K. statutory tax rate from 27% to 26%.  Overall, the differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, certain tax credits, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items. Our foreign earnings are generally taxed at lower rates than in the United States.

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Nine Months EndedSeptember 30, 2010 and September 30, 2011

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 (Unaudited):

	Nine Months Ended
(In thousands)	September 30, 2010			September 30, 2011
Net revenue	$	565,829		$	741,803
Costs and expenses:
Cost of revenue	183,093			226,244
Sales and marketing	69,913			93,053
General and administrative	142,263			198,232
Depreciation and amortization	114,366			140,568
Total costs and expenses	509,635			658,097
Income from operations	56,194			83,706
Other income (expense):
Interest expense	(6,087		)	(4,544		)
Interest and other income (expense)	(264		)	(968		)
Total other income (expense)	(6,351		)	(5,512		)
Income before income taxes	49,843			78,194
Income taxes	17,024			26,830
Net income	$	32,819		$	51,364

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

	Nine Months Ended
(Percent of net revenue)	September 30, 2010		September 30, 2011
Net revenue	100.0	%	100.0	%
Costs and expenses:
Cost of revenue	32.4	%	30.5	%
Sales and marketing	12.4	%	12.5	%
General and administrative	25.1	%	26.7	%
Depreciation and amortization	20.2	%	18.9	%
Total costs and expenses	90.1	%	88.7	%
Income from operations	9.9	%	11.3	%
Other income (expense):
Interest expense	-1.1	%	-0.6	%
Interest and other income (expense)	0.0	%	-0.1	%
Total other income (expense)	-1.1	%	-0.7	%
Income before income taxes	8.8	%	10.5	%
Income taxes	3.0	%	3.6	%
Net income	5.8	%	6.9	%

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

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Net Revenue

Our net revenue was $565.8 million for the nine months ended September 30, 2010 and $741.8 million for the nine months ended September 30, 2011, an increase of $176.0 million, or 31.1%. The increase in net revenue was primarily due to an increased volume of services provided, resulting from an increasing number of new customers and incremental services rendered to existing customers. Partially contributing to the revenue increase was the positive impact of a weaker U.S. dollar relative to the pound sterling for the nine months ended September 30, 2011 compared to the nine months ended September 30, 2010. Net revenue for the nine months ended September 30, 2011 would have been approximately $8.9 millionlower had the U.S. dollar to the pound sterling exchange rate remained constant from the prior year.

Cost of Revenue

Our cost of revenue was $183.1 million for the nine months ended September 30, 2010, and $226.2 million for the nine months ended September 30, 2011, an increase of $43.1 million, or 23.5%. Of this increase, $23.1 million was attributable to employee-related expenses due to increases in salaries and benefits of $20.7 million and non-equity incentive compensation of $2.7 million, partially offset by a decrease in share-based compensation expense of $0.3 million. These increases are primarily due to additional headcount to support our growth, salary increases, and higher percentage attainment against the preset target for non-equity incentive compensation. The cost increase was further attributable to an increase in data center costs of $11.3 million related to power and rent, an increase in license costs of $8.5 million, and an increase in maintenance of $0.6 million, partially offset by a decrease in consulting fees related to data center assessments and improvements of $2.9 million. The remaining variance was due to small changes in other cost of revenue expenses.

Sales and Marketing Expenses

Our sales and marketing expenses were $69.9 million for the nine months ended September 30, 2010 and $93.1 million for the nine months ended September 30, 2011, an increase of $23.2 million, or 33.2%. Of this increase, $12.7 million was attributable to employee-related expenses due to increases in salaries and benefits of $11.8 million, and commissions of $2.6 million, partially offset by a decrease in share-based compensation expense of $1.7 million due to a change in our stock option forfeiture estimate. Total compensation increased as a result of salary increases and the hiring of additional sales and marketing personnel and the impact of commissions associated with increased sales. Internet-related marketing spend increased $9.2 million in order to drive future growth, while consulting fees increased $0.9 million. The remaining increase was due to small changes in other sales and marketing expenses.

General and Administrative Expenses

Our general and administrative expenses were $142.3 million for the nine months ended September 30, 2010 and $198.2 million for the nine months ended September 30, 2011, an increase of $55.9 million, or 39.3%. Of this increase, $36.8 million was attributable to employee-related expenses due to increases in salaries and benefits of $27.9 million, non-equity incentive compensation of $5.3 million, and share-based compensation expense of $3.6 million. These increases are primarily due to additional headcount, salary increases, higher percentage attainment against the preset target for non-equity incentive compensation, and equity awards granted in 2010 and the first nine months of 2011. Professional fees and legal expenses increased $8.9 million primarily as a result of increased consulting expenses related to accounting and tax services, corporate strategy and internal system maintenance and improvements. Travel and other employee related expenses such as recruiting fees and relocation increased $4.2 million primarily due to a general increase in hiring during the nine months ended September 30, 2011. Additionally, property tax increased $0.7 million due to the addition of data center facilities, office expenses including rent and maintenance increased $1.2 million, and merchant credit card fees and bad debt increased $2.0 million and $0.5 million, respectively, due to a higher volume of sales.

Depreciation and Amortization Expense

Our depreciation and amortization expense was $114.4 million for the nine months ended September 30, 2010 and $140.6 million for the nine months ended September 30, 2011, an increase of $26.2 million, or 22.9%. The increase in depreciation and amortization expense was a direct result of an increase in property and equipment related to depreciable assets to support the growth of our business, which included increases in data center equipment and leasehold improvements due to data center build outs and internally developed and purchased software.

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Other Income (Expense)

Our interest expense was $6.1 million for the nine months ended September 30, 2010 and $4.5 million for the nine months ended September 30, 2011, a decrease of $1.6 million, or 26.2%. The decrease was primarily due to the decreased level of indebtedness, as well as decreased borrowing rates. Interest expense was partially offset by capitalized interest of $0.5 million for the nine months ended September 30, 2010. There has been no interest capitalized in 2011.

Interest and other income (expense) was $(0.3) million for the nine months ended September 30, 2010 and $(1.0) million for the nine months ended September 30, 2011. The nine months ended September 30, 2010 included foreign currency losses of $0.5 million compared to foreign currency losses of $0.2 million in the nine months ended September 30, 2011.

