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Rackspace Hosting, Inc. (NYSE:RAX)

March 05, 2013 11:30 am ET

Executives

Bryan McGrath

Jason Luce

Unknown Analyst

Hello, everyone. Welcome to the fourth telecom track of the day. My name is Jordan Sanchez. I'm a member of the U.S. telecom services research team here at Deutsche Bank. We're very pleased to have Rackspace with us today. From Rackspace, we have Jason Luce, VP of Finance; and Bryan McGrath, Director of Finance. So we'll just jump right into Q&A and I'll make sure to leave some time at the end for some questions from the audience.

Question-and-Answer Session

Unknown Analyst

But just to get things get started off. Last year was a pretty busy year. The back half of the year, you launched some OpenStack products and you kind of started moving over to the OpenStack platform. So maybe you can talk about some of the key milestones you guys hit last year. And did you come in as expected? Or are you seeing the sales you expected? Did products come in as expected, et cetera?

Bryan McGrath

Yes. So just to take a few setbacks, so a couple of years ago, 5 years ago, we acquired this company called Slicehost, which will enable you to do -- to take a physical server, divide it up into multiple pieces and sell those as they were their own physical server. And that became kind of the genesis of what is our cloud business today. And so over the years, we've reiterated on that technology and built the business. It was a couple of hundred million dollars, growing, call it 80% year-over-year. But we got to a point where that business, that platform was limiting. We had customers who were getting -- who were kind of tapping out into how big they could possibly get. And so, we -- our the biggest competitor, of course, Amazon, was getting much larger workloads. And so last year, the milestones that you touched on, were all about rearchitecting that business and that platform, deploying OpenStack, which is an open-source software project that we're cofounders of and building our cloud based on OpenStack. So the milestone all last year where getting the brand-new cloud out, up and running and getting it going. So that was the #1, 2 and 3 goals last year. And so the very first pieces went out and went live in August and the last pieces went live in the last couple of days of October. So those are the milestones we had for the year.

Now one of the best accolades so far is we haven't had any big outages, right? Brand new platforms comes out and rolls out, we are really hyperfocused on making sure it's up and running, that we get good performance metrics, that we get good reliability out of it because that's the key into attracting new deployments of the cloud. And last year was about getting it out. This is the year we're all about going and marketing it and selling it. So once -- when we got everything out and we really got it rolling, when we had it up and running, we kind of laid out 2 new operational goals for us. The first was that we needed to attract, get close, deploy and be able to tell the world about some big, kind of complex workload.

And then second being, if we're successful with that, then in time we should be able to reaccelerate the growth of the cloud business. And a lot of the thinking there was kind of looking back what happened with Amazon Web Services. So they were, obviously, the pioneers in this whole idea of this cloud computing. Huge adoption of their platform was when they had some big workloads they can point to and Netflix was the one that really stands out in my mind. That when Netflix came out and said, "You know what? We're going to deploy our stuff onto your platform." That gave anyone, not anyone, but for many customers or potential customers that had -- was reluctant to adopt the platform, that for scalability or for whatever reason, that got them over that hump. And so we need to do the [indiscernible]. Right? We've got a lot of, or a good handful of pilot customers that we think will fit that bill but we haven't done any of them live and certainly, we don't have anything that we can talk about. So those are the key milestones that we need to kind of -- they need to judge us on going forward.

Unknown Analyst

So you guys launched several products in the back half of last year. Maybe you can talk about, which products you're the successful to date. And if there are any glaring holes that you guys kind of wish to fill going forward or is the product platform kind of set.

Bryan McGrath

Yes, we have the -- I would characterize it more as the brand new re-architective platform and there's a lot of different pieces to it, right? But just to kind of give you a high-level how we think about it. The whole idea is to, what does it take to run very complex, highly scalable workloads, right? And so if you look at what it takes, you need a big compute platform. So we got cloud servers which is our compute format. The -- our prior platform was similar -- had servers we called the Cloud Servers but the ability for it to scale was very limited. This one we don't know what the limits are yet.

Another big hole as you put it, that we had to fill last year, I mean, last year was about filling the holes we had, was block storage. But performance-based storage, we simply didn't even have that product last year, if you will, or that piece of the new platform. That was one of the products that rolled later in the year. A network, right? Being able to have an isolated network virtually in the cloud is a new functions, 1 of the 7 components, if you will, of the new platform. Again, it didn't even exist last year, now we have it at this point. Yes, that was the last piece of the launch. I mean, there are a couple of other pieces. There's monitoring, backup, what you should think of [indiscernible] as different pieces of a platform that you need to run large-scale application.

