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Rackspace Hosting, Inc. (NYSE:RAX)

Q4 2009 Earnings Call Transcript

February 16, 2010 4:30 pm ET

Executives

Jason Luce – VP, Finance

Lanham Napier – CEO and President

Bruce Knooihuizen – SVP, CFO and Treasurer

Analysts

Winston Len – Goldman Sachs

Chris Larsen – Piper Jaffray

Jonathan Schildkraut – Jefferies

Bryan McGrath – Credit Suisse

Simon Flannery – Morgan Stanley

Chad Bartley – Pacific Crest

Gray Powell – Wells Fargo

Steve Salberta – Boenning & Scattergood

Patrick Walravens – JMP Securities

Alex Kurtz [ph] – Merriman & Company [ph]

Frank Louthan – Raymond & James

Eric Suppiger – Signal Hill

Operator

Ladies and gentlemen, good day and welcome to Rackspace Hosting’s fourth quarter 2008 earnings conference call. As a reminder, today’s conference is being recorded. At this time all lines are in a listen-only mode to prevent background noise. After the speakers’ remarks there will be a Q&A session. (Operator instructions)

It is now my pleasure to introduce Jason Luce, Vice President of Finance for Rackspace. Please go ahead, sir.

Jason Luce

Good afternoon. Thank you for joining Rackspace’s fourth quarter and full year 2009 earnings conference call. I’m here today with Lanham Napier, our CEO and Bruce Knooihuizen, our CFO.

We issued a press release after the close of the market today with our unaudited financial results for the fourth quarter and full year of 2009. If you do not have a copy please visit the Investor section of our Web site at ir.rackspace.com, where this call is also being webcast.

The primary purpose of today’s call is to discuss the fourth quarter and full year 2009 results. However, some of our comments today are forward-looking statements that involve risks, uncertainties and assumptions. If the risks or uncertainties materialize or assumptions prove incorrect, our results could differ materially from those expressed or implied by the forward-looking statements and assumptions.

All statements, other than a historical fact are statements that could be deemed forward-looking statements, including any statements concerning expected operational and financial results, long-term investment strategies, growth plans, the performance for market share relating to products and services, any statements of expectation or belief and any statements of assumptions underlying any of the foregoing.

These risks, uncertainties and assumptions include infrastructure failures, the potential deterioration of economic conditions, and other risks that are described in our third quarter Form 10-Q filed with the SEC on November 12, 2009, and our Form 10-K for the year that will be filed on/or before March 1st, 2010.

These forward-looking statements speak as of today. Except as required by law we assume no obligation to update these forward-looking statements publicly or to update the reasons and actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

During today’s discussion we will be using GAAP as well as non-GAAP financial measures such as adjusted EBITDA, our GAAP results and GAAP to non-GAAP reconciliations can be found in the earnings release we issued earlier today. We just posted on our Web site as mentioned previously. Following our prepared remarks today, we’ll open the call for your questions.

Okay, let’s get started.

Lanham Napier

Thank you for joining us today. In a moment Bruce Knooihuizen will share our strong fourth quarter and full year results. But before he does I want to briefly touch on the business, the market opportunity for us and our aggressive pursuit to build upon our market leadership at 2010.

Today, we are the leader in the Hosting and Cloud Computing industry. A massive and emerging sector that’s virtually untapped. During our 11-year history, Rackspace has made significant progress and create a real value for customers, Rackers and stockholders. We have built our company in a sustainable fashion and at this point we have won the first phase of our industry development.

As we work out to our future, we are well-positioned to seize in even merger opportunity. The ongoing trend for business is to purchase IT as a service from a company like ours have accelerated. Because business leaders continue to scrutinize IT budgets and they recognize that an in-house computing infrastructure provide them with a competitive advantage.

Today, more than 90% of corporate computing takes place inside of company’s offices. In the future, the vast majority of corporate computing will occur to a service provider like Rackspace. Why will this happen? It’s pretty simply. We’re cheaper, faster and more reliable and we’re purpose built to deliver technology outcomes. More and more corporate IT organizations are looking for partner to help them run their computing infrastructure.

In the Fanatical Support the Rackspace provides to its customers continue to prove to be a compelling proposition. The size of the opportunity is hard to precisely calculate but we know it’s massive. We estimate there are 50 million servers in the world today and we manage about 0.1% of these in our facilities.

As to demand for computing grows we have the opportunity to compete and serve this market. The shift in the computing landscape will be bigger and faster than the shift for mainframe to client server computing or LAN, or any other recent trend, simply because there is much more computing in the world today. The market opportunity for us is billions of dollars and global in nature.

Traditional technology markets are blurring as companies enter new segments. For example, Cisco has entered the data center provisioning business as part of its strategy to become one of the major systems companies in the world. Google, Microsoft and Amazon all see the potential in the market and are therefore positioning for growth while we move quickly to strengthen our market position.

We have spent the past year preparing for the next cycle of growth. We have a strong position in the market today. Because our specialized focus on Host a computing, our unique culture of customer service known as Fanatical Support, and our unique hyper portfolio approach that combines dedicated Hosting and Cloud Hosting.

During 2010, we will aggressively pursue market leadership in the next larger phase of hosting and cloud computing. We will make discipline investments to reach even greater levels of scale. We are expanding our operational capabilities and giving our Rackers better tools to deliver Fanatical Support to our customers. Rackspace will only be great if our customer say we are. And this brings our Fanatical Support model must continue to serve them well. That does tend to invest in our typical depth with specific technologies of software development.

We are investing heavily in our leadership because we need leaders that have experience and executing to capture large opportunities. And lead a second drive even greater performance for our customer facing service teams. So what’s this all mean? In 2009, given the extreme uncertainty in the economy, we were focused on cash and margins and we proved that we could flex our model.

We showed separated ourselves from the pack and emerge as a stronger competitor. In 2010, we will shift our primary focus to growth. Although we remain committed to enhancing our profitability, we believe that it’s best to focus more on growth this year to increase market share at this stage of the technology adoption life cycle.

Our ultimate rate of growth in 2010 is highly correlated to the general state of the economy. But regardless of the economic conditions we think we will experience market leading growth, boosting our revenue faster than the industry and our competitors.

We are currently seeing certain precursors to faster growth. Our experience has been the customer stop churning and stop cutting their IT expenditures before they finally begin to spend more. In the fourth quarter we saw evidence in our business that churn slowed and that lease will tick upward.

As we think about our aggressive pursuit of market leadership we believe our financial results will be the prudent point to our growth strategy. Our financial results will be the prudent point that there are millions of companies in the world that value Fanatical Support and a world-class customer outcome the Rackspace uniquely delivers.

We are focused on four key components to our growth strategy. First, Enterprises. Our Fanatical Support message resonates with (inaudible) but equally important is the potential cost savings for customers when they select us over companies like IBM and HP. We do not have all the brand strength we would like. But we have a business model advantage over these competitors that can deliver enduring value for customers.