Income Taxes

Our effective tax rate increased slightly from 34.2% for the nine months ended September 30, 2010 to 34.3% for the nine months ended September 30, 2011. Our foreign earnings are generally taxed at lower rates than in the United States. The differences between our effective tax rate and the U.S. federal statutory rate of 35% principally result from our geographical distribution of taxable income, contingency reserves for uncertain tax positions and permanent differences between the book and tax treatment of certain items.

Liquidity and Capital Resources

At September 30, 2011, our cash and cash equivalents balance was $124.7 million. We use our cash and cash equivalents, cash flow from operations, capital leases, and existing amounts available under our revolving credit facility as our primary sources of liquidity.  We currently believe that cash generated by operations, current cash and cash equivalents, and available borrowings through vendor financing arrangements and our credit facility will be sufficient to meet our operating and capital needs in the foreseeable future.

On September 26, 2011, we entered into a revolving credit facility with a syndicate of seven banks led by JPMorgan Chase. This facility replaces our previous credit facility, which was due to expire in August 2012. The new credit facility has a total commitment in the amount of $200.0 million and matures in September of 2016.  The facility is unsecured and governed by customary financial and non-financial covenants, including a leverage ratio of not greater than 3.00 to 1.00, an interest coverage ratio of not less than 3.00 to 1.00 and a requirement to maintain a certain level of tangible assets in our U.S. entities. As of September 30, 2011, we were in compliance with all of the covenants under our facility.

We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), and our overall cost of capital. As of September 30, 2011 there was no amount outstanding under the new facility except for an outstanding letter of credit of $0.4 million, resulting in an additional $199.6 million being available for future borrowings.

We have vendor finance arrangements in the form of leases and notes payable with our major vendors that permit us to finance our purchases of data center equipment.  As of December 31, 2010 and September 30, 2011, we had $131.7 million and $144.2 million outstanding with respect to these arrangements.  We believe our borrowings from these arrangements will continue to be available, and as long as they are competitive, we expect to continue to finance at least some of our equipment purchases through these arrangements.

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Capital Expenditure Requirements

For the full year 2011, we expect to incur a total of $350 million to $360 million in capital expenditures. This is above the previously stated top-end of the range and is due to customer gear purchases in response to the demand we are facing in connection with supply chain considerations, additional spend on software development and further build-out costs in connection with our corporate headquarters facility in San Antonio, Texas.

Our available cash and cash equivalents are held in bank deposits, overnight sweep accounts, and money market funds. Our money market mutual funds invest exclusively in high-quality, short-term securities that are issued or guaranteed by the U.S. government or by U.S. government agencies. We actively monitor the third-party depository institutions that hold our cash and cash equivalents. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances may exceed the Federal Deposit Insurance Corporation or “FDIC” insurance limits or may not be insured by the FDIC. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted if the underlying depository institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to our invested cash and cash equivalents; however, we can provide no assurances that access to our funds will not be impacted by adverse conditions in the financial markets.

We currently believe that current cash and cash equivalents, cash generated by operations and available borrowings through vendor financing arrangements, data center lease arrangements, and our credit facility will be sufficient to meet our operating and capital needs in the foreseeable future. Our long-term future capital requirements will depend on many factors, most importantly our growth of revenue and our investments in new technologies and services. Our ability to generate cash depends on our financial performance, general economic conditions, technology trends and developments, and other factors. As our business continues to grow, our need for data center capacity will also grow.  Most recently we have financed data center growth through leasing activities, and we will continue to evaluate all opportunities to secure further data center capacity in the future.  We could be required, or could elect, to seek additional funding in the form of debt or equity.

The following table sets forth a summary of our cash flows for the periods indicated: 

	Nine Months Ended September 30,
	(Unaudited)
(In thousands)	2010			2011
Cash provided by operating activities	$	169,965		$	238,062
Cash used in investing activities	$	(98,459	)	$	(203,631	)
Cash used in financing activities	$	(30,603	)	$	(14,646	)
Acquisition of property and equipment by capital leases and equipment notes payable	$	54,767		$	62,755

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Operating Activities

Net cash provided by operating activities is primarily a function of our profitability, the amount of non-cash charges included in our profitability, and our working capital management.  Net cash provided by operating activities was $170.0 million in the first nine months of 2010 compared to $238.1 million in the first nine months of 2011, an increase of $68.1 million, or 40.1%.  Net income increased from $32.8 million in the first nine months of 2010 to $51.4 million in the first nine months of 2011.  A summary of the significant changes in non-cash adjustments affecting net income is as follows:

• Depreciation and amortization expense was $114.4 million in the first nine months of 2010 compared to $140.6 million in the first nine months of 2011.  The increase in depreciation and amortization was due to purchases of servers, networking gear, computer software (internally developed technology), electrical equipment, and leasehold improvements primarily for data center expansion, as well as the amortization of intangibles related to acquisitions.

• Our provision for bad debts and customer credits increased from $3.0 million in the first nine months of 2010 to $4.5 million in the first nine months of 2011 due to the increases in net revenue and accounts receivable.

• The change in deferred income taxes created a $3.0 millionincrease to cash flow from operating activities in the first nine months of 2010 compared to a $9.2 millionincrease in the first nine months of 2011. The change in deferred income taxes is due to the utilization of existing net operating losses as part of the intellectual property transfer to an offshore subsidiary.

• The change in deferred rent created a $4.2 million non-cash increase to cash flow from operating activities in the first nine months of 2010 compared to $8.3 millionincrease in the first nine months of 2011.  The change resulted from data center lease arrangements that were entered into in 2009, 2010 and 2011 with terms that included escalating rental payments.  As total rent expense for each of these lease arrangements is recorded on a straight-line basis for the term of the lease, there is a difference between rent expense and cash paid for rent during the period.

• Share-based compensation expense was $19.5 million in the first nine months of 2010 compared to $21.2 million in the first nine months of 2011.  The increase in expense was due to stock options and restricted stock units granted in 2010 and the first nine months of 2011.

A summary of changes in assets and liabilities impacting operating cash flows is as follows:

• The change in accounts receivable was a cash outflow of $9.1 million in the first nine months of 2010 compared to a cash outflow of $17.4 million in the first nine months of 2011. Accounts receivable increased due to the increase in sales.