Unknown Analyst

Okay. And then maybe you can talk about the opportunity in the enterprise space. Could you provide an example of some of the things you're doing for a typical SMB customer on your legacy platform, maybe the average monthly spend there and how that's changing now that you're moving into the more complex workloads?

Bryan McGrath

So I would say -- I would characterize, even the Century up to this date, so a couple of hundred million dollar business growing 30%. The workloads were basically all very simple-type workloads, the test dove, but, no material, there's not a lot of production environments that we can point to that were on our cloud. That's how we've gotten to where we are today. Again, the goal here is to be able to point to some really mission-critical production workload. And so I would look at that as layering on top of the simple stuff. And while we still certainly believe that we're going to continue to get simple workloads, because there's a lot of that light-use cases that fall under the category, simple that belong in the cloud. But on top of that, we call that the bread and milk today. We want layer in big workloads, big mission-critical workloads. And again, we don't have anything to talk about yet, but we've only been out for a couple of months so I think it's not -- I mean, it's not -- pretty par for the course that we would still be in kind of improvement mode with a lot of these pilots.

Unknown Analyst

So another key thing that you guys are kind of going through this, just migrating some of the legacy, I guess, potentially migrating some of the legacy customers on the legacy platform over to the new platform. Is that something -- are customers kind of coming to looking for an upgrade? Or are you going to them, kind of trying to push them over to the new platform?

Jason Luce

Yes, I would just -- I think, what -- the way Bryan just described it is accurate. When you think about the migration piece, it's not so much the customer as moving an existing workload or migrating it over yet. It's that, we're doing business with 200,000 customers and those customers are running multiple, in a lot of cases, multiple workloads with this. So think about 100% of all incremental workloads for those existing customers, are going onto the new platform. At some point, will they migrate? Will there be a migration from existing workloads from the old platform moving onto the new platform? Yes. I would sort of say, think about that over the next 12 to 18 months. But right now, what customers are excited about are running new workloads on this platform that is significantly a more feature-rich. And they can do more things. So it's basically the workloads that they wanted to give us 6 months ago that we couldn't handle, now we can handle a lot of those. So that's the incremental stuff to be excited about. And the conversation activity is around, basically having now an alternative to the leading cloud, being Amazon. Now companies have an open alternative and there's sort of, a lot of history, you can go back and look, on why the world demands this.

Unknown Analyst

Another big opportunity for you guys is deploying private cloud services on the customer premise. Maybe you can just talk a little bit about that and how the economics differ versus providing the dedicated infrastructure that you guys currently do.

Jason Luce

Okay. So, what -- think about -- if you think about where IT is currently running the world. There's something like 80%, 85% of it. Today, it's still running our corporate data center. We built $1 billion business, serving some fraction of the 15% to 20% of workloads that runs in a service provider's facilities, on the service provider's gear. So by us now offering a downloadable version of OpenStack that we can support, customers can take an application, they can take this reference architecture and they can deploy it in their data center and then ask Rackspace, based on OpenStack, then ask Rackspace to support it. So I sort of think about it 2 ways. One is, obviously our opportunity set just got a lot bigger, that we couldn't do this 6 months ago. So now, is it 8x bigger? Probably not but some fraction of that. So that's exciting from a growth perspective. And then from a -- sort of, I think about it from a business model perspective, we think of everything sort of on a return on capital basis and obviously, it's a return on capitals, margin times turns. The turns part of this business is significantly better because -- it's infinitely better because there's no capital. Right? It will basically build and monetize our service delivery model on top of their capital. So I think the question is, when does that become a significant part of our mix and I think we'll know more over the next 18 to 24 months.

Unknown Analyst

How do you price it based on the fact that you don't have to recoup some of your capital?

Jason Luce

Yes, great question. So think about pricing in general for Rackspace, it's all cost plus. So what you do is you take basically this EVA pricing model and the capital that I have to recoup today, you just take that out. So the ASP or the revenue per workload is lower but the returns are significantly higher.

Unknown Analyst

Okay. Now just talking, you guys said you had nothing to really add in terms of winning new enterprise workloads just yet. But I understand a lot of them are in these pilot periods right now. Can you just talk about how long those periods typically take? What are customers look for? Are they kind of evaluating versus some of your peers and how are you stacking up?