We launched our enterprise sales initiative in April of 2009 and we are seeing some very encouraging results. Second, Cloud Traction. As Cloud adoption accelerates we can deepen our leadership position. In February, we launched a beta version of Cloud Servers for Windows. This launch more than doubled the size of our addressable market for Cloud Servers. We approach our Cloud just as we do our core business.

We will serve businesses willing to pay a premium for a world-class service experience, because they are running an important IT apps in the cloud. The combination of our traditional managed hosting offerings on dedicated infrastructure and our evolving cloud offerings creates a powerful portfolio approach, we call hybrid hosting. This approach is about providing the right fit for our customers. We are able to tailor the right productized IT services to run our customers IT workloads and back all of that with Fanatical Support.

Third, SMBs. These customers will remain a big part of our company’s future. Even if IT spending remains flat for many SMB customers. We plan to improve our core offering and in turn improve our penetration in the segment. Over the next year we plan to further separate ourselves from the traditional competitive set in this space.

Fourth our installed base. In the past, our existing customer base represented revenue growth of almost 20%, net of churn. We stood by our customers in tough times, offering voluntary downgrades while maintaining our pricing discipline. Now, we are beginning to see our customers' needs growth so the investments we made in our customers during a recession is starting to pay us back. This year, with minor installed base, serve our customers better and help reignite their growth.

To successfully execute on our aggressive pursuit of market leadership, we are making investments to make us more efficient. To succeed in the second phase of this industry’s development we need to add more automation to the routine parts of our business. To help our Rackers delivery and better customers service and the situations where matters most.

These investments will be critical to our success and we are committed to making these investments in a profitable way. As always, we will maintain our transparency and provide you with periodic updates of our most current thinking. In early May, we will host an Analyst Day in New York where we share our latest views on the business.

2010 will be an exciting year for us. Our advantage as the world’s leader in the hosting and cloud computing industry and as the only provider of Fanatical Support our role have been embraced by our customers. We have a great position in the market. And we should be able to create lots of value for our stockholders. We can see the opportunity and now we must do the heavy lifting to further strengthen our position.

The past few quarters we had shared some key customer wins with you, so we would like to do it again. Now, for the customer wins. Gucci, a recognized name in design, distribution and manufacturing of luxury apparel and accessories host the technical operations of its order management system and its web site for Rackspace.

Gucci has entrusted these integral parts of their business with Rackspace and has come in a first-handed value of our world-class Fanatical Support. Comsberg [ph], a leading international provider of high technology systems and solutions, recently selected Rackspace as its infrastructure partner for the first hosted deployment of its oil drilling exploration software.

The end user is a major oil company with global operations which was actively involved in proving of selection of Rackspace for its crucial deployment. Comsberg chose Rackspace to host a new SaaS offering because of our speed to market as we deploy the full IT hosting solution in eight business days and our commitment to Fanatical Support. NBCOlympics.com is NBC’s marketing web site, featuring all the exciting news, photos and video of the 2010 Winter Olympics Games. Over the 18 days of the Olympics Games in February this site will be visited by millions of viewers.

NBC chose Rackspace as a managed hosting partner host a secondary infrastructure in the event of a disaster recovery scenario with their primary site. NBC selected Rackspace based on flexibility, ease of doing business, and our ability to deliver the infrastructure within a very short timeframe. Serving (inaudible) across America, Dennis operates more than 1500 restaurants in the U.S. and abroad with a heavy advertising presence during major sporting event, such as the Super Bowl 44. Dennis realized they need a very capable hosting partner.

They chose Rackspace for reliability and the commitment we exhibit to our customers. For Super Bowl 44, Dennis.com sails smoothly. Even during sudden traffics like fault in the airing each of their three commercials, announcing a free grand slam breakfast to America.

I would also like to highlight the fact that we hosted web sites for three other companies that ran Super Bowl this year. Before I hand the call over to Bruce, I would like to close by saying that I am proud of our accomplishments in 2009 and I am excited for 2010. I would like to thank Rackers around the world for their hard work and dedication. With that, I will turn over to Bruce to discuss our financial results. After Bruce finishes up, we will take your questions. Bruce?

Bruce Knooihuizen

Thank you, Lanham. Last February, we outlined three objectives for 2009. First, we wanted to grow our business albeit we expected to grow at a slower rate than in the past due to economic pressures. Second, we want to scale the business and enhance returns. And third, we promised minimal if any cash burn. A year later, as we sit here today, I am pleased to report that we delivered on each of these objectives.

For the full year of 2009, total revenue were $629 million, representing an annual growth rate of 18% which is slower than our historic rates, but a rate we are proud of considering the difficult economic conditions we face. Adjusted for the full year FX headwind of approximately 28 million, our growth rate would have been 23%.

As we exercise financial and operational discipline I’m also proud to report that full year adjusted EBITDA margin was 31.9%, an improvement of more than 450 basis points year-over-year. Lastly, we generated 14 million of adjusted free cash flow, further demonstrating the resiliency of our business model.

Overall, 2009 was a great year, and in a bit, I will discuss our plans for 2010. But before I do let’s get into some detail around the fourth quarter. Beginning with revenue and growth our total net revenue for the fourth quarter was 170 million, up 4% from the third quarter, an 18% from the fourth quarter of 2008. Cloud revenue for the fourth quarter was 17 million, up 12% from the third quarter and almost 100% from the fourth quarter of 2008.

Managed hosting revenue increased to 152 million, up 4% from the third quarter, and 14% from the fourth quarter 2008. Our managed hosting business is benefiting from our new enterprise offering, which has allowed us to move up market and compete and win bigger deals. Lanham highlighted some of these big wins.

Turning to the macro environment and demand, we were certainly excited to see significantly higher levels of economic output in the fourth quarter. We continue to believe our business was highly levered to an economic rebound and these improved economic levels positively impacted our business in the fourth quarter.

First, our churn for the fourth quarter was 0.8%. This is the lowest level of churn we have seen since the fourth quarter 2007 and matches our best levels during 2006 and 2007. During the depths of the recession we stood by our customers, providing them with world-class customer service that we call Fanatical Support. In the down market our Fanatical Support kept churn rate in check. And in the fourth quarter we improved on those rates.

Second, towards the end of the year, collection efforts improved as fewer customers had trouble paying their bills. Both DSOs and bad debt came down from their highs in 2009. In the fourth quarter our DSO stood slightly north of 20 days and bad debt was 0.3% of revenue, both very healthy levels. If the economy remains stable we feel bad debt levels should stabilize in the 1% area. Net upgrades for the fourth quarter were 1.3%, up from 1.2% in the third quarter. Net upgrades are key part of our installed base growth and we continue to be optimistic that if the economy continues to improve net upgrades will also improve.

As a result of our improved churn and slightly better net upgrades our installed base growth for the fourth quarter was 0.4%, the highest level we have seen since our third quarter of 2008.

Total server account increased by 2016 servers to 56,671 servers, up from 54,655 servers at the end of the third quarter. We are getting close to 100,000 customer level as total customers increased by 9,981 customers to 90,925 customers, up from 80,944 customers at the end of the third quarter.