• The change in income taxes receivable was a cash inflow of $4.4 million in the first nine months of 2010 compared to a cash inflow of $4.4 million in the first nine months of 2011.  In the nine months ended September 30, 2011, we received $4.4 million of federal tax refunds related to a carryback claim for prior periods.

• The change in prepaid expenses and other current assets was a cash outflow of $14.6 million in the first nine months of 2010 compared to a cash outflow of $10.1 million in the first nine months of 2011. The cash outflow in the first nine months of 2011 was primarily due to an $18.0 million prepayment for a specified quantity of software licenses.

• The change in accounts payable and accrued expenses created a $13.0 million cash inflow in the first nine months of 2010 compared to a $38.2 million cash inflow in the first nine months of 2011.  The changes resulted from the timing of payments for trade payables and payroll-related expenses.

Investing Activities

Net cash used in investing activities was primarily capital expenditures to meet the demands of our growing customer base. Historically our main investing activities have consisted of purchases of IT equipment for our data center infrastructure, furniture, equipment and leasehold improvements to support our operations.

Our net cash used in investing activities was $98.5 million in the first nine months of 2010 compared to $203.6 million in the first nine months of 2011, an increase of $105.1 million, or 106.7%.  The increase was primarily due to an increase in purchases of customer gear and capitalized software projects.

We purchase equipment through capital lease arrangements and other types of vendor financing that do not require an initial outlay of cash.  Purchases through these arrangements increased from $54.8 million for the first nine months of 2010 to $62.8 million for the first nine months of 2011.

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Financing Activities

Net cash used in financing activities was $30.6 million in the first nine months of 2010 compared to $14.6 million in the first nine months of 2011, a decrease of $16.0 million. Principal payments on capital leases and notes payable were $42.0 million in the first nine months of 2010 compared to $50.3 million during the first nine months of 2011.  Cash proceeds from employee stock plans increased from $11.4 million in the first nine months of 2010 to $27.8 million in the first nine months of 2011 due to increased stock option exercise activity. Additionally, in the first nine months of 2011, there were cash outflows of $1.1 million for payments of debt issuance costs related to our new revolving credit agreement and $2.9 million for payments of earn-out provisions related to our December 2010 acquisition. Our net leverage as of September 30, 2011 was 0.06 times.  See above for our discussion of Non-GAAP Financial Measures.

Contractual Obligations, Commitments and Contingencies

The following table summarizes our contractual obligations as of September 30, 2011: 

(In thousands)	Total		2011		2012-2013		2014-2015		2016 and Beyond
	(Unaudited)
Capital leases (1)	$	150,235	$	16,957	$	112,475	$	20,803	$	—
Operating leases	570,633		7,372		74,511		84,116		404,634
Purchase commitments	51,753		18,369		33,174		210		—
Software and equipment notes (1)	1,327		442		885		—		—
Total contractual obligations	$	773,948	$	43,140	$	221,045	$	105,129	$	404,634

(1) Represents principal and interest.

Leases

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

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

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

Purchase commitments

Our purchase commitments are primarily related to costs associated with our data centers including bandwidth, electricity, and consulting services, as well as commitments to purchase hardware and to prepay for certain software licenses.  

Software and Equipment Notes

We finance certain software and equipment from third-party vendors. The terms of these arrangements are generally one to five years. The interest rates on the arrangements range from 0.0% to 6.0%.

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Uncertain Tax Positions

We have excluded $1.9 million of uncertain tax positions from the table above as we are uncertain as to if or when such amounts will be recognized.

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.

We have entered into various indemnification arrangements with third parties, including vendors, customers, landlords, our officers and directors, stockholders of acquired companies, and third parties to whom and from whom we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by third parties due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. Certain of these agreements require us to indemnify the other party against certain claims relating to property damage, personal injury or the acts or omissions by us, our employees, agents or representatives. To date, there have been no claims against us or our customers pertaining to such indemnification provisions, and no amounts have been recorded.

These indemnification obligations are considered off-balance sheet arrangements. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnification obligations in our financial statements.

Critical Accounting Policies and Estimates

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

We review our estimates and judgments on an ongoing basis, including those related to revenue recognition, service credits, allowance for doubtful accounts, property and equipment, goodwill and intangibles, contingencies, the fair valuation of stock related to share-based compensation, software development, and income taxes.

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

A description of our critical accounting policies that involve significant management judgment appears in our Annual Report filed on Form 10-K filed with the SEC on February 22, 2011 under “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies.”

Recent Accounting Pronouncements

For a full description of new accounting pronouncements, including the respective dates of adoption and impact on results of operation and financial condition, see “Notes to the Unaudited Consolidated Financial Statements – Note 1. Company Overview and Summary of Significant Accounting Policies.”

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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no significant changes to our market risks since December 31, 2010. 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, 2010.

ITEM 4.–CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

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

Changes in internal control over financial reporting

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

Inherent Limitations of Internal Controls

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

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PART II – OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS

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

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ITEM 1A – RISK FACTORS

Risks Related to Our Business and Industry

Our physical infrastructure is concentrated in a few facilities, and any failure in our physical infrastructure or services could lead to significant costs and disruptions and could reduce our revenue, harm our business reputation and have a material adverse effect on our financial results.

Our network, power supplies and data centers are subject to various points of failure.  Problems with our cooling equipment, generators, uninterruptible power supply, or UPS, routers, switches, or other equipment, whether or not within our control, could result in service interruptions for our customers as well as equipment damage.  Because our hosting services do not require geographic proximity of our data centers to our customers, our hosting infrastructure is consolidated into a few large facilities. While data backup services and disaster recovery services are available as a part of our hosting services offerings, the majority of our customers do not elect to pay the additional fees required to have disaster recovery services store their backup data offsite in a separate facility, which could substantially mitigate the adverse effect to a customer from a single data center failure. Accordingly, any failure or downtime in one of our data center facilities could affect a significant percentage of our customers. The total destruction or severe impairment of any of our data center facilities could result in significant downtime of our services and the loss of customer data. Since our ability to attract and retain customers depends on our ability to provide customers with highly reliable service, even minor interruptions in our service could harm our reputation. The services we provide are subject to failure resulting from numerous factors, including:

▪ Power loss;

▪ Equipment failure;

▪ Human error or accidents;

▪ Sabotage and vandalism;

▪ Failure by us or our vendors to provide adequate service or maintenance to our equipment;

▪ Network connectivity downtime;

▪ Improper building maintenance by the landlords of the buildings in which our facilities are located;

▪ Physical or electronic security breaches;

▪ Fire, earthquake, hurricane, tornado, flood, and other natural disasters;

▪ Water damage; and

▪ Terrorism. 

