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Executives

Jason Luce – Vice President, Finance

A. Lanham Napier – President and Chief Executive Officer

Karl Pichler – Acting Chief Financial Officer, Principal Financial Officer and Treasurer

Analysts

Scott Goldman – Goldman Sachs Group Inc.

Christopher Larsen – Piper Jaffray Companies

James Breen – William Blair

Jonathan Atkin – RBC Capital Markets

Jonathan Schildkraut – Evercore Partners Inc.

Mitesh Dhruv – Bank of America/Merrill Lynch

Simon Flannery – Morgan Stanley

Frank Louthan – Raymond James

Rackspace Hosting, Inc. (RAX) Q3 2011 Earnings Call November 7, 2011 4:30 PM ET

Operator

Good evening, ladies and gentlemen, and welcome to the Rackspace Hosting Quarter Three Earnings Release 2011 Conference Call. As a reminder, this call is being recorded; at this time all lines are in listen-only mode to prevent background noise. After the prepared remarks, there will be a question-and-answer session. (Operator Instructions) It is now my pleasure to introduce Jason Luce, Vice President of Finance for Rackspace. Mr. Luce, you may begin.

Jason Luce

Good afternoon. Thank you for joining Rackspace's Third Quarter 2011 Earnings Call. I'm here today with Lanham Napier, our CEO; and Karl Pichler, our CFO.

We issued a press release after the close of the market today with our unaudited financial results for the third quarter of 2011. If you do not have a copy, please visit the Investors section of our website at rackspace.com where this call is also being webcast. The primary purpose of today's call is to discuss the third quarter 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 historical facts are statements that could be deemed forward-looking statements. These risks, uncertainties and assumptions are described in Rackspace Hosting's Form 10-K for the year ended December 31, 2010, filed with the SEC on February 22, 2011, and in Rackspace Hosting's Form 10-Q for the quarter ended September 30, 2011, expected to be filed shortly.

These forward-looking statements speak as of today. Except as required by law, we assume no obligation to update these forward-looking statements publicly 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, which is posted on our website as mentioned previously. Following our prepared remarks today, we will open the call for your questions. Okay, let’s get started Lanham?

A. Lanham Napier

Thanks, Jason. Good afternoon, and thank you for joining our third quarter earnings call. In the third quarter, we improved upon the solid results that we delivered in the first and second quarters by continuing on our strong pace of revenue growth while boosting margins and returns. In short, Q3 was the strongest quarter so far in 2011.

Here are the highlights. First, our revenue growth rate adjusted for currency improved to 7.3% sequentially, and 31.3% year-over-year, several factors have enabled us to increase growth in 2011 including continued rapid growth in our public cloud business, which grew 89% year-over-year in Q3, improved traction in serving large enterprises, customers leveraging our enhanced portfolio of products and services, and a significant pick up in sales to existing customers.

Monthly installed base growth remained at 0.9% per month for the quarter, although we’re not at pre-recession levels on installed base growth, which was approximately 1.5% per month on average. Our rate of 0.9% for the first nine months of 2011 is higher than the 0.2% that we achieved in 2009, and the 0.5% that we have averaged in 2010. Our second highlight for Q3, is that both adjusted EBITDA margins and net income margins improve sequentially.

Our final highlight is that, revenue per server increased for the ninth consecutive quarter, and our fully burden return on capital increased for the eighth consecutive quarter to 14.8%. As you all aware, the results we’ve generated in the first nine months of 2011 have occurred during a time of tremendous macroeconomic uncertainty, punctuated by the fear of a double dip recession, and a decline in the overall demand environment. We’ve heard these concerns first hand throughout the year in meetings with customers and prospects as well as investors. And one of our biggest concerns with that at some point, the persistent fear of recession would become so fulfilling.

With nine months of the year behind us, we’re not seeing any significant slowdown in demand for our services. We’re successfully executing on our internal growth and profit plan. So today, demand for cloud computing backed by Fanatical Support is not our constrain for growth.

We believe that cloud computing era represents the biggest market opportunity in all of tech, more and more corporations are discovering that using a specialized service provider is the faster, cheaper, more affective way to address their IT needs. Basically, pay less and get more.

We are beneficiary, so the math is secular shift towards cloud computing, and believe it can represent a multi-billion dollar revenue stream for Rackspace. What accounts for our success is the Fanatical Support that our employees called Rackers deliver to our customers.