Shifting the profitability on the cost side of the business adjusted EBITDA for the fourth quarter grew to 56 million. A sequential increase of 9% and a year-over-year increase of 31%. Adjusted EBITDA margin, adjusted only for non-cash share based compensation was 33%. This represents an improvement of more than 130 basis points sequentially and 320 basis points year-over-year.

To quickly update you on our progress in our Virginia and Chicago lease data centers we are now making cash payments for five of 10 phases in Virginia, expect to open Chicago operations in the first quarter of this year. As you may recall, lease accounting rules under GAAP require us to straight-line a full amount of rental expense, even though we structured the cash payments to match our expected demand. Because of the GAAP requirement we recognize 2.5 million of non-cash data center rent expense in the fourth quarter and 4.6 million for the full year for the two facilities.

Excluding the non-cash data center rent expense adjusted EBITDA margins would have been higher for the fourth quarter and the full year. In the first quarter of 2010, we expect to incur 2 million of non-cash data center rent expense for these two data centers and 6 million to 8 million for all of 2010.

We remain highly focused and controlled in our costs. And in the fourth quarter we were able to improve our cost of revenue, sales and marketing, and G&A line items as a percent of revenue. In our support organization we focused on improving our efficiency and productivity levels as we continue to reduce air rates and improve the customer service experience, allowing us to serve more customers with the same number of Rackers.

In December of 2009, our front line support Rackers supported 18% more servers than they did two years ago. We also continued to better align sales and marketing spend with demand, improving our acquisition multiple from the third quarter to the fourth quarter.

Let’s move on to capital expenditures. For the year, we spent 186 million. Of this amount, we spent 109 million in customer gear, 37 million on data center build-ups, 15 million on office space, and 25 million on capitalized software and other.

Our annualized return on capital for the fourth quarter was 10%, up from 8.6% in the third quarter. However, that number would have been higher excluding the fourth quarter non-cash rent expense. As we think about returns going forward every new server added to a customer’s dedicated environment has more profit than the one before because of the economies of scale, the account management level, and lower sales and marketing expense.

Even greater economic exist in the cloud, because in the long run, we believe we will get higher revenue per server on a less expensive box, and those assets will have a longer service life. As the mix for Rackspace’s total server shifts more meaningfully toward cloud servers, we expect our return on capital levels to grow.

Net income for the quarter was $9 million, up 32% from last year, and 19% from the third quarter. For 2010, as we position our company for the next cycle of growth we expect to spend between 185 million and 235 million in capital expenditures. Approximately, 75% of the total projected capital expenditures are for customer gear which is virtually all success-based, specifically, we intend to spend between 140 million and 160 million on customer gear.

Around at our capital expenditures we expect to spend 10 million to 20 million for data center build outs, 10 million to 20 million for our office build out and 25 million to 35 million on capitalized software and other as we continue to develop proprietary software manage tools for our managed hosting and cloud businesses.

We also recently hired what we think are the most capable and smartest minds in the data center space to enhance our existing footprint. This is an investment for us as we continue to grow our operations and bring on additional capacity.

Our balance sheet remains strong. We ended the full year with a 125 million of cash and cash equivalents in excess to an additional 194 million under our revolving credit facility. Our total debt outstanding including capital leases was 167 million, and net debt was 42 million. Net leverage at the end of the year was 0.21 times.

We are pleased with the business performance in 2009, amid the toughest economy in seven years we delivered on the promises that we outlined last February. As we think about 2010 we’re excited about the opportunities from both our managed hosting and cloud businesses. We have made significant investments over the past year.

We bolstered our management team, developed an enterprise offering and transformed the cloud. These investments and others have earned us the number one spot in the managed hosting and cloud computing market, thus positioning us the next cycle of growth. To close, the message I hope you walk away with is this. One, we believe we grew faster than the market in 2009. Secondly, normalizing for service credit and FX we grew fourth quarter revenue sequentially at a rate faster than any other quarter in 2009. We expect for installed base growth to come back with the economy. We should provide to boost the sales this year.

We continue to show that there is leverage in this model. We posted fourth quarter adjusted EBITDA margins of 33% and that percentage includes the non-cash rent expense associated with our Virginia and Chicago lease facilities. We have positioned well to accelerate growth if the economy cooperates. And finally, we remain committed to profit but have shifted our priority to grow. With that we are now ready to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you (Operator instructions) First, go to Winston Len with Goldman Sachs.

Winston Len – Goldman Sachs

Thanks for taking the questions. Lanham, maybe just start with a strategic question around the cloud. We have seen Amazon, Microsoft and other players (inaudible) offerings, but less focus on customer support. So what do you feel confident that your customer support centric approach is the right one? And maybe you can share some data points around what your cloud customers are seeing in terms of customer support? And then I have a follow-up question.

Lanham Napier

The cloud represents a huge opportunity. We are taking part in the service revolution within technology. The cloud and the adoption of that technology set accelerate this revolution. As we won the first phase of our industry, we differentiated around being a service leader. It’s about Fanatical Support; it’s about providing a world-class service experience to our customers. And so, this service revolution is taking place, it’s going to fundamentally change how business has consumed IT.

The new entrants of Amazon and Microsoft into the marketplace validate the size of this opportunity. All of these companies are going to have to find their point of difference in the marketplace. So as we think of our point of difference and what we’re trying to build, we’re trying to build one of the world’s greatest service companies, we’re trying to build the greatest service company in tech. Fanatical Support is a key part of our strategy to do it. So we believe the point of difference we’ve achieved in our traditional managed hosting offering, around Fanatical Support and being the service leader, is entirely consistent with the path we’re on now as we extend into the cloud market itself.

The new entrants have come in, for example, Amazon has cut its price, and their price move has not had any impact on our take rate, in our cloud. Okay? So with this fuzz that we’re serving a different customer. When we talked on earlier calls we discussed the situations in which we are very competitive and the right fit for a customer. These situations are when we’re servicing a business and that business want a service experience. That business is willing to pay a premium for that service experience. Another key attribute of the situations where we’re good is when we can bring our portfolio approach to it. So it’s a combination of our traditional managed hosting offerings along with our new cloud offerings as a hybrid solution to customers, this is when we’re good at this.

So, right now, we have a portfolio advantage on those pure cloud only players, if the cloud market continues to develop we believe that that market will segment and there will be a segment of businesses that will have a world-class service experience that are willing to pay a premium, there will be a segment of that market, they just wants a commodity experience, and we are not fit for that segment. If people want commodity experience they are not to call Rackspace. We’re about providing a world-class service experience that we call Fanatical Support so that will remain our point of difference.

Winston Len – Goldman Sachs

Great. And then maybe just one on installed base goes. Your churn at a two year low and net upgrades are trending up. So how should we think about growth into 2010 given the positive trends here?