Additionally, in connection with the expansion or consolidation of our existing data center facilities from time to time, there is an increased risk that service interruptions may occur as a result of server relocation or other unforeseen construction-related issues.

We have experienced interruptions in service in the past due to such things as power outages, power equipment failures, cooling equipment failures, routing problems, hard drive failures, database corruption, system failures, software failures, and other computer failures. While we have not experienced a material increase in customer attrition following these events, the extent to which our reputation suffers is difficult to assess. We have taken and continue to take steps to improve our infrastructure to prevent service interruptions, including upgrading our electrical and mechanical infrastructure. However, service interruptions continue to be a significant risk for us and could materially impact our business.

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Any future service interruptions could:

▪ Cause our customers to seek damages for losses incurred;

▪ Require us to replace existing equipment or add redundant facilities;

▪ Affect our reputation as a reliable provider of hosting services;

▪ Cause existing customers to cancel or elect to not review their contracts; or

▪ Make it more difficult for us to attract new customers.

Any of these events could materially increase our expenses or reduce our revenue, which would have a material adverse effect on our operating results.

If we are unable to adapt to evolving technologies and customer demands in a timely and cost-effective manner, our ability to sustain and grow our business may suffer.

Our market is characterized by rapidly changing technology, evolving industry standards, and frequent new product announcements, all of which impact the way hosting services are marketed and delivered. The adoption of new technologies, a change in industry standards or introduction of more attractive products or services could make some or all of our offerings less desirable or even obsolete. These potential changes are magnified by the continued rapid growth of the Internet and the intense competition in our industry. To be successful, we must adapt to our rapidly changing market by continually improving the performance, features, and reliability of our services and modifying our business strategies accordingly. We cannot guarantee that we will be able to identify the emergence of all of these new service alternatives successfully, modify our services accordingly, or develop and bring new products and services to market in a timely and cost-effective manner to address these changes. Our failure to provide products and services to compete with new technologies or the obsolescence of our services would likely lead us to lose current and potential customers or cause us to incur substantial costs by attempting to catch our offerings up to the changed environment.

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

The acceptance and growth of cloud computing is an example of a rapidly changing technology that has impacted our business and our market. Because of the technological advances and the market adoption and utilization of cloud computing, we have adapted to the changing market and implemented the new technology in our hosting service delivery. This change has already required us to make a substantial financial investment to develop and implement cloud computing into our hosting solution model and has required significant attention from management to refine our business strategies to include the delivery of cloud computing and hybrid solutions. As the market continues to adopt this new technology, we expect to continue to make substantial investments in our service solutions and system integrations.  Even if we have developed an attractive solution to the changing technology or standards, our introduction of the new solution could have lower price points than other offerings and may result in our existing customers switching to the lower cost products and services, which could reduce our revenue and have a material, adverse effect of our operating results. For example, the introduction of our cloud computing solutions provides a reasonable alternative to some of our dedicated hosting solutions at a lower price point, and some of our dedicated hosting customers have switched to cloud computing solutions. We expect that other customers in this situation will switch to cloud computing in the future and will encourage them to do so when we believe that such a switch results in the best solution and /or best value for that customer.

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

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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.

We may not be able to compete successfully against current and future competitors.

The market for hosting and cloud computing services is highly competitive. We expect to face intense competition from our existing competitors as well as additional competition from new market entrants in the future as the actual and potential market for hosting and cloud computing continues to grow.

Our current and potential competitors vary by size, service offerings and geographic region. These competitors may elect to partner with each other or with focused companies like us to grow their businesses. They include:

▪ Do-it-yourself solutions with a colocation partner such as AT&T, Equinix, and other telecommunications companies;

▪ IT outsourcing providers such as CSC, Hewlett-Packard, and IBM;

▪ Hosting providers such as AT&T, British Telecom, Softlayer, Verio and other telecommunications companies; and

▪ Large technology companies such as Amazon, Microsoft, Google, IBM, Hewlett-Packard, Dell and Salesforce.com, 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; 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, computer viruses, denial of service attacks, accidents, employee error or malfeasance, intentional misconduct by computer “hackers,” and other disruptions can occur and infrastructure gaps, inadequate or missing security controls and exposed or unprotected customer data can exist, that (i) interfere with the delivery of services to our customers, (ii) impede our customers' ability to do business, or (iii) compromise the security of systems and data which exposes information to unauthorized third parties.

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

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

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

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

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

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

We provide service level commitments to our customers, which could require us to issue credits for future services if the stated service levels are not met for a given period and could significantly decrease our revenue and harm our reputation.

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

If we are unable to maintain a high level of customer service, customer satisfaction and demand for our services could suffer.

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

Our existing customers could elect to reduce or terminate the services they purchase from us because we do not have long-term contracts with our customers, which could adversely affect our operating results.

Customer contracts for our dedicated 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 cloud computing products and services, are generally provided on a month-to-month basis and do not have an extended initial term at all. Our costs associated with maintaining revenue from existing customers are generally much lower than costs associated with generating revenue from new customers. Therefore, a reduction in revenue from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue to retain our existing customers could have a material adverse effect on our operating results.

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

Because our hosting services are critical to many of our customers’ businesses, any significant disruption in our services could result in lost profits or other indirect or consequential damages to our customers. Although we require our customers to sign agreements that contain provisions attempting to limit our liability for service outages, we cannot assure you that a court would enforce any contractual limitations on our liability in the event that one of our customers brings a lawsuit against us as the result of a service interruption or other Internet site or application problems that they may ascribe to us. The outcome of any such lawsuit would depend on the specific facts of the case and any legal and policy considerations that we may not be able to mitigate. In such cases, we could be liable for substantial damage awards that may exceed our liability insurance coverage by unknown but significant amounts, which could materially impair our financial condition.