We believe that our strategy to be the dominant service leader on cloud computing market will drive sustained growth. Ruining mission critical IT systems requires a complex combination of computing hardware, software management tools and a technical staff that has expertise in diverse range of technologies, and is obsessed with customer service.

Fanatical Support combines these ingredients to deliver the best technology service results in the industry to our customers. In short, Fanatical Support changes the way businesses consume IT. Instead of buying this simply in all the various IT inputs, Rackspace customers can purchase IT as an output as a service.

This service delivery strategy is the core of our differentiation. It is a complex business process that offers us a sustainable competitive advantage. We will continue to invest in this core and improve the value delivered to customers. We believe the investments we make today will help us take full advantage of the huge market opportunity in cloud computing.

During the quarter, demand from enterprise customers were strong, both from a new customer accusation and installed base growth standpoint. During the earlier years of Rackspace, our services were adopted and validated mainly by small/medium sized businesses, and those companies remain a vibrant part of company.

At the same time, more and more large corporations today are discovering that using a specialized service provider like Rackspace is the better, faster, cheaper way to address our IT needs, and we are optimistic that enterprises will represent a larger share of our revenue going forward.

One notable example from the quarter is a new deployment from CA Technologies, a $5 billion enterprise software company. CA selected Rackspace to host its cloud IT management application called Nimsoft. A software as a service monitoring and reporting application that CA customers use to proactively track the performance and availability of their IT infrastructure.

High levels of availability are important to any SaaS application, but they are especially critical for one that is used to ensure the uptime of organization’s underlying IT infrastructure. Ensuring that applications are on available on a 24 by 7 by 356 basis is Rackspace’s expertise, and are pleased that CA has trusted us to run this mission-critical application for them.

Another prologue of our growth is to build out our product portfolio to include higher service levels and additional capabilities. We are investing heavily in this strategy and Rackers in our product development groups are creating new technologies to help businesses leverage the benefits of the cloud.

Hosted Virtual Desktop, our managed cloud service, the UK cloud and cloud load balancers are a few of the recent examples of new capabilities developed by Rackers that are available on the market today that make us more competitive, drive revenue growth and improve returns.

Our product roadmap includes a variety of new capabilities and features including cloud block storage, enhancements to RackConnect, and of course building a support business around the OpenStack cloud computing platform.

Back in March, we launched Rackspace Cloud Builders, a new service offering certification and deployment support for organizations that need help building OpenStack environments. The primary goal of Cloud Builders was to help drive widespread adoption of the OpenStack platform, while investigating the feasibility of building a new service offering.

Since the launch of OpenStack, more than 130 companies have joined the project and Rackspace has been involved with the proof-of-concept implementations with large enterprises and service providers. Based on the experience we’ve gained working with customers running OpenStack, as well as the strong adoption of the software platform in the market, we’re ready to move into the next phase of our OpenStack strategy with the introduction of a new service we call Rackspace Cloud Private Edition. This new offering will enable Rackspace to extend Fanatical Support beyond the balance of our data centers by remotely supporting a managing OpenStack environments that run in almost any data center.

We’ve already helped more than a dozen customers to build and/or manage OpenStack clouds including eBay for its X.commerce venture. We believe that Rackspace Cloud Private Edition has the potential revolutionized IT organizations worldwide, while dramatically improving the capital efficiency of our business.

This initiative is still in its early stages of development. We have much to learn about delivering Fanatical Support outside of our data centers. There are still issues that need to be addressed, holes to be filled and unforeseen obstacles to overcome. However, we see the Rackspace Private Cloud Edition as an important opportunity to drive massive incremental demand, expect you a lot more about this new capability going forward.

Before I turn the call over to Karl to review our detailed financial results, let me summarize our results through September. In the first quarter, we set the bar high with a strong start to the year.

In the second quarter we achieved $1 billion annualized revenue, in the third quarter we began our journey towards the $2 billion revenue milestone, and we did it while growing rapidly the services that we expect to significantly improve the capital efficiency of our business model.

In the fourth quarter, we will be focused on delivering a strong ending to a great year, Karl?

Karl Pichler

Thank you, Lanham. For the third quarter, total revenue was $265 million, representing 7.0% growth from the second quarter, and 32.5% growth compared to the third quarter of 2010. Exchange rates had a negative impact on revenues of approximately $793,000 compared to the second quarter of this year, and a positive impact of $2.4 million compared to the third quarter of 2010.

On a constant-currency basis, revenue grew 7.3% sequentially and 31.3% year-over-year. Installed base growth was 0.9% in quarter, which is in line with the previous two quarters and an improvement from 0.5% that we saw in the third quarter of 2010.