Lanham Napier

Let’s talk a little bit about what’s causing this change in the churn rates and installed base growth rates. Last year, we made a conscious decision, which we communicated on these calls that we’re in a standby our customers through the tough times. So we helped customers right size their solutions with us, so that they can really get a high utilization rate on the services we were providing now. What’s happened here in the back half of the year we have seen our customer scores in terms of quality, service we provide, customers client, we have also seen the economy start to firm up, so in looking at the metrics, we can see where the churn rate has declined, this is a function of we’re serving them better and their businesses are doing better.

You see the economy firming up, which embosses part of the call, we reference the DSOs and how bad debt have fallen. So you have a macro factor, your things getting better for our customers, you have a specific factor to Rackspace and that we’re servicing our customers better. So, what we see here are some of the precursors of demand, in our experience now, building the company for 11 years, it’s that coming out of a tough time first people will stop, reducing their budgets, and their IT budgets will stabilize. Then they will start thinking about how to get more out of what they have, and then they will start thinking about how to spend more with us.

So we see some of those demand signs, some of those precursors already assemble, we also have some data from the fourth quarter that indicated our lead flow, started to trend up as well, so we don’t have everything lined up yet, but we’re starting to have some major pieces fall in place.

Winston Len – Goldman Sachs

Great, thank you.

Operator

Next, go to Piper Jaffray, Chris Larsen

Chris Larsen – Piper Jaffray

Thanks for taking the question. Questions on some margins, first, to Bruce, I want to clarify the margins on the non-cash, if I added those back your margins were about 34.5%, and then as your revenues grow, the margin impacts become less and less meaningful. And I wanted just to make sure I’m thinking about that right, you have the full run rate now for the non-cash?

Bruce Knooihuizen

Yes, in terms of that non-cash cost element, you’re absolutely right. As we go forward, less and less of that will be non-cash. But, keep in mind that as we move forward as well, the way we have structured these deals was to have the cash increase over time, as our demand increases, and so there is a match in between revenue and the cost as we go forward.

Chris Larsen – Piper Jaffray

Perfect. And then, Lanham, as you shift now more towards growth can you talk a little bit about the trade-off between what that might mean to revenues and rather to margins and what sort of revenue acceleration to be starting to see margins either have come down or how we want to think, how we want to phrase up?

Lanham Napier

Sure, a year ago, when we set forth our plan for 2009, we prioritized profitability and cash, higher level of the growth. A year ago, things were crazy and uncertain. And so, we really wanted to convey to our investors that we were focused on the margin potential of our business model. Okay? As we sit here today, we see some precursors to meet up demand that we believed harbingers of higher growth ahead of us. That not of here yet, it’s not aligned up but we can see this opportunity firming.

So as we look at that opportunity and we think about separating ourselves from our competition we want to make sure we have market-leading, industry-leading growth within our service sets. So we prioritize growth ahead of profitability this year. We are able to do that because, last year, we made great progress on profitability. We’re proud of the work that Rackers did in the improvements we made in profitability. So, we certainly believe that we have additional upside in our margin structure; we believe as we serve customers better, there’s a sweet spot where we can actually serve them better, create a more valuable experience for our customer and create a larger margin for our investors. It’s just right now that is a secondary concern relative to the growth opportunity in front of us.

Chris Larsen – Piper Jaffray

Okay, thank you and then just one more if you don’t mind. Bruce, is there any change in the cost of the customer gear per server or how would you want to think about it, as you add more capabilities we think that the dollar spent per number of servers added is going to go up or down or any dramatic changes there?

Bruce Knooihuizen

In terms of the cost per server we’re not seeing significant changes in the cost per server, but as we talked about, there are more different economics in terms of the cloud compute versus our managed hosting business, where we can be more efficient with the cloud, much like our customers. And so over time, we will see more and more of that impacting our financials, certainly, as we start gaining to scale on that environment.

Chris Larsen – Piper Jaffray

Perfect, thank you very much.

Operator

Jonathan Schildkraut with Jefferies. Go ahead, sir.

Jonathan Schildkraut – Jefferies

Just a couple of questions. First, let me circle back on to some of the cloud items that were asked earlier and just to make sure I get this right and understand the company strategy. Lanham, as we look at the cloud market and cloud has become probably too big a definition for what it is, but it shared infrastructure we see a bifurcation. Part of that is called on-demand access to infrastructure, which is more of that Amazon model that you noted before.

The other part of the bifurcation is essentially managed hosting in a cloud. And I define that as different from dedicated, which is the equipment piece there. I understand that going forward it would be Rackspace’s position to try to dominate the managed hosting in a cloud environment, but to-date, it seems like the business has been scaling more on the on-demand access to infrastructure, so it’s a little bit deeper there.

Additionally, it does seem like the growth slowed a little bit in the fourth quarter and I am wondering if you’ve gotten a business to scale from a perspective of enough customers to test your infrastructure and also may be where you are in the profitability in order to allow you to go back and implement the systems around the cloud in order to be profitable on longer-term, thanks.

Lanham Napier

Okay, thank you, Jonathan, those were good questions. We agree with your market segmentation and the bifurcation between on-demand access to base level infrastructure versus a managed hosting experience in a cloud. When we talk about our strategy of owing to differentiate on servers and the cloud, we are squarely in the long-term think it about that managed hosting type experience within a cloud technology paradigm, just to clarify the first part of your question.

Some of our early offerings in the cloud have been more on target with the on-demand access piece. So, for example, you go through our cloud service set today, our cloud servers offering is more akin to the on-demand access piece than it is or traditional managed hosting experience in a cloud. We do run within our enterprise to specifically a number of private clouds for the customers and so there it is much more a traditional managed hosting type, servers experience on a cloud infrastructure.

Going forward, in the investments we are making today in our cloud, are all about increasing the service levels in our cloud offering. So, if you migrate from cloud servers and the cloud sites, you will see there we have a pretty well-managed stack. It’s not all the way back to the service levels experienced in managed hosting, but it’s certainly a step above, some of our initial work that we did in our cloud service offering.

With respect to scale, as we think about our infrastructure we’re making the investments in that infrastructure to run our business of what we consider to be a web scale type level. Recently, we announced hiring of a new Chief Operations Officer, Mark Roenigk. Mark joined us from eBay and before eBay was in Intuit and has had a lot of experience in running infrastructure of those companies as well as managing their operations and supply chain.

So we see ourselves as a company at a magic inflection point here, where we continue to grow, we have a chance to really differentiate ourselves as a service leader within the service revolution in tech and that our infrastructure added a web scale. So with the growth we’re experiencing in our cloud services, specifically, we have a lot more scaling to do there. We are still in the early innings of that developmental gain.

Jonathan Schildkraut – Jefferies

All right, great, thank you. And just one more housekeeping item, if I may. Last quarter, you gave us a sense as to customers, which were at the low end the transition from the dedicated platform or to the cloud hosting platform, I was wondering if we might get a similar number this quarter, please?

Bruce Knooihuizen

Yes, the number still remains very small and it’s really immaterial in terms of our total number, but while that number is small, I know some people are concerned about the consumption of cloud into the managed hosting, what that allowed us to do is to gain about 10,000 other customers who otherwise won’t have access to, and so, our customer base is significantly larger even though a immaterial amount have migrated over from managed to cloud.