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

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

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Our use of open source software and contributions to open source projects could impose limitations on our ability to provide our services, expose us to litigation, and cause us to impair some assets which could adversely affect our financial condition and operating results.

We utilize open source software, including Linux-based software, in providing a substantial portion of our services. The terms of many open source licenses have not been interpreted by U.S. courts, and there is a risk that such licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to offer our services. Additionally, the use and distribution of open source software can lead to greater risks than the use of third-party commercial software, as open source software does not come with warranties or other contractual protections regarding infringement claims or the quality of the code. From time to time parties have asserted claims against companies that distribute or use open source software in their products and services, asserting that open source software infringes their intellectual property rights. We have been subject to suits, and could be subject to suits in the future, by parties claiming infringement of intellectual property rights with respect to what we believe to be open source software. In such event, we could be required to seek licenses from third parties in order to continue using such software or offering certain of our services or to discontinue the use of such software or the sale of our affected services in the event we could not obtain such licenses, any of which could adversely affect our business, operating results and financial condition. In addition, if we combine our proprietary software with open source software in a certain manner, we could, under some of the open source licenses, be required to release the source code of our proprietary software.

We have also sponsored an open source project called OpenStack, which is designed to foster the emergence of cloud computing technology standards and cloud interoperability. Our participation in the project includes the release of our previously proprietary core cloud storage code, and we expect to release additional core cloud code in the future and contribute to the on-going development of all of the OpenStack projects. In addition, we also participate in other open source projects and plan to continue to do so in the future. Our participation in and support for these projects could cause us to change our current software development and data center strategies. Our utilization of open source software and open data center design projects like the Facebook Open Compute project, which may replace our current capitalized design and development projects, could result in an impairment of those design and development assets.

In addition, our activities with these open source projects could subject us to additional risks of litigation including indirect infringement claims based on third-party contributors because of our sponsorship of this project.

We may not be successful in protecting and enforcing our intellectual property rights, which could adversely affect our financial condition and operating results.

We rely primarily on patent, copyright, trademark, service mark, and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights, all of which provide only limited protection. We rely on copyright laws to protect software and certain other elements of our proprietary technologies. We cannot assure you that any future copyright, trademark or service mark registrations will be issued for pending or future applications or that any registered or unregistered copyrights, trademarks or service marks will be enforceable or provide adequate protection of our proprietary rights. We currently have onepatent issued and 19 patent applications filed in the U.S. Our patent applications may be challenged and/or ultimately rejected, and our issued patent may be contested, circumvented, found unenforceable or invalidated.

We endeavor to enter into agreements with our employees, contractors, and parties with whom we do business to limit access to and disclosure of our proprietary information. The steps we have taken, however, may not prevent unauthorized use or the reverse engineering of our technology. Moreover, others may independently develop technologies that are substantially equivalent, superior to, or otherwise competitive to the technologies we employ in our services or that infringe our intellectual property. We may be unable to prevent competitors from acquiring trademarks or service marks and other proprietary rights that are similar to, infringe upon, or diminish the value of our trademarks and service marks and our other proprietary rights. Enforcement of our intellectual property rights also depends on successful legal actions against infringers and parties who misappropriate our proprietary information and trade secrets, but these actions may not be successful, even when our rights have been infringed.

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

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Our corporate culture has contributed to our success, and if we cannot maintain this culture, we could lose the innovation, creativity, and teamwork fostered by our culture, and our operating results may be harmed.

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity, and teamwork. If we implement more complex organizational management structures because of growth or other structural changes, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future operating results. In addition, being a publicly traded company may create disparities in personal wealth among our employees, which may adversely impact our corporate culture and employee relations.

If we are unable to manage our growth effectively, our financial results could suffer.

The growth of our business and our service offerings has strained 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;

▪ Our inability to market our services in a cost-effective manner to new customers;

▪ The inability of our customers to differentiate our services from those of our competitors or our inability to effectively communicate such distinctions;

▪ Our inability to successfully communicate the benefits of our services to businesses;

▪ The decision of businesses to host their Internet sites and web infrastructure internally or in colocation facilities as an alternative to the use of our hosting services;

▪ Our inability to penetrate international markets;

▪ Our inability to provide compelling services or effectively market them to existing customers;

▪ Our inability to strengthen awareness of our brand; and

▪ Reliability, quality or compatibility problems with our services.

A substantial amount of our past revenue growth was derived from purchases of service upgrades by existing customers. Our costs associated with increasing revenue from existing customers are generally lower than costs associated with generating revenue from new customers. Therefore, a reduction in the rate of revenue increase or a rate of revenue decrease from our existing customers, even if offset by an increase in revenue from new customers, could reduce our operating margins. Any failure by us to continue attracting new customers or grow our revenue from existing customers for a prolonged period of time could have a material adverse effect on our operating results.

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Our operating results may be further adversely impacted by unfavorable economic conditions, worldwide political and economic uncertainties and specific conditions in the markets we address.

Recently, general worldwide economic conditions have experienced deterioration due to, among other things, credit conditions resulting from the financial crisis affecting the banking system and financial markets, including: slower economic activity, concerns about inflation and deflation, volatility in energy costs, decreased consumer confidence, reduced corporate profits and capital spending, the ongoing effects of the wars in Iraq and Afghanistan, recent international conflicts, terrorist and military activity, and the impact of natural disasters and public health emergencies. These conditions can make it extremely difficult for both us and our customers to accurately forecast and plan future business activities.  Additionally, they could cause U.S. and foreign businesses to slow spending on our services, which could delay and lengthen our new customer sales cycle and cause existing customers to do one or more of the following:

▪ Cancel or reduce planned expenditures for our services;

▪ Seek to lower their costs by renegotiating their contracts with us;

▪ Move their hosting services in-house; or

▪ Switch to lower-priced solutions provided by us or our competitors.