Managed hosting revenues increased to $214 million representing 4.7% sequential growth, and 24% growth on a year-over-year basis. Growth in managed hosting continues to be driven by strong upgrade activity and new sales to enterprise customers.

Cloud revenue for the quarter was $51 million representing 18% sequential growth, and 89% growth on a year-over-year basis. Cloud growth is driven by a combination of new subscribers, increased usage from existing customers and contribution from newer services such as Load Balancers a service.

Overall, we added more than 8800 new customers in the quarter bringing our total count to more than 161,000. Moving on to profitability, adjusted EBITDA grew to $88 million representing 7.8% sequential growth, and 29% growth on a year-over-year basis. Adjusted EBITDA margin was 33.3% in the third quarter, 0.3% higher than the first and second quarters of this year, but below the 34.3% margin we show in the third quarter of 2010.

Depreciation and amortization expense came to $50 million in the quarter, representing approximately 18.7% of revenue, slightly below the 19% to 20% range that it has been since the beginning of 2009. Net income came to $20 million in the third quarter representing growth of 13.8% over the second quarter, and 69% from the third quarter of 2010.

Third quarter net income was positively impacted by lower effective tax rate compared to the first and second quarters of the year. Although our tax rate has fluctuated on a quarter-to-quarter basis, it has remained flat at approximately 35% for the prior two yea, and we continue to expect it to be close to the rate for the full year in 2011.

Capital expenditures totaled $94 million, of this amount we spent $54 million on customer gear; $17 million on data center build out; $9 million in our office facility; and $14 million on capitalized software development and other projects. For the nine months ending in September, total capital expenditures were $266 million.

Looking ahead for the full year of 2011, we now expect total capital expenditures to be in the range of $350 to $360 million. This is above the high end of the previously stated range, and is due to higher demand. As we have indicated previously, our total capital expenditure purchased for 2011 includes approximately $20 million of CapEx for building out of the final phase of our London data center, which will be finished in the year. Going forward, we plan to lease the capacity instead of building, which has resulted in data center CapEx moderating overtime. Additionally, beginning in the first quarter of 2012, we will modify the way we measure and report data center utilization to better reflect their level capacity.

Moving on to cash flow and returns. Adjusted free cash flow came in at a negative $5 million, and capital turns decreased sequentially to $1.84 times during the quarter primarily due to the high capital expenditures for the London data center and consolidation of our headquarters here in San Antonio.

As Lanham indicated during his prepared remarks, return on capital improved to 14.8%, which is driven by a combination of lower tax rate and improved margin. Average monthly revenue per server grew to $1155 to $1141 in the second quarter and $1058 in the third quarter of 2010.

We ended the quarter with a total cash balance of $125 million. Our total debt outstanding including capital leases worth $144, which translates to a net debt position of approximately $20 million or net leverage of potentially zero.

Last, but not least, we renewed our revolving credit facility in September. This facility replaces our previous credit facility, which is due to expire in August 2012. The credit facility has a total commitment of $200, and matures in September 2016. This agreement is no longer secured by our intangible assets. Our marginal borrowing cost from the facility are $125 basis points over LIBOR. The agreement further includes an accordion feature, which allows for an increase in the commitments to a total of $400 million under the same terms and conditions subject to credit approval of the participating banks.

In summary, we’re very pleased with this quarter’s results. We’re focused on finishing the year on a strong note and we’ll give you a more in depth look into our 2012 plan when we report our full year results in February. This is the end of our prepared remarks. Operator, please open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Scott Goldman with Goldman Sachs.

Scott Goldman – Goldman Sachs Group Inc.

Hey guys, good afternoon and thanks for taking the questions. I have a couple of questions. One, just on the revenue growth accelerating again this quarter both reported in FX adjusted basis and part of it was driven by the installed base growth stability. As you guys look at enterprise continuing to grow at a very healthy pace, cloud reaccelerating growth there, is there any reason why potentially installed base growth may not be able to go above where it currently is today? Are we staying stable net at the current level despite broader macro concerns?

And then secondly on the margins, I was surprised to see the 30 basis point improvement sequentially and I think as I sort of look at it, you brought a lot of square footage on in the quarter, perhaps timing of that may have had an impact, but we would think that would bring some incremental expense without bringing necessary all the revenues benefit to that. And then an offset there might have been, a little bit slower in hiring in the quarter. So, just help us think through some of the puts and takes on the margins for the quarter, and what it may look like going forward?