Bryan McGrath

Yes, it's -- that's a great question. You can imagine we're intently focused on that one ourselves. A lot of this, there's a lot of use -- a lot of the cases or case studies, if you will, at this point are unique to each customer. A couple of things that are -- you can kind of -- a couple of vignettes that are consistent through the -- are, look, first of all, our platform is fully out since the end of October. Right? And so there's an element of they're not familiar with our platform, because it is brand new and there's, I'm like, a realistic element that they want to make sure it's fully ready for prime time and hasn't even been full 6 months yet or just approaching that. And so they want to get real comfortable that our platform is steady enough to run. So that is really important to them. And I think that's -- it's a fair fear of theirs for now and we need to get over that. That's something that time and a couple of production workloads will help get over that. But we're certainly in that phase where some of them aren't yet.

The OpenStack technology, which our cloud is based on, is still very new, right? I mean, these companies that we're talking, don't have competencies in OpenStack, right? If it was a Java-based cloud, I mean, they all have tons of competency in Java, so there is no getting over that technology adoption once they deal with our cloud. So there's that and those 2 things kind of come out with every single one of the pilots that we're talking to.

And then another is the cadence of whatever project that is. Because essentially, what these pilots are, are projects these companies are rolling out for very simple reasons and these have their marketing. They're marketing things, marketing deployments, marketing projects, some of them internal focused but they all have their own timeline and there's not a lot we can do it to influence or influence to speed up when they're going to deploy these things. So those are the kind of couple of things that are floating around but we have one that is a SaaS company, it's a SaaS app that they're, I mean, that they're seriously evaluating us for. The migration from the other platform to our platform was going to take a long time and it's going be a testing and a testing-intensive process. Nothing we can do to speed that up.

Unknown Analyst

Are you seeing a similar education process among your SMB customers? Or is that kind of ramping up a little more quickly, are they a little less risk averse?

Bryan McGrath

Yes. So we get questions kind of like this a lot, our SMB customers versus our enterprise customers. And there's -- I understand what -- there's some utility in looking at things that way but when it comes to kind of these deployments, it's always more important to look at it through the size of the deployment. For example, Pinterest, right? Pinterest is an SMB -- in the SMB category. But we would love to have that deployment. I mean, that would qualify for a highly complex production environment on our clock, right? And just to kind of -- they're not what we're talking about, but as an example, it's one everyone knows about, then they would be very reluctant to probably move platforms because it's a lot of risk and it will take a long time. But if they did, we would be happy to tell the world about it. Even though they're very small company, that would be a very large workload, right? Instagram will be another one. Some of the biggest workloads that you'll ever see are from these companies that you've never heard of yesterday but now, that are big.

With regard to SMB versus enterprise. The enterprises we are dealing with, especially we are dealing with is the department or the office of the CIO, are very risk-averse. They're going to very sure that your platform is ready before they go and deploy something that where their career and their reputation is online, which is again another reason we need a bunch of deployment that we can point to get them over that hump.

Unknown Analyst

So another goal for the year was reaccelerating growth. Maybe you can start off first just by discussing some of the trends maybe over the last year in terms of the deceleration in growth and growth from the installed base and would've been the primary drivers there.

Jason Luce

Yes, I'll take that. That's right. Our stated goal for the year is to reaccelerate cloud growth. So let's just start with that. Last year, our cloud was decelerated as we went through this platform shift. So there was going to be a new product, so call it, there were some air pocket in there where customers were reticent to put a workload on a platform and then there'll be a new platform out there. So we experienced that. These big workloads that Bryan's talking about, we call them White House customers, we think that, that will be the catalyst to reaccelerate that growth. And look, the reason why we put that goal out there is because, we sort of look the conversation activity and how that transforms into proof of concepts or pilots, and then those pilots become commitments and then those commitments become revenue. We think that is what will allow us to reaccelerate cloud growth. And because, as Bryan mentioned, we're now operating on the customer's timeline of when they're ready to put their important applications on this new platform, we think, we sort of talk about, we think that goal, if it's achievable, would be achievable in the back half of the year. All right? So we're super excited, all the works that we're doing with these customers, we're confident that they will, be a very important part of our growth engine, is just going to take some time.

In terms of the installed base growth, that's basically our same-store-sales metric and we calculate it as a percent of revenue growth month-over-month from existing customers. That number, in 2011, trended probably at 1% a month, or add it, roughly simple math, call it 12-ish percent growth year-over-year. In 2012, that number came down a little bit. And in the fourth quarter, you saw it actually come down to 0.5% per month. And the main reason behind that is we have less upsells to sort of our existing enterprise customers, more on the dedicated side. The good news is that churn, we also report churn, churn is still very healthy. So it's not that the customers have left or that we lost those deals, it's just that we got to go get them now. All right? And I can tell you that we're pulling out all the stops to try and reinvigorate that. So that will also be -- if we're able to successfully do that, that will also be a significant part of getting this growth reaccelerated.