Jonathan Schildkraut – Jefferies

Bruce, I fully understand that particularly from a revenue perspective, having walked through the economics, but I was just trying to get a sense that if I netted out the transition customers are to get a sense of how many customers who are actually added on the dedicated side? That’s all.

Bruce Knooihuizen

It’s less than 200 that migrated from one to the other.

Jonathan Schildkraut – Jefferies

Thank you so much.

Operator

Let’s move on to Bryan McGrath with Credit Suisse.

Bryan McGrath – Credit Suisse

Hey, guys, great quarter. Just, Lanham, question about some of the pre-cursors to growth, you mentioned. With more and more interest in demand from larger enterprises, larger businesses, do you get longer sales cycles and therefore have more visibility into what future new deals might be coming online?

Lanham Napier

Good question. So first let’s touch on some pre-cursors, the pre-cursors specifically are the lower churn, the uptick and lead flow, the economy stabilizing in our enterprise opportunity, which we have identified. The sales cycle that we’ve experienced in our enterprise initiative, which we launched last April, is a longer cycle than our SMB business. So think of our SMB business as the higher transaction, higher volume economics. That SMB business gives us a wonderful operational base, upon which to add and tailor our services for enterprise customers.

So the sales cycle is longer, that gives us a better visibility into that particular customer set, create to understand what’s happening there and when we think about our enterprise market opportunity, we really see it is we have a business model advantage over HP and IBM. And what happens here is we are purpose built to deliver the services to run this web infrastructure, we’re productized whereas in HP and EDS and IBM, their entry in to this is really, it’s legacy stuff that started in the original outsourcing business where there are a job shock. And they will run here IT from A to Z. We don’t do that.

So, for the services that we can provide is productized, it’s a better quality experience and will save you 50% relative to what those people offer. So we’re looking back to you for Rackspace, is that we can get a compelling price, deliver Fanatical Support in a way that is responsive, and expertly delivered, and also create an all time margin for our company. So that what we have here is the confluence of some market factors that just make us a great pick for those customers and so as you mentioned if the longer sales cycle we’re chipping in a way at it, we bring our lunch box with us every day and get to work on this stuff.

As we go to work on winning these customers, our approach is going to be very different than have the outsourcers originally approach this market. There’re going to be trade-offs we make in terms of (inaudible) versus our centralized volume model to make sure we protect our customer acquisition costs. We cannot allow ourselves get upside down and acquisition of these new customers roughly forfeit that margin opportunity, I just talked about. So our desire here is, how do we bring our productized approach in a way that resonates with these customers so that on our service set, their stocks off and they’ve given us 10 out of 10, at the same acquire down in an economically advantage way for us.

Bryan McGrath – Credit Suisse

Got it, thank you very much.

Operator

And now, Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley

Thank you very much. Good afternoon. You talked about some of the pre-cursors to demand, can you talk about what you are seeing on international markets versus the U.S.? And then if I look at the customer gear CapEx guidance, you’re guiding up about 38% at the mid-point. Is that a pretty fair sort of proxy for what you are expecting in terms of incremental demand and how tight is the relationship between the customer care and the sort of the revenue we should be seeing next year, thanks.

Lanham Napier

Sure, this is Lanham, I’ll take the first part of the question about the international feeling today and then I’ll let in, Bruce, handle the CapEx. From an international point of view, I would say, first, on the country where we operate, where the U.S., Western Europe and Hong Kong. When you go across those markets, the story between them is really pretty similar. Now Hong Kong is significantly smaller. So when you look at percentage growth rate that notched up the small numbers tend to afflict those percentages. So it’s a small part of our business, but from a percentage point of view, that’s going to give that analysis and advantage toward Hong Kong. Generally speaking, we are seeing very similar attributes across the different geographies in which we operate.

Bruce Knooihuizen

In terms of the customer gear CapEx, you’re right; there is a correlation between customer gear and our growth rate. Now, as we said before, we don’t give guidance, but certainly, customer gear is very success based. There are a lot of factors that can influence the growth rates. How quickly we deploy the equipment when customers come on board. The recycle rate we have for all the equipments, the upgrades that some of our customers have. And so, you have to look at all those factors, but, generally, the growth rate will drive the amount of customer gear CapEx that we have. Now, in terms of your growth rates, I’m not going to comment on those, but certainly, you know, historically how our CapEx has gone based on our growth rates.

Simon Flannery - Morgan Stanley

Okay, is there any sort of first half, second half way in to the CapEx or is the fairly smooth for the year?

Bruce Knooihuizen

The customer gear is the biggest item in our CapEx and it just depends on the growth rates and how they progress throughout the year. If they are relatively flat through the year, I’d say that our CapEx would be relatively flat, to accelerate or decelerate that will impact.

Simon Flannery - Morgan Stanley

Thank you.

Operator

Let’s go to Chad Bartley with Pacific Crest now.

Chad Bartley – Pacific Crest

Hi, thanks a lot. Wanted to follow-up on a margin question that was asked earlier, I know you want to stay away from specific guidance, but given the focus on growth this year, directionally, can you talk about EBITDA margin? Is it all realistic for that, stay flat or should we definitely expect to see that decline in 2010?

Bruce Knooihuizen

Again on just marrying on some of the things that Lanham had mentioned that, we certainly believe, we still have room for improvement on the margins where they are today. Likewise, lot of the improvements we’ve made historically had not come because sales have declined necessarily, but we’ve instituted a lot of programs and processes and improvements that will help us when demand scales going forward. Ultimately, we are very focused on profits margins. Big part of that would be influenced on just how robust the economy is though.

Chad Bartley – Pacific Crest

Sounds like you guys think the economy is improving or a little bit stronger in 2010, so again I’m just hoping to get some color, direction and what you might think margins can do just to avoid any confusion?

Lanham Napier

I think what we’re trying to convey to everybody is that a year ago, we wanted to clearly state that it was about margins and cash and then we wanted to grow despite the world shrinking. This year, what we want to convey to people is that we want to pursue market leadership. We feel like we’re at a point in the development of our industry, where leaders are going to separate from the pack. We want to be one of those leaders. We think there is still upside in our margin structure, but we are not going to focus on increasing our margin this year like we did last year.

Our number one priority is going to be to increase our separation from competitors to build a differentiated position and so ultimately our strategy here on how we build the business is going to differentiate on Fanatical Support, we’re going to bring a portfolio approach to the marketplace, and if we’re right, all this stuff is going to show up in our financials, improve out that we pick the right strategy.

Chad Bartley – Pacific Crest

Okay, thanks very much, guys.

Operator

At Wells Fargo we’ll go to Gray Powell.

Gray Powell – Wells Fargo

Hi, good afternoon, everyone. Thanks for taking the questions. I just have a few here. What kind of impact could Windows and the Cloud have on new business wins in 2010, and at what point, do you think it actually becomes relevant to driving new business?