A. Lanham Napier

Okay. Thanks for the questions. This is Lanham, I’ll take the first question about revenue growth and what’s happening there specifically with installed base growth. Installed base growth is a measure of existing customers consuming more services from us. It’s net of churn so it takes into account customers upgrading and then any customers that we may lose on a revenue basis. Your question gets to the heart of in and today’s macro environment of what do we expect to happen here, do we have upside in this number or is this number stable or we have risk of it moving lower.

Generally speaking, installed base growth is the best proxy inside of our business for what’s happening in the macro environment. If you look at installed base growth this year, it has stayed real consistent. It’s not at that pre-rescission level of 1.5%, but its pretty strong at 0.9%, it’s almost double this year versus what it was last year.

The question becomes what’s causing this, why has it stabilized given all the macro economic choppiness out there? A couple of things are driving it. The number one thing driving it is our enterprise business. As we win an enterprise customer, the adoption rate tends to follow along the following path.

We win an initial application form them. Once we earn their trust, these customers then send additional applications to us. Our share of wallet today with any one of our enterprise customers is actually pretty well. Another way of putting that is, we have a lot of installed base growth ahead of us with the existing enterprise customers we serve.

We launched our enterprise segment focus and earnest a year-and-a-half to two years ago. This means that we are still in the early days of this business for us so not only do we have a lot of installed base growth opportunity in our enterprise business we also have a lot of new customer opportunity in our enterprise business.

The second piece that’s driving our installed base growth rate to these levels is our cloud business. Our cloud business is growing at a rapid rate. We mentioned in our remarks it’s almost 90% year-over-year. So these two pieces of our business, the enterprise and cloud, are really what’s driving that installed base growth metric where it is.

Installed base growth is not as high as it used to be pre-recession. We don’t have any indicator to believe that in an expansionary economic environment, we expect it to go back to the previous levels we’ve achieved. We don’t have any indicator to own us that those previous levels are now unattainable. We think it’s really driven by the macroeconomic conditions, and what we’ve been able to do in the past couple of years is launch new products and services to position ourselves into the growing portion of the market.

So Karl, why don’t you address the margins?

Karl Pichler

Yeah. So on the margins, let’s differentiate a little bit. There are different components that drive these margins. So, again the first two components on the cost of revenue side, the major ones there are the money that we spend on supporting our customers directly through our support teams and then, the second piece is kind of our infrastructure cost. And as you rightfully pointed out when we add capacity in the way that the accounting treats the leases, you have the expense immediately hitting even if you don’t use the space yet.

We also have a very strong intention to further build out our service leadership in that region, differentiate ourselves from our competitors, so it’s probably likely to say that we’re going to invest more in fanatical support to further drive that differentiation, but then we should get some leverage over on the cost of revenue side from increased efficiencies of larger scale data centers.

On the sales and marketing side, I think it’s fair to say that in the process where we are right now, where we are going through kind of an accelerated revenue phase that the sales and marketing contribution to the total cost basis is roughly flat from a revenue perspective. And then on the corporate cost side, we expect scale to happen over time. And so, depending on how all these different things come together in a quarter that’s why you see the fluctuation. So in some situations when the things come together all at the same time you see a couple of paces point blips or the other way around and that’s really what drives the variabilities on the margins these days.

Scott Goldman – Goldman Sachs Group Inc.

Great. And if I could just follow-up very quickly with Lanham, just going back on the enterprise side, you know, one of you can just sort of refresh for us what the growth of enterprise for this quarter and whether or not you’re seeing a change in the types of applications that enterprises are putting within Rack’s?

A. Lanham Napier

Okay. From a metrics perspective, we have not broken out the enterprise growth rate on an individual basis. What I would tell you is that if you look across our business, it is one of the fastest growing pieces of our business today. In terms of the adoption rate and the different types of applications that enterprise customers are sending to us, I’ve characterized it this way. The early adoption that we went from enterprise customers intense to be a mission critical web app that their IT department is not tailor made to run. Inside of every enterprise, CIOs, IT department today there is a long tail of applications.

The IT department itself is tailor made to run a handful of those applications. The billing system, ERP system, the manufacturing system et cetera, the innovation and the proliferation of apps has happened further outside the IT department down that long tail in the web app space, this is where Rackspace comes in, this is were we are a perfect fit to serve these customers. So whether it’s a share point application or another web application that the customer has created to help run their business we start winning those apps and then, once we are on that first one they sent us additional ones to run for them simply because we’re fast, we can save them money, and we can provide a high service level experience for them.