Unknown Analyst

So installed based growth, going back a few years, was as high as 1.5%. During an improved economy or at when the economy's a little better off, do you think going forward, you could potentially reach that again, if the economy kind of picks up a little bit? And what do you think the drivers would be there?

Jason Luce

I think that there is no reason to think that we can't. Okay? The things that are different when you look at where we were from a business standpoint, call it 2006, 2007, when you're at -- you're right, we were driving kind of 1.5% per month. The things that are different today from a business standpoint is obviously our cloud business, which is now kind of 1/4 of our business, is absolutely a -- is additive to that because customers can just do so much more. And they can do it on demand.

The second thing is really we didn't have an enterprise business back then. Right? And so when you think about it, then we probably had, I don't know, a handful of Fortune 100 companies whereas today, we're doing business with 60 of the Fortune 100. So I think we have the Rolodex and the opportunity size is really big. We got to go execute on that. So if the economy were to be where it were back in 2006, 2007, and we're not were not predicting that, we're not going to unless -- but if it were, then I think that those 2 differences will actually -- could actually help drive it even higher.

Unknown Analyst

You mentioned that you have 60 or so Fortune 100. Do the service model or sales model change at all, now that you're kind of doing some of these more -- these larger workloads with enterprise customer?

Bryan McGrath

Yes. I mean it's kind of going back to kind of how it's church-rights zero there. So it's -- you come into our organization, you see our service department, you can't, I mean, it's one group is working almost a craft per se, another would group may be working on EA but another group maybe on a company you've never of heard but is doing a very complex workload. So it's what you work backwards from or the teams are structured for, the size and complexity of the workload and the service level that you then pay for, depending on what your needs are, as opposed to how the big the company is.

Unknown Analyst

Okay. How does your OpenStack platform currently compare to some of the other offerings out there. You were talking about Amazon Web Services, the key competitor. How do you guys match up in terms of products and pricing? I understand you guys also recently cut pricing. Maybe you could talk a little bit about that.

Bryan McGrath

So feature-, function-wise, so there's a lot there. It's real complicated to get feature-, function-wise but we have -- again, our strategy is to figure out what are the kind of building blocks, the main building blocks that, we'll say 80% of the workloads out there need to run. So it's compute, block storage, or different storage labels if you will, networking, things like that. Versus Amazon who has, I mean, they have all sorts of advanced features. I mean, they have graphic processing chip features that we're not -- I mean, I think you should never say never but it's unlikely we're going to get graphic processor chips because it's a niche piece of the market. It has an important and -- I'm sure they have lots of big -- they get a lot of revenue from that. But that's not a 80 -- that's not 80% of the workloads don't need graphic processor. And so I mean from a scalability standpoint, we certainly believe we can be able -- we can compete against the largest deployments that they have. Again, but within that 80-20, we're not going to be on the niche of some of those other things.

Price-wise, we've always been -- Amazon is a price leader. I mean, that's -- they go to market with price. They use their skill advantage to drive lower and lower pricing. And as they get bigger and bigger or they get more efficient, they pass it on to their customers via lower pricing. We do the exact same thing. We are riding those exact same cost curves down as they are, albeit, we're behind them because they're bigger than us. And as we get better, as we get more efficient, then we're able to offer that same level of compute for lower pricing so then we incrementally pass it on our customers as well. So when you do apples-to-apples, well, it's hard to do apples-to-apples, but when you compare the 2, we're still more expensive. Right? And so we need to be able to make up the difference in price some way and we do it again, the value, by having higher value around the service and around the support. Right?

When you get a unit of compute from us, you not only get the capital required to produce that unit of compute, but you also get our -- bundling of our support organization. So we bundle those together and sell it to you, again, as a unit versus Amazon who just gives you the compute piece. Now if you want support, then it's -- you have to add that separately. That's how we go to market. We're trying to the market self select between what are the customers or what are the use cases where they value support, where they value access to our support organization versus when they don't need support, where they don't need access to our support organization.

Jason Luce

I would just to add to that. I think, really, its consuming IT as an input. Right space, power cooling, connectivity, servers, firewalls, load balancers, operating systems software, virtualization software, load your codes, run your app, I think that's consuming IT as an input. When you go to Rackspace, you just give us your code and you consume it as an output, very similar to sort of the more developed Software-as-a-Service model. So that's sort of the -- that's the difference between -- well, Amazon's done a great job of abstracting all of the inputs except for the human element. What Rackspace does is, we just add the human element.