Lanham Napier

Okay, do you have more questions or was that a, you’re going to give me four, five or something?

Gray Powell – Wells Fargo

No, I guess, my other questions were more of a follow-up, I was just trying to think about the timing of clouds for demand in 2010 do you expect it to be more evenly loaded throughout the year or back end loaded?

Lanham Napier

Okay, so why don’t I take the first question here around the cloud with respect to our Windows launch, launching Windows in a cloud basically doubles our addressable market, but to this point our public cloud has been driven by the Linux platform, our private cloud which we offer enterprise customers is a VMware based offering. So what the Windows Cloud does is really double our addressable market. So this is something that certainly within that product set, if we get it moving the way we wanted to move it will have a direct and meaningful impact on our traction in the cloud this year.

Bruce Knooihuizen

Looking at the overall demand, when you think about our business, Lanham just talked a little about the impacts that Windows could have on the demand. On the managed hosting side we really have two components. We have the new customer segment as well as our installed base. And if you think back in to last year, our installed base for the most parts of the fourth quarter was relatively flat. So we didn’t get a lot of the growth that you saw last year from our installed base. We believe that that’s going to be very closely tied to the economy. That’s our expectations.

And so, as we’re looking now into next year, you need to think about what you believe the economy will do. If the economy grows stronger throughout the year, then our expectations would be that our installed base would grow throughout the year. If you think the economy is just going to come out blazing from the beginning, then it is probably be a little bit more even throughout the year. And so that’s how we look at growth and how we think about growth and how it relates to the economy.

Gray Powell – Wells Fargo

Okay, great, that’s all I had. Thank you very much.

Lanham Napier

Thank you.

Operator

Let’s now go to Steve Salberta with Boenning & Scattergood

Steve Salberta – Boenning & Scattergood

Hi guys, you mentioned that churn is back to the 2007 level, but when we go back to that time, you were doing much better than 2% monthly net upgrades. Would you expect assuming a positive economic environment that you can get back to that sort of number in 2010?

Lanham Napier

Okay, short answers. We still hope so. If our experience of serving customers is that what happens first is things stabilize. IT budget firm up churn declines and then spending starts. Now the take rate of that spending is driven one part by what we can offer our customers, the other part is what’s going on in their business. So if you read some of the analysts reports that stuff out there, they talk about IT budget starting to expand this year in 2010, if that comes true, then yes, you will see the net upgrades lines start to increase, how far it will increase I think really depends on the strength of that recovery in the expansion of IT budgets.

So the way we see things today is the middle of last year, the middle of 2009 we were at the bottom. We had churned tat to a higher level than we have it today. We’re starting to see the churn improve; we’ve seen DSOs and bad debt come back to a lower level. This has resulted in the first stick upward nm our install base growth in a meaningful manner in quite a while. So, if this rebound continues to strengthen and firm the next step that we believe would happen is we will start to have additional spinning out of our base, so you will see the net upgrades line increase.

Steve Salberta – Boenning & Scattergood

It sounds like so far in the year you’ve kind of seen that things build from the fourth quarter level, is that fair?

Lanham Napier

You’re talking about the Q4 of 2009…

Steve Salberta – Boenning & Scattergood

Yes, Q4 2009, so what you’ve seen so far is you are seeing the strengthening in net upgrades and the momentum in churn continue?

Lanham Napier

Well, we don’t really want to comment on Q1 2010, what we’re trying to convey right now is that through the back half of '09, in the calls, we told investors that things felt better and sure enough they not only felt better, they got better and so that’s what, that’s how we ended last year. Because of our success last year we think we can reorient our priorities around growth versus margin, we think this is a really important development because our industry is a place where we believe there’s going to be competitive separation that some of our traditional competitors will not make the leap to this service revolution in technology, we want to be a leader who seizes the service leader point of positioning in the prospects mind in the market. We’re trying to do here is reorient our thinking and at the same time convey to people that we’re business model focused.

Steve Salberta – Boenning & Scattergood

Okay. With respect to the managed hosting customer base, what should we think about going forward? Is this the right level, where you bring in more larger enterprise type customers than smaller customers that lead to kind of just hover rate around here or as with the economy improving should we see the total managed hosting customers begin to grow?

Lanham Napier

Yes, great question, okay, so with our portfolio approach that we set for in 2009, within our traditional managed business, we’re moving up the stack and sought more complexity. So this board self out that we look at the average revenue per customer managed, it grew during the year. We also took more simple IT workloads and wanted to migrate that to the cloud, because we can serve those customers better in the cloud, and we believe in the long run, we will have a better economic outcome for a company serving them in the cloud. Now, if you look at our customer count today and you see our managed hosting customers 19,304, relative to the total number of SMBs out there, 19,304 is a pretty small number.

And so as we look at what we’re going to do, we’re going to aggressively pursue our enterprise growth opportunity. We also talked in our prepared remarks about reinvesting in our traditional SMB offer to try to reignite that growth as well, so we think there is more progress to be made in the SMB marketplace, we think the portfolio approach combining cloud with managed there, will really help us further penetrate that market. All right? So what will happen here on our customer counts is that over time we’re going to have customers subscribing to what our traditional managed services as well as today we’re classified as cloud services.

So we’re going to have a blurring on the lines here so that crisply, breakout a pure managed customer versus a pure cloud customer, our ability to provide that data to you, will start to decline over time, as our portfolio really catches on. So to give you a good picture of it in managed, we’re going to keep moving our market where and win customers, we think there’re actually more SMBs to win as well. If SMB, IT spending comes out we think the combination of our cloud service offering, our managed offering is going to be very compelling for SMBs.

Steve Salberta – Boenning & Scattergood

Okay, my final question guys is, with respect to employee headcount addition in 2010. When I think about investments you have, software that kind of rolls into the P&L over time, capacity you added a bunch of it at the end of '09 and utility expenses are kind of things that are success based so they come pretty coincident with revenue growth. So really the remainder there is employees. Can you add employees best enough and what is your goals there in terms of additions throughout '10?

Lanham Napier

Okay, when we think about Rackers, we think about this on a couple levels. As we screen folks the first thing we screen around is values, in an aptitude and attitude to serve, then we want to train the technology skills that they need. Okay? And so sometimes we can find hardcore technical folks that share values and have an attitude to serve already, other times we have to train more on the technology piece of it. Our ability to attract the Rackers we need, to build the business has never been better. So an example there would be Mark Roenigk, our new CEO, who is freewheeling from the West Coast to San Antonio, Texas.

This demonstrates our ability as a company to recruit highly talented folks from very successful companies to volunteer their best for our cause. So we feel like our ability to attract talent has never been better that we’re a preferred employer in the markets in which we operate and so we have a high degree of confidence that we will be able to continue to hire people.

In terms of our business model, Bruce, had a reference in his language about Rackers being able to support 18% more devices on a front (inaudible) relative to a year ago. So the other thing where being possible about is that we improve our operational effectiveness, we get efficiency gains out of the work we do for customers. So this is where quality makes all the difference in our processes.