Customer collections are our primary source of cash. We have historically grown through a combination of an increase in new customers and revenue growth from our existing customers. Over some recent quarters, we have experienced a decrease in our installed base growth.  If the economic conditions were to deteriorate, we may experience additional reductions in our installed base growth, increases in churn and/or longer new customer sales cycles. We could also experience a decrease in revenue and a reduction in operating margins. Further, during challenging economic times, our customers may have difficulty gaining timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. We cannot predict the timing, strength or duration of any economic slowdown or subsequent economic recovery. If the economy or markets in which we operate were to deteriorate, we may have to record additional charges related to the impairment of goodwill and other long-lived assets, and our business, financial condition and results of operations could be materially and adversely affected.

Finally, if investors have concerns that our business, financial condition and results of operations will be negatively impacted by an economic downturn, our stock price could decrease.

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. In the past, we have either leased data center facilities and built or maintained the facilities ourselves or leased data centers from data center operators who have built or maintained the facilities for us. 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. We currently plan to increase our infrastructure as required through the addition and expansion of data centers in the U.S. and internationally. In contrast to most of our data centers that we acquired early on in our operating history, several of which were acquired relatively inexpensively as distressed assets of third parties, current expansion plans may require us to pay full market rates for new data center facilities if we were to follow that expansion model of building and maintaining the data centers. 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.

If we overestimate the demand for our services and therefore overbuild our data center capacity or commit to long-term facility leases, 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. Additionally, we may be required to limit new customer acquisition while we work to increase data center capacity to satisfy demand, either of which may materially impair our revenue growth.

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We rely on a number of third-party providers for data center space, equipment, maintenance and other services, and the loss of, or problems with, one or more of these providers may impede our growth or cause us to lose customers.

We rely on third-party providers to supply data center space, equipment and maintenance.  For example, we lease data center space from third-party landlords, lease or purchase equipment from equipment providers, and source equipment maintenance through third parties. While we have entered into various agreements for these products and services, any failure to obtain additional capacity or space, equipment, or maintenance, if required, would impede the growth of our business and cause our financial results to suffer. For example, if a data center landlord does not adequately maintain its facilities or provide services for which it is responsible, we may not be able to deliver services to our customers according to our standards or at all.  Further, the equipment that we purchase could be deficient in some way, thereby affecting our products and services. If, for any reason, these providers fail to provide the required services, fail to deliver their equipment, or suffer other failures, we may incur financial losses and our customers may lose confidence in our company, and we may not be able to retain these customers.

We may not be able to renew the leases on our existing facilities on terms acceptable to us, if at all, which could adversely affect our operating results.

We do not own the facilities occupied by our current data centers, but occupy them pursuant to commercial leasing arrangements. The initial terms of our main existing data center leases expire over a period ranging from 2012 to 2028, with each having at least one renewal period of no less than three years.  Upon the expiration or termination of our data center facility leases, we may not be able to renew these leases on terms acceptable to us, if at all. If we fail to renew any data center lease and are required or choose to move the data center to a new facility, we would face significant challenges due to the technical complexity, risk, and high costs of relocating the equipment. For example, if we are required to migrate customer servers to a new facility, such migration could result in significant downtime for our affected customers. This could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Even if we are able to renew the leases on our existing data centers, we expect that rental rates, which will be determined based on then-prevailing market rates with respect to the renewal option periods and which will be determined by negotiation with the landlord after the renewal option periods, will be higher than rates we currently pay under our existing lease agreements. If we fail to increase revenue in our existing data centers by amounts sufficient to offset any increases in rental rates for these facilities, our operating results may be materially and adversely affected.

We rely on third-party hardware that may be difficult to replace or could cause errors or failures of our service, which could adversely affect our operating results or harm our reputation.

We rely on hardware acquired from third parties in order to offer our services. This hardware may not continue to be available on commercially reasonable terms in quantities sufficient to meet our business needs, which could adversely affect our ability to generate revenue. Any errors or defects in third-party hardware could result in errors or a failure of our service, which could harm our reputation and operating results. Indemnification from hardware providers, if any, would likely be insufficient to cover any damage to our business or our customers resulting from such hardware failure.

We rely on third-party software that may be difficult to replace or which could cause errors or failures of our service that could lead to lost customers or harm to our reputation.

We rely on software licensed from third parties to offer our services. This software may not continue to be available to us on commercially reasonable terms, or at all. Any loss of the right to use any of this software could result in delays in the provisioning of our services until equivalent technology is either developed by us, or, if available, is identified, obtained, and integrated, which could harm our business. Any errors or defects in third-party software or inadequate or delayed support by the third party could result in errors or a failure of our service, which could harm our operating results by adversely affecting our revenue or operating costs.

We engage and rely on third-party consultants who may fail to provide effective guidance or solutions, which could result in increased costs and loss of business opportunity.

We engage third-party consultants who provide us with guidance and solutions relating to everything from overall corporate strategy to data center design to employee engagement. We engage these parties based on our perception of their expertise and ability to provide valuable insight or solutions in the areas that we believe need to be addressed in our business. However, these consultants may provide us with ineffective or even harmful guidance or solutions, which, if followed or implemented, could result in a loss of resources, operational failures or a loss of critical business opportunities.

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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. Further, power requirements at our data centers are increasing as a result of the increasing power demands of today’s servers. Increases in our power costs could impact our operating results and financial condition. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, our data centers could have a limited or inadequate amount of electrical resources necessary to meet our customer requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. Any system downtime resulting from insufficient power resources or power outages could damage our reputation and lead us to lose current and potential customers, which would harm our operating results and financial condition.

Increased Internet bandwidth costs and network failures may adversely affect our operating results.

Our success depends in part upon the capacity, reliability, and performance of our network infrastructure, including the capacity leased from our Internet bandwidth suppliers. We depend on these companies to provide uninterrupted and error-free service through their telecommunications networks. Some of these providers are also our competitors. We exercise little control over these providers, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions or delays in network service. Any failure on our part or the part of our third-party suppliers to achieve or maintain high data transmission capacity, reliability or performance could significantly reduce customer demand for our services and damage our business.

As our customer base grows and their usage of telecommunications capacity increases, we will be required to make additional investments in our capacity to maintain adequate data transmission speeds, the availability of which may be limited or the cost of which may be on terms unacceptable to us. If adequate capacity is not available to us as our customers’ usage increases, our network may be unable to achieve or maintain sufficiently high data transmission capacity, reliability or performance. In addition, our business would suffer if our network suppliers increased the prices for their services and we were unable to pass along the increased costs to our customers.