So the enterprise business starts with our first app, the enterprise growth component of it is driven by the adoption of those incremental applications. So, when we talked a few minutes ago about a stall base growth, the enterprise contribution to this is driven by those additional applications coming in which is why enterprise is such an important component of our installed base growth today.

Scott Goldman – Goldman Sachs Group Inc.

Great. Thanks, Lanham.

A. Lanham Napier

Thank you.

Operator

Our next question comes from Chris Larsen with Piper Jaffray.

Christopher Larsen – Piper Jaffray Companies

Hey, thanks and I guess Lan you’ve seen this terrific growth and I think we all certainly hope it keeps continuing, but how quickly if you needed to could you adjust this down and how closely can you monitor, how rapidly you are growing to make sure. And one of the comments you made was that demand is not the constraint, maybe you could just touch on what that constraint is today, is it just getting enough Rackers in position?

A. Lanham Napier

Yeah, okay. A couple of things here for you, Chris. The first thing in terms of the growth, in what we would do to respond in the event that there was a crazy financial crisis or something like that again. I would point back to the performance that we generated right after we went public. Our timing to go public was impeccable from a go public right before the world gets really tough.

Christopher Larsen – Piper Jaffray Companies

Yeah, I remember that one.

A. Lanham Napier

Right. So, we went public on 08/08/08. If you need to know who can call the market, it’s us. So what happened there was we recognized the financial crisis and that the world was shifting. So we went to work on margins, and I won't get this exactly right off the top of my head, but basically, I believe over the next 18 months, we increased our margins by 300 to 400 basis points. The question is how in the world we do that? Well, you know our business has some really good cost levers for us to control, whether its customer acquisition or productivity with respect to how much, how well we serve customers and what type of economic leverage we get as well as the fact that the vast majority of our investments around here are success based. So when times got tough in call it ’09, we were able to respond very rapidly to those changing conditions. Maintaining a high level of agility I think is important for all businesses to have chuzzle space that we are going to operate in a world of uncertainty for quite a while.

As a company, we take a long-term perspective on this, so as we do our planings, we have no doubt that 15 or 20 years form now, we will continue to be the service leader on cloud computing. As we get there, we will continue to be nimble and agile with respect to any financial crises that shows up.

So there within our operating and CapEx budgets, there are absolutely items that we would review thoroughly to understand what news we would need to make. I mean obviously like the rest of the world, we much prefer a growing expansionary ecomanic time as appose to all the choppiness, the only thing I’d tell you is that choppiness does have a silver lining to it and that silver lining is a relative benchmark in competitiveness, I believe that the actions and leadership moves we made as a company during ’08, ’09 and ‘10 or the reason we are emerging as the service leader on cloud computing today.

So there are some investments around here that we will not cut, there are other investments around here that we’ll accord if things get really choppy because you know we will keep our eyes on the price, the price here being with constructive service leader on cloud computing.

In terms of the risk to that, I would say the number one risk is our ability to execute. If you go to our product roadmap and our plans, we have a lot of stuff on our plate that we want to do everything from our, we call it Cloud 2.0 getting our cloud on to open stack completing network, increasing our service levels in the cloud, to enriching our hybrid portfolio experience for customers is our meaningful projects.

In many ways these are projects that require computer scientist to make it happen, so the intellectual property we are building inside of our company really does put us on the cutting edge of technology in a cloud computing world, so the number one risk from our perspective is our ability to execute that.

You’ve mentioned in your question, getting Rackers online and finding Rackers to do this, I mean we are absolutely, as crazy as it sounds in the technology world specifically in the big data, big web app cloud world, we’re in a talent world. This is where our culture really matters and gives us a competitive advantage over other players in the marketplace, so I think the number one risk is our ability to execute.

Christopher Larsen – Piper Jaffray Companies

Great, that’s really helpful, and just a housekeeping or a clarification on the CA project you just won. Is that going to be considered a direct customer or they going to be partner customers rather they bring on new clients, those clients were retransferred over to you.

A. Lanham Napier

Yeah, right now the deployment we talked about in the call is a direct customer.

Unidentified Analyst

Okay, thanks a lot.

Operator

We’ll take our next question from James Breen with William Blair.

James Breen – William Blair

Just a couple of questions, one sort of relatively you talked about to Mr. Larsen, if you look from you know ’07, ’08 coming out, you said you made some changes, can you give us a little bit more color in terms of, how is your company now different then it was two years ago related to the environment that you are in, and how the environment changed.