The better we serve customers in some ways that prevents further rework, it presents additional work that we have to go do, so we think when we have the ability to hire the right people, we think we still have upside and efficiency effectiveness gains in terms of how we run the business so that we can continue to get additional leverage in our model. So between those two, we feel really good about our position regarding bringing in our new Rackers to build the business.

Steve Salberta – Boenning & Scattergood

Great, thank you.

Operator

And now let’s go to Patrick Walravens with JMP Securities.

Patrick Walravens – JMP Securities

Congratulations, guys. I just want to, you get over-satisfied, just wanted to see if I am thinking about this right. So your average revenue per cloud customer dropped a little bit from around, $250 a quarter to $240 a quarter, and then on the managed hosting side actually took a nice step up from, if I’m doing my math right, something like $7,200 to $7,900, so do those trends continue that your revenue per managed hosting customer keep moving up market, is that getting bigger and on the revenue per cloud customer, and that’s a competitive space, does it keep going down, how should we think about that?

Bruce Knooihuizen

Pat, this is Bruce, what we really think about is in our business we have servers and capital and so what we try to do is figure out the most efficient way and effective way we can deploy our capital and provide a service that customers really love, be a Fanatical Support. And so when we start looking at some of these statistics we really focus more on revenue per server than customers. Certainly, when you thinking about our revenue, if you try to correlate our revenue to the number of customers, it's going to be all over the board. If you were to correlate it to servers, this probably a 97% correlation between the two. And so, for us from a capital utilization, from a capital deployment, and from an ability to see where our business is going, the revenue per servers probably a better measure.

Patrick Walravens – JMP Securities

Okay and do that work on the cloud side too, though?

Bruce Knooihuizen

Oh, absolutely, absolutely, because when you look at cloud, for instance, the cloud customers are today on average bring us less revenue per customer basis right. But we can pull a lot of cloud customers on a piece of hardware and so that means a hardware can afford multiple cloud customers where that same piece of equipment may only be able to hold one, one managed customer. So if we translate that to what’s the actual revenue per server, when you think about unit economics in our business, that’s a much more compelling and probably more important statistic thing for you.

Lanham Napier

We talked earlier about the segmentation of the cloud, how some of our early success there has been more than what we talked about the on-demand access to infrastructure versus the managed hosting servers experience on a cloud, as we roll out additional services into the cloud, we will be able to increase our price point on those services to customers.

Patrick Walravens – JMP Securities

Okay, thank you.

Operator

Alex Kurtz [ph] with Merriman & Company [ph], go ahead please.

Alex Kurtz – Merriman & Company

Yes, thanks for taking the question. So just on to the thought around margin for 2010 and sort of where you guys are investing, as you move upstream and some enterprise customers land up, you think that you’re going to be getting a grass with some of the pricing because those are typically, from a hardware system perspective pretty aggressive sometimes with larger accounts, what do you think the investments really going to come in the form of sales and marketing and expanding footprint in sales, sales force capabilities there?

Lanham Napier

Yes, in terms of expanding our enterprise business, pricing, because we’re already at a discount to some of our competitors there, HP/EDS and IBM I don’t think pricing is a big lever. I believe that as our branch strengthens we will able to raise our price in that market. So in terms of acquiring new customers I think it’s more about managing our customer acquisition cost, maintaining the discipline with respect to how we price stuff and building now those capabilities to win more enterprise customers.

Alex Kurtz – Merriman & Company

Yes, just on that point, you talk about moving into the enterprise gradually, I’m just trying to figure out a way as to quantify what you mean by that, is that more sales force, more technical training, so what is that, what does that mean and sort of how that flows back to the EBITDA margins?

Lanham Napier

Okay, so I’ll draw some comparisons for you. The traditional approach is to have a lot of hands of freedom in the industry, that create a lot of account coverage, in golf games etc., Our approach has been more of a volume operations model so where we have a centralized sales force and then we will go visit customers and geographies as necessary as part of helping customer discover that we’re the right partner for them. We’re going to be much more, much closer to our traditional roots on this. Will we invest in some hand of freedom in the industry resources? Yes.

But we’re talking about minimal investment there and trying to leverage the central investment that we already have. We’re not going to go to a high cost direct model. There’s a lot of war stories and data out there about the effectiveness of those models. The leverage that we bring to it is our service experience and our volume mass prioritized shop and so can simply cover more grounds essentially than if we can for actually out what hand of freedom in the industry. A question earlier we had was we experiencing an uptick in our average revenue per managed hosting customer. What’s doing it? It’s enterprise customers.

We’re actually selling them more services than we do a traditional SMB customer and with those services it is a positive impact on our margin serving those customers. So as a customer expands their footprint with us we have economies of scale around account management and technical services we provided them. To do it for incrementally a few more servers, for example, we have a nice incremental margin on that additional service to the customer.

Alex Kurtz – Merriman & Company

Okay, got it, thank you very much.

Lanham Napier

Yes, thank you.

Operator

Let’s now go to Frank Louthan with Raymond & James.

Frank Louthan – Raymond & James

Hi, great, so you mainly to make some minimal investment in some, some industry, what other operational changes do you think that you’re going to need to make to get to the next phase in the cloud computing and how do you think that’s going to affect your organization, are these more gradual changes, are you looking to further sort of broader operational changes to serve these larger customers?

Lanham Napier

Okay, so, are you still there?

Frank Louthan – Raymond & James

Yes, I’m here.

Lanham Napier

Okay, sorry, I heard a phone hang up or something like that. So when we talk about enterprise there is this investment set around customer acquisition, which we talked about, the key here is we have to remain a productized service delivery model. If we deviate from that and become a job shop we will wreck the advantage that we have.

The reason we can serve these customers so well at high quality levels, at high customer outcomes, and still make a great margin for us, is because we are productized, that for us the services that we provide that will just knock out as if it’s a factory. And we think ourselves as a lien services factory. So this gives us a tremendous advantage relative to the incumbents there, IBM and EDS.

So I think with the investments there, it’s about extending this model, not deviate from it. It’s making it more powerful and figuring out better tactics and approaches to customer acquisition is still fall within or pricing discipline. When you get into the cloud and the investors are making there, most of these investments on the people side, tend to be in development activities. This is where we start to create additional intellectual property within our business. Because as we look at building out our infrastructure, the truly web scale, and running a larger and larger percentage of apps out there, there’s intellectual property opportunity for us. Most of the traditional technology solutions out there were not conceived or architected with an idea about the cloud of mind.

So part of the service revolution that’s taking place in technology is companies like Rackspace, it does providing customers access to this on a web scale basis, even though they may only consume is perceived to be a small portion of the cloud available. So the investments here would be in the form of people with IP that we create. There may come a time where we’re investing in sort of an infrastructure systems as well, to better manage this.

Because we want to make sure that we maintain our productized approach here in the cloud so that we have this infrastructure in the cloud today we’re going to add to it additional service sets, we’re going to bring our portfolio to bear, so depending on which work load the customers running one of it maybe in the cloud, another maybe on a traditional dedicated environment. We wrap Fanatical Support around all of these to provide them a world-class experience.