Our operating results may fluctuate significantly, which could make our future results difficult to predict and could cause our operating results to fall below investor or analyst expectations.

Our operating results may fluctuate due to a variety of factors, including many of the risks described in this section, which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our operating results for any prior periods as an indication of our future operating performance. Fluctuations in our revenue can lead to even greater fluctuations in our operating results. Our budgeted expense levels depend in part on our expectations of long-term future revenue. Given relatively fixed operating costs related to our personnel and facilities, any substantial adjustment to our expenses to account for lower than expected levels of revenue will be difficult and time consuming. Consequently, if our revenue does not meet projected levels, our operating expenses would be high relative to our revenue, which would negatively affect our operating performance.

If our revenue or operating results do not meet or exceed the expectations of investors or securities analysts, the price of our common stock may decline.

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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 $22.0 million in state enterprise fund grants on the condition that we meet certain employment levels in the State of Texas paying an average compensation of at least $56,000 per year (subject to increases). To the extent we fail to meet these requirements, we may be required to repay all or a portion of the grants plus interest.  In September 2007, we received the initial installment of $5.0 million from the State of Texas, which was recorded as a non-current liability.

On July 27, 2009, the Texas Enterprise Fund Grant agreement was amended to modify the job creation requirements.  Under the amendment, the grant has been divided into four separate tranches. The first tranche, called “Basic Fund” in the amendment, is $8.5 million with a Job Target of 1,225 new jobs by December 2012 (in addition to the 1,436 jobs in place as of August 1, 2007, for a total of 2,661 jobs in Texas). We already have drawn $5.0 million of this grant. We can draw an additional $3.5 million when we reach 1,225 new jobs. If we do not create 1,225 new jobs in Texas by 2012, we will be required to repay the grant at a rate of $1,263 per job missed per year (clawback). The maximum clawback would be the amounts we draw plus 3.4% interest on such amounts per year.  The remaining three tranches are at our option. We can draw an additional $13.5 million, based on the following amounts and milestones: $5.5 million if we create a total of 2,100 new jobs in Texas; another $5.25 million if we create a total of 3,000 new jobs in Texas; and $2.75 million more if we create a total of 4,000 new jobs in Texas. We are responsible for maintaining the jobs through January 2022. If we eliminate jobs for which we have drawn funds, the clawback is triggered.

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.

As of September 30, 2011, there was no outstanding indebtedness under our credit facility other than an outstanding letter of credit in the amount of $0.4 million. Our credit facility requires compliance with a set of financial and non-financial covenants. Those covenants include financial leverage limitations and interest rate coverage requirements, as well as limitations on our ability to incur additional debt or liens, make restricted payments, sell assets, enter into affiliate transactions, merge or consolidate with other companies, make certain acquisitions and take other actions.  If we default on our credit agreement due to non-compliance with such covenants or any other contractual requirement of the agreement, we may be required to repay all amounts owed under this credit facility.

We also have substantial equipment lease obligations, the principal balance of which totaled approximately $142.8 million as of September 30, 2011. The payment obligations under these equipment leases are secured by a significant portion of the hardware used in our data centers. If we are unable to generate sufficient cash flow from our operations or cash from other sources in order to meet the payment obligations under these equipment leases, we may lose the right to possess and operate the equipment used in our data centers, which would substantially impair our ability to provide our services, which could have a material adverse effect on our liquidity or results of operations.

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

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

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

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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 2011, we expensed approximately $16.8 million to utility companies to power our data centers. We anticipate an increase in our consumption of power in the future as our sales grow. Power costs vary by locality and are subject to substantial seasonal fluctuations and changes in energy prices. Our largest exposure to energy prices currently exists at our Grapevine, Texas facility in the Dallas-Fort Worth area, where the energy market is deregulated. Power costs have historically tracked the general costs of energy, and continued increases in electricity costs may negatively impact our gross margins or operating expenses. We periodically evaluate the advisability of entering into fixed-price utilities contracts and have entered into certain fixed-price utilities contracts for some of our power consumption.  If we choose not to enter into a fixed-price contract, we expose our cost structure to this commodity price risk. If we do choose to enter into a fixed-price contract, we lose the opportunity to reduce our power costs if the price for power falls below the fixed cost.

Our main credit facility is a revolving line of credit with a base rate determined by variable market rates, including the Prime Rate and the London Interbank Offered Rate (LIBOR). These market rates of interest are fluctuating and expose our interest expense to risk. At this point, our credit agreement does not obligate us to hedge any interest rate risk with any instruments, such as interest rate swaps or interest rate options, and we do not have any such instruments in place. As we borrow more, we may enter into swaps to continuously control our interest rate risk.  As a result, we are exposed to interest rate risk on our current 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, 2011, 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 of data networks is largely unsettled, 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 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.

We rely on our Channel Partner Program members for a significant portion of our revenues, and we benefit from our association with them. The loss of these members could adversely affect our business.

Our Channel Partner Program drives a significant amount of revenue to our business through referral and reseller arrangements. Most of our member partners offer services that are complementary to our services; however, some of the participants may actually compete with us in one or more of our product or service offerings. These network partners may decide in the future to terminate their agreements with us and/or to market and sell a competitor’s or their own services rather than ours, which could cause our revenue to decline.

Also, we derive tangible and intangible benefits from our association with some of our network partners, particularly high profile partners that reach a large number of companies through the Internet. If a substantial number of these partners terminate their relationship with us, our business could be adversely affected.

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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 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.

Terrorist activity throughout the world and military action to counter terrorism could adversely impact our operating results.

Terrorist attacks and other acts of violence, as well as governments’ responses to such activities, may have an adverse effect on business, financial, and general economic conditions internationally. Terrorist activities may disrupt our ability to provide our services or may increase our costs due to the need to provide enhanced security, which would have a material adverse effect on our business and results of operations. These circumstances may also adversely affect our ability to attract and retain customers, our ability to raise capital, and the operation and maintenance of our facilities. We may not have adequate property and liability insurance to cover catastrophic events or attacks brought on by terrorist attacks and other acts of violence. In addition, we depend heavily on the physical infrastructure, particularly as it relates to power, that exists in the markets in which we operate. Any damage to such infrastructure in these markets where we operate may materially and adversely affect our operating 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 and other factors beyond our control, such as stock market volatility and fluctuations in the valuation of companies perceived by investors to be comparable to us.