And then secondly, with respect to hiring, you’ve been hiring couple of hundred employees a quarter for the last several quarters, this quarter you hired it’s look like more than 70 or 80, but you’re seeing good scale in the business, just how do you guys think about brining employees as the revenues growth gets up north of 32%, 33%. Thanks.

A. Lanham Napier

Sure, so how are we different? We are different in a lot of ways. I think the number one way that we are different is during this choppy time we’ve launched new businesses, the work we’ve done in the cloud is a great demonstration of this, you’ve looked at our company three or four years ago, we were not all in on that form factor yet, and I’d say really starting ’08 is when we went, probably we went and really got serious about that form factor and technology solution.

Another way that we are very different is the investments that we’ve made in enterprise. This is another area where if you look back three or four years ago, we were not a significant player in that market segment as we are today.

What happened is, during ’08, ’09, 2010, as things got choppy, other people pulled back and our company just went forward and made the investments to keep going. So we’ve increased our service levels across each of those form factors. If you recall, we’ve done everything from launching of UK cloud, to manage cloud, to critical sites and enterprise, and we will continue to march up the stack across those different form factors.

So I think what’s happened is, as our SMB business was impacted by the financial recession, we were able to innovate and invest in new growth areas and position ourselves for that growth. So part of the remarks I made a minute ago around having corporate agility, this agility is reflected in our investment framework and how we were able to invest in these high growth areas and then deliver on it?

So when I was asked earlier about, what’s the number one risk? I think it’s our ability to execute on a roadmap. We have the right roadmap, it’s just about do we roll it out in a Fanatical fashion. So those are ways that we are different.

In terms of hiring and what’s going on there, you are right, if you look at our key metrics page, we did not hire as many people in Q3 as we did in Q2. I would tell you that just been selective, we wanted to hire more people. When we think about hiring people, the first thing, we think about is our culture and their values basically from a values perspective, are they going to fit inside of our culture? Then we think about their aptitude and specific skills that they bring to it.

Our perspective is, we want to build this company in a sustainable fashion. We think our culture is the number one secret sauce ingredient to making Fanatical Support real. So as we hire people, we want to hire who’re fit on that. We’d rather limp than put the wrong person in a seat.

So if you look at our different hiring number, these numbers have always ebbs and flowed based on what’s going on, but this talent war that we are in as a company is a real thing, we like our position in it, because of the culture we have and the work that we’re doing we’ve been able to attract some incredibly talent folks here over the last quarter to join our company in some specific technology areas.

One of the things we’re doing now on hiring is, we are hiring up in our San Francisco office in addition to our Austin, San Antonio, Blacksburg and other offices here in the states. So our approach to hiring will remain the same, we want to do it in a world-class fashion. We want to do it in a way that’s consistent with our culture.

James Breen – William Blair

Okay, thanks and just one follow up Equinix actually, especially saying that they’re providing you Rackspace Cloud, the private edition services, can you talk about just that overall environment for infrastructure and how you guys are thinking about going forward in terms of leasing space or owning your own space and how the environment may have changed in the last couple of quarters, thanks.

A. Lanham Napier

Yeah, sure. Well, there is a couple of different nuances in your questionnaire. Let’s start I guess, which is the infrastructure environment in general. Our intention consistent with the prepared remarks is that we will be leasing space, but the reason we want to do that is it just better aligns the timing of the expense with the investment with the revenue we have received that from a basically it turns into a variable nature instead of a fixed nature that is all up front for us. Nothing has changed in the market place to make us deviate from that plan that is core to our strategy going forward, if you look at the infrastructure expansion, we’ve had over the last call it year and a half, vast majority it has been within this recent model.

We believe it’s very effective, we’ve been able to deliver great results to our customers in it specifically with what’s happening with the Equinix, in our press release we are pretty excited about the Rackspace Cloud private edition, for us this is a first step for us to take Fanatical support outside of our data centers, which is consistent with our long-term vision of managing and running open stacked powered clouds anywhere, basically if a customer wants to deploy an environment just for themselves inside an Equinix data center, we want to be able to provide Fanatical Support for them.

So we see it real simply is that there are two primary layers in our business, the infrastructure layer and a service layer in this Rackspace cloud private edition based on the open stack technology, the customer would be purchasing the infrastructure, paying Equinix rent for that data center infrastructure, and then they would be paying us the service fee to manage it remotely on top of that infrastructure.