Unknown Analyst

Okay. Just a final piece on this recent pricing change. I'm like, you guys cut prices for the CDN product for bandwidth and you introduced tier pricing for a portion of your cloud business. Is that something you expect to eventually for your entire -- for all the kind of services you kind of offer in the long term?

Bryan McGrath

Yes. So again, how we again do it or how we price. The strategy behind it is to as -- like, for example, bandwidth and CDN, right? Bandwidth and CDN it's a cost to us. We have to -- we purchase bandwidth and CDN in order to support workload. But if I can just -- I think we'd be the first to admit, we don't add any value on bandwidth and CDN, right? Our customers don't come to us because of our bandwidth. We simply buy it and we sell it. And so as we get better and better, bigger and bigger and get better pricing, we then -- the strategy is to pass that on to our customers, right? And then to make up all the margin and returns in the business on the support piece that we bundle in together.

Unknown Analyst

Okay. And just moving on to different topic. The OpenStack community, it's seen some pretty decent growth in terms of number of members. Can you talk a little bit about how much of the code you're contributing to it? I understand at one point it was near 100%. And who are some of the other large contributors to the coding need in the community?

Jason Luce

Yes, that's right. So at the outset it was basically NASA and Rackspace. We're happy today that we're actually contributing less than 50%. So the other big contributors, I mean, if you look at the ecosystem, and it's kind of everybody except for a few players. There's an announcement that we're really excited about yesterday. You can read about it in AllThingsD. IBM came out and said they're going to build their entire cloud business based on OpenStack. So this -- we don't think it's going to be a public cloud business, so there's no overlap there. But they'll come up with their own version of the sort of OpenStack trunk code and they'll run their services business around that. We actually think that's actually a really good thing. Because, look, if the world wants to buy IBM's version of OpenStack and run it on their premise, we believe they're going to want that environment to talk to a public cloud environment. And so the natural beneficiary there is us. Because we'll be running the largest public cloud environment in the world.

Unknown Analyst

Just to build on that, how do you guys compete within the -- you spoke a lot about how you compete against Amazon and things like that. But how you guys compete? Is it the same sort of competition strategy within the OpenStack platform? If you get those, then you'll also provide further services?

Jason Luce

Yes. So other companies that are absolutely vocal about having an OpenStack strategy are VMware, Red Hat, HP. HP is already -- they're writing an OpenStack-based cloud and, look, we're very excited when we see that. We're very excited about having OpenStack proliferate as the standard, the open-source alternative on the cloud side. We think that what it does for Rackspace is, significantly it increases sort of the overall opportunities that work for us. I mean, going back 6 to 12 months, I think the world was even more fragmented. As OpenStack has proliferated, we're really happy about that. And there are going to be -- just like Linux, Red Hat's going to run it. There are going to be a bunch of companies that want to run their flavor of it. Same with OpenStack, it's not going to be 1 player. No, we're pretty confident and -- that the world will get comfortable with Rackspaces. Ability to run OpenStack? Because if you just study the performance metrics, I mean, we should have more of them than anyone else because, like I said, we'll be running the largest OpenStack deployment in the world.

Unknown Analyst

At this point, I'd like to see if there are any questions in the audience. All right. I have a couple of more questions just to wrap up here. Maybe we could talk about your data center strategy. You guys are a wholesale consumer of data center space. Who do you guys use? Are there any markets where you're looking to kind of expand into say kind of -- with some additional data center footprint?

Jason Luce

That's right. We are a consumer of wholesale data center. What we try to do just from a sort of a business model perspective is we try to make our data center rent as variable as possible. And to date, we really use -- we have 2 great partners in [indiscernible] and Digital Realty. In terms of regions, our -- we're primarily in Texas today, in Chicago, in Virginia. I think that when we think into the future, where do we want to be? We want to take advantage of favorable practice. We want to take advantage of being able to use ambient air, for instance, because that brings your per megawatt build cost down, so obviously, better economics. Again, something that we can pass on to the customer. So we look at places like Oregon, like Washington, like Reno, Nevada, and, well, I think what you should expect is to see us have these partners build for us in the areas were, again, where we can bring the cost down.

Unknown Analyst

That's all I had. If there are no other questions that will be all. Thank you.

Jason Luce

Thank you.

Bryan McGrath

Thank you very much.

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