Further, the stock markets have experienced price and volume fluctuations that have affected our stock price and the market prices of equity securities of many other companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market and industry fluctuations, as well as general economic, political, and market conditions, such as recessions, interest rate changes or international currency fluctuations, may negatively affect the market price of our common stock. We may experience additional volatility as a result of the limited number of our shares available for trading in the market.

In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

Our common stock has only been publicly traded since our initial public offering on August 7, 2008, and the price of our common stock has fluctuated substantially since then and may fluctuate substantially in the future.

Our common stock has only been publicly traded since our initial public offering on August 7, 2008. The trading price of our common stock has fluctuated significantly since then. For example, between December 31, 2010 and September 30, 2011, the closing trading price of our common stock was very volatile, ranging between $29.78 and $46.19 per share, including single-day increases of up to 12.4% and declines up to 12.4%. Our trading price could fluctuate substantially in the future due to the factors discussed in this Risk Factors section and elsewhere in this quarterly report on Form 10-Q.

Contractual lock-up restrictions on the sale of approximately 99 million shares held by certain stockholders expired on February 3, 2009, and to the extent a stockholder is not an affiliate, its shares are now eligible for sale without restriction. Affiliate sales are subject to the volume, manner of sale and other restrictions of Rule 144 of the Securities Exchange Act of 1933, which allow the holder to sell up to the greater of 1% of our outstanding common stock or our average weekly trading volume during any three-month period. Shares beneficially held by Graham Weston and certain other parties will be subject to such requirements to the extent they are deemed to be our “affiliates” as that term is defined in Rule 144. Additionally, Weston, and certain other holders possess registration rights with respect to some of the shares of our common stock that they hold. If they choose to exercise such rights, their sale of the shares that are registered would not be subject to the Rule 144 limitations. If a significant amount of the shares that become eligible for resale enter the public trading markets in a short period of time, the market price of our common stock may decline.

Additionally, certain of our large stockholders are entities that may from time to time distribute the shares of our stock held by them to their beneficial owners in order to provide them with liquidity with respect to their investment in our stock. The distributed shares may be eligible for immediate resale, in which case all or a significant portion of these shares may be sold by these beneficial owners in the public markets during a short period of time following their receipt of these shares, which may cause the market price for our stock to decline.

The issuance of additional stock in connection with acquisitions, our equity incentive and stock purchase plans, or otherwise will dilute all other stockholdings.

We have a large number of shares of common stock authorized but unissued and not reserved for issuance under our stock option plans or otherwise. We may issue all of these shares without any action or approval by our stockholders. We intend to continue to actively pursue strategic acquisitions. We may pay for such acquisitions, partly or in full, through the issuance of additional equity. In addition, our Amended and Restated 2007 Long-Term Incentive Plan and out Employee Stock Purchase Plan contain evergreen provisions, which annually increase the number of shares issuable under the applicable plan. Any issuance of shares in connection with our acquisitions, the exercise of stock options or otherwise would dilute the percentage ownership held by our then-existing stockholders.

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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.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change of control, even if an acquisition would be beneficial to our stockholders, which could affect our stock price adversely and prevent attempts by our stockholders to replace or remove our current management.

Our restated certificate of incorporation and amended and restated bylaws contain provisions that could delay or prevent a change of control of our company or changes in our board of directors deemed undesirable by our board of directors that our stockholders might consider favorable. Some of these provisions:

• Authorize the issuance of blank check preferred stock which can be created and issued by our board of directors without prior stockholder approval, with voting, liquidation, dividend, and other rights senior to those of our common stock;

• Provide for a classified board of directors, with each director serving a staggered three-year term;

• Prohibit our stockholders from filling board vacancies or increasing the size of our board, calling special stockholder meetings or taking action by written consent;

• Provide for the removal of a director only with cause and by the affirmative vote of the holders of a majority of the shares then entitled to vote at an election of our directors; and

• Require advance written notice of stockholder proposals and director nominations.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our restated certificate of incorporation, amended and restated bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our board of directors or initiate actions that are opposed by our then-current board of directors, including a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our board of directors could cause the market price of our common stock to decline.

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

    None

ITEM 3 – DEFAULTS UPON SENIOR SECURITIES

    None

ITEM 4 – RESERVED

ITEM 5 – OTHER INFORMATION

    None

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ITEM 6 – EXHIBITS

Exhibit Number	Description
10.1 *†	Fourth Amendment to Lease, dated August 19, 2011, by and between Tarantula Ventures LLC and Rackspace US, Inc.
10.2	Revolving Credit Agreement, dated September 26, 2011, by and between Rackspace Hosting, Inc. and JPMorgan Chase Bank, N.A., Barclays Bank PLC, Regions Bank, and Wells Fargo Bank, N.A. (1)
10.3	Guarantee Agreement, dated September 26, 2011, by Guarantors of Rackspace Hosting, Inc., in favor of JPMorgan Chase Bank, N.A. as Administrative Agent for the benefit of the Lenders pursuant to the Revolving Credit Agreement dated September 26, 2011 (1)
31.1 *	Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 *	Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 **	Certifications of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 **	Certifications of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS **	XBRL Instance Document
101.SCH **	XBRL Taxonomy Extension Schema
101.CAL **	XBRL Taxonomy Extension Calculation Linkbase
101.DEF **	XBRL Taxonomy Extension Definition Linkbase
101.LAB **	XBRL Taxonomy Extension Label Linkbase
101.PRE **	XBRL Taxonomy Extension Presentation Linkbase

* Filed herewith

** Furnished herewith

† Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from this Quarterly Report on Form 10-Q and submitted separately to the Securities and Exchange Commission.

(1) Incorporated by reference to the Company's Current Report on Form 8-K/A (File No. 001-34143), filed September 29, 2011.

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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 8, 2011.

Rackspace Hosting, Inc.

Date:	November 8, 2011	By:	/s/ Karl Pichler
			Karl Pichler
			Chief Financial Officer and Treasurer
			(Principal Financial Officer)

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