So this is a business model innovation for us, which has minimal capital involved in all of the profit margin of our service layer. So we like this innovation, we are just getting started with it, there will be a lot more work to do, but we believe this is a good solid first step.

James Breen – William Blair

Terrific, thanks a lot.

A. Lanham Napier

Sure, thank you.

Operator

Our next question comes from Jonathan Atkin with RBC.

Jonathan Atkin – RBC Capital Markets

Yes, so just on the last question. Given the rapid build out in wholesale space in many regions of the country, I'm wondering if you’re expecting to get similar or better leasing terms as you expand to additional sites overtime. And then just on the product mix, I’m just wondering if you could provide a little bit more specifics around particular cloud and managed products that you are seeing the greatest demand for and how that might differ in the US versus the UK?

A. Lanham Napier

Okay, let's start with the wholesale space question, let's take a step back to look at our approach to infrastructure, where that to be located et cetera, because for us location matters, the reason matters is when a custom infrastructure we are a performance and economic driven company, location drives economics and performance on infrastructure.

I'll give you some examples. There are high cost market places like New York City, it doesn’t matter how much wholesale spaces in New York City, I think we will probably never have a facility there.

We are looking at places to where we are going to get a combination of the right climate, a good tax environment, green power in the right infrastructure to deliver good performance for our customers. We want to combine that with the right wholesale DC partner, okay, we will continue down that path and that’s how we think about it.

So it’s the more wholesale space in general available in the market place that’s a good thing for us, and then more specifically the more wholesale space available in geographies that we are very interested in, is a even better thing for us. We are about optimizing that relationship around the cost and performance of the facility relative to the location, so that’s how we think about wholesale space. In terms of product…

Jonathan Atkin – RBC Capital Markets

If I could inter check briefly, I think it’s a 36,000 square feet of unused capacity at this point, so how long did that last you and how soon [energy] will look into to make additional decisions on leasing?

A. Lanham Napier

Yeah, we are currently looking at new space, I mean if you look at our growth rate today call it 30 plus percent year-over-year. We are now thinking a space in terms of megawatts and what we are going to require going forward more and more because we are reaching a scale that very few other companies and providers in the market place address.

So from our perspective, we are in a perpetual state, the expansion that we believe, humanities thirst for a compute and storage in a cloud world is almost [sensible] underpinning all of that, will be infrastructure investments that we have to make. So that 36,000 feet will carry us for a while, but from our perspective Jonathan we’ll really focused around having a ongoing plan and program for infrastructure expansion.

Jonathan Atkin – RBC Capital Markets

Thanks, and then other product mix?

A. Lanham Napier

Yes and your questionnaire was about the mix between our traditional managed business versus cloud business, did I get that right?

Jonathan Atkin – RBC Capital Markets

Yeah and then specific products within those categories that you’re seeing that the most demand for and if there is any geographic difference between the U.S. and the more enterprise focused U.K. market?

A. Lanham Napier

Yeah, this I would say are the trends here go on the following lines. If you look at our cloud business for example, it’s been established here in the states longer than in the U.K. We had a big launch last year just a few months ago now for a managed cloud. We are pleased with the take rates on managed cloud, those continue to climb within our cloud business. We are seeing a similar trend in the U.K. so part of what happens here is we understand how these products work, we’ve rolled them out in the U.S., some we’ve rolled them out globally, so we have a good experience curve with understanding what the right performance ought to be.

I would say the new products that we launch we expect to become a growing share of our revenue, most of the new products that we’ve launched here by definition have been out very long, so there is still a minority of that revenue stream, we expect that to change over time. When you look inside of our managed business with enterprise, we’ve talked about that already on the call a fair amount, and that enterprise is a high growth opportunity for us. We just talked about Rackspace Cloud Private Edition. This is an interesting business model innovation, from a realistic perspective we’re $1 billion revenue business today, so Rackspace Cloud Private Edition will not move the revenue needle from a miss perspective for some period of time and I would guess it’s couple of years until it’s really large enough to make a meaningful difference on the topline for us.

So we have the rest of our mix issues that will continue to carry us. But what you will see from us with continued execution of our roadmap is on a regular basis, the arrival of new service sets and products for customers that we just want to keep end to our mix to serve customers better and continue executing on our path to be in the service leader on cloud computing.

Jonathan Atkin – RBC Capital Markets

And then finally, on OpenStack, I wondered to what extent Amazon is a stumbling block to growth in terms of the features of two APIs?

A. Lanham Napier

Yeah. I think that there is room for two. You're talking about the AWS compute API?