Frank Louthan – Raymond & James

Great, that’s helpful. You talked about some of precursors demand here. Where do you think you are relative to the competition and seeing some of the shifts are you ahead of them or are you seeing some others move in, move up market in this way that you’re trying to keep up with or how should we think about that from a competitive standpoint?

Lanham Napier

I will confess that I do not extensively study our competition. I am much more concerned about what we do and how we serve our customers than what our competitors are doing. I think that we control our destiny in our own hands. So my first obsession is how we’re serving our customers, what’s our growth rate. We absolutely check how we’re performing relative to others in terms of our traction. So whatever the benchmark is for our industry our expectation and desire is that we will be higher than that benchmark for growth. We fancy ourselves and believe that we are the market leader that we are seizing the service point of difference in the marketplace, and therefore, within those segments we expect to grow faster than our competition.

Frank Louthan – Raymond & James

Okay, great, thank you.

Operator

Let’s go now to Eric Suppiger with Signal Hill.

Eric Suppiger – Signal Hill

Good afternoon.

Lanham Napier

Hello.

Eric Suppiger – Signal Hill

Hey. So on the CapEx, on the customer gear, can you remind us is it 10% of your revenues that we can assume goes to maintaining customer gear and then everything above that would be the incremental growth?

Bruce Knooihuizen

We have sort of this crazy little formula that’s not a precise formula but it seem to hold true in the past that about 10% of our prior years revenue was for maintenance type capital and then roughly 50% of the incremental revenue, would be used for customer gear. And there’re a lot of factors that influence that. If you look over time, and try to follow that rule, you will see that our incremental spend went from the high 30s to low 50s% level. And so, there are a lot of factors. When I mentioned earlier about things like our ability to recycle the equipment, how quickly we can get back deploy in our data centers, the prices we pay for equipment, those are all influenced ultimately how much customer gear that we end up spending or buying.

Eric Suppiger – Signal Hill

The simple math is 150 over 109s; high 30s, and then you are saying that the incremental when you factor in the incremental piece, the incremental growth is more in the 50s% range, is that right?

Bruce Knooihuizen

No, no, no. I’m not sure what that question was, but let me sort of go back through the Quick and Dirty formula. If you try to figure out how much CapEx our company may require in terms of customer gear, the Quick and Dirty formula is 10% of the prior year’s revenue would equate it to the customer gear that I would call or consider maintenance CapEx. And in addition to that we’ve got new revenue incremental revenue, whether it’s coming from existing customers or new customers. And that roughly you could look at incremental revenue expectations you have and hereby a factor of from $0.40 to $0.50.

Eric Suppiger – Signal Hill

Okay, all right. Second question on the sequential growth did you give us what the sequential growth would have been for Q4 on an adjusted basis for FX? Or put simply, what was the incremental benefit from foreign exchange?

Bruce Knooihuizen

Okay, it’s the adjusted for FX sequentially; the fourth quarter would have grown about 5% over the third quarter.

Eric Suppiger – Signal Hill

Okay, and then lastly, on the margin front, it sounds to me like there are some areas of investment that you’re going to be making going forward, but I don’t hear you’re suggesting that we’re going to go back to historical levels in terms of sales and marketing as a percentage of revenue and it doesn’t sound like we’re going to see a notable degradation in terms of gross margin. So I acknowledge that you’re going to be focused on growth, but it doesn’t sound like we’re looking at EBITDA margins eroding so much as probably maintaining these levels. Is that the way to think about it?

Lanham Napier

Couple different contextual points here for you. With respect to growth anything we do we’ve to maintain our discipline. We will make investments so long as we believe we’re going to get a good return out of it. So that what we’re thinking about as we look at the marketplace is when we look at the play book from last year, we executed really well increasing our markets and it was a priority for us. A year ago, things were highly uncertain, there were dark clouds over the economy, so we were very focused on flexing our business model to increase margin. And with growth a secondary concern. This year we’ve just inverted that.

When we think about our plan this year, growth is more important to us because we’re trying to achieve competitive separation. Margin and margin expansion, specifically, is less important to us. We believe there is upside in our margins from here. It’s just not nearly as important to us to achieve that today relative to creating separation from others in our service set. So in terms of the timing of investments you will lot of the stuff will track as IT spending starts to grow, and how aggressively want to get, if we make changes to our play book we will certainly talk to everybody about it.

Eric Suppiger – Signal Hill

Okay, but it sounds like it’s a question of rate of improving margins from here rather than rate of declining margins from here.

Lanham Napier

We’ll see there was a scenario to grow the business, let’s just say, crazy scenario. 150% this year. If we want to grow 150% that would be tough to grow that fast and increase margins. Maybe one day we’ll figure that out. But I don’t know how to do that today. So that when we look at our plan, we put more emphasis on growth today. We think there’s an upside in margin, but we’re not focused on increasing our margins like we were last year. Will investments come as IT spending rebound? Absolutely. They will. So those will be pretty tightly correlated. So as we go through the year we will execute on this play book and be able to update you going forward.

Eric Suppiger – Signal Hill

Okay, very good. And then actually my last question, just on the average revenue per cloud customer, I know you kind of a pointed more towards server revenue, but can you just comment how much influence does the e-mail service have on our average revenue per cloud customer? Because I think that’s included in theirs. Is that correct?

Bruce Knooihuizen

Yes, that’s all part of our cloud offering. And when you look at our cloud customers we talk about managed hosting and there’s a wide variation, there’s a wide variation even in the cloud, we might have some folks in the cloud, they come in and spend $20 with us a month and then there’re going to be folks that come in whether they’re e-mail customer or not spending significantly more. So there is a wide variation even in cloud.

Eric Suppiger – Signal Hill

So the email pieces on a per customer, not a perceived basis, so that would actually be benefiting the clouds, revenue per customer, is that right?

Bruce Knooihuizen

Yes.

Eric Suppiger – Signal Hill

Okay, very good. Thank you very much.

Lanham Napier

Yep, thank you.

Operator

And gentlemen, we have time for one more question. We’ll go to Colby Synasael with Kaufman Bros.

Colby Synasael – Kaufman Bros.

Make it easy, all my questions have been answered, thanks.

Operator

Thank you very much. At this time we will conclude the question and answer session. I now turn the conference back to our presenters for any closing remarks.

Lanham Napier

Yes, thank you. First off, thanks to all the folks on the call today in their interest in Rackspace. We want to thank our customers that we serve and that a part of this revolution we’re trying to build here, everyday, we’re working to deepen our capability and serve you better. We want to thank all the Rackers on a global basis that volunteer their best to make Fanatical Support real. And we’re on a special journey to build something truly great, something that lasts and that’s what we’re going to do. So we will get back to work here. Thank you.

Operator

We now conclude our conference call for Rackspace Limited. Thank you for joining us today.

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Source: Rackspace Hosting, Inc. Q4 2009 Earnings Call Transcript
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