Jonathan Atkin – RBC Capital Markets

Yes.

A. Lanham Napier

Yeah. I think there's going to be room for multiple APIs in the marketplace now, I think there are going to be 20 compute APIs raising in the marketplace, but I think the reality is there are three platform standards emerging in the cloud today; one being AWS, one being the VMware, another being OpenStack.

Today our unction and belief is that OpenStack is de facto open source cloud computing standard that the traction around that standard in the ecosystem that’s forming really validates them into demand we've had already in our Rackspace Cloud builders to deploy OpenStack clouds. They drove us to this launch today and an announcement of the Rackspace Cloud Private Edition. So we think that because of the ecosystem, around OpenStack that API is validated, we believe the market will have room for multiple APIs. So we feel good about our position.

Jonathan Atkin – RBC Capital Markets

Thank you.

Operator

We'll take our next question from Jonathan Schildkraut with Evercore.

Karl Pichler

Good evening.

Jonathan Schildkraut – Evercore Partners Inc.

Good evening, just kind of two questions here. First from Karl, I was just wondering if you might dive a little bit more into the implications on expected free cash flow generation of burn this year, based on the increased CapEx guide, and then secondly maybe if you guys could talk a little bit more broadly about a longer term perspective on capital efficiencies, in particular Rackspace private edition potentially providing a Rackspace managed hosting on top of say an HP or Dell, very large public cloud. And then also just in terms of the open stack transition, where we’re relative to new customers and moving the embedded base over from Slicehost?

Karl Pichler

Okay, so let me take the capital fees first, right. So I want to build on from some comments that were made earlier on. The vast majority of our capital spending is really also success based, right. So we have basically three layers on the tangible side, which is equipment that is very closely directly related to revenue, and very close also in terms of lead times. So the cloud actually has a little bit more lead time because you basically roll in pre-configured racks whereas managed hosting you basically is very, very, very close to revenue, but insignificant difference of a couple of days, maybe week.

On the DC side, as we get bigger and continue to basically grow at constant percentage rates, we're always going to be in DC expansion mode, which now more and more goes into the OpEx line, but as we saw it has a significant CapEx requirements as well.

And then the third one is the office, so based on the comments that were made before we had a significant intake of employees in Q1 and Q2, the low number in Q3 is probably as much a reflection of that huge intake in Q1 and in Q2, but overall we continue to add more people and if we don't have to, then we don't, we won't hire the individuals and that doesn't require us to basically build out office space.

And then the second part of CapEx, which is really spend on top end and IT development are some of these investments that we really need to make and want to make to build the product of the future and to build the system that allow us to scale our business in the future.

So all of that really what happens this year to us is that we are on the high range and above really in most of these categories because the vast, as I said, the vast majority of these are success base, there is no speculative build, there is no betting on the future, it’s just a response to the demand that we are facing.

The other little curveball is our supply chain consideration, so for example if you, I am sure you know about the issues that we have in Thailand and the associated supply chain consideration for hard drive manufacturers, and so we respond a little bit to that and then there are some other minor items; minor items in terms of excess free cash flow. So for example if we do a prepay on certain equipment purchases or license purchases, which is done in the third quarter, that has an impact on operating cash flow and then reduces your burden. The grand scheme of things, the business model doesn’t change, we do the same thing as we’ve always done and you know overall we are probably going to have burn somewhere in the area of $30 million for this year.

So, this is kind of where we think we’re going to be slightly higher than the numbers that we originally talked about, but if you think about it, it’s basically a direct result of the areas that we constantly mentioned which is the office and the (inaudible)

A. Lanham Napier

And I will take the second half of your question, Jonathan. With respect to the capital efficiency and the business model plus tax transition et cetera; broadly speaking, as the marketplace shifts to a cloud world, there are going to be a handful of major cloud platforms, AWS has won, Rackspace has won. So we will probably always be in the business of running a large multi-tenant public cloud here on behalf of customers.

What OpenStack allows us to do, because OpenStack creates an open source standard, is it allows us to put our service layer on top of other OpenStack environments on a global basis. So, while we will continue to run a large cloud ourselves to the extend customers want to run an OpenStack cloud inside of their data center under a prescriptive architecture that we provide, we can then layer Fanatical Support on top.

We have customers asking us to do this for them today, which is why we’ve started the Rackspace Cloud Private Edition. We believe that this revenue opportunity from a return on capital perspective is superior to our current business. In the long-term, what you basically have is our business model shifting a bit. And today, if we look at our pricing structure and value add it’s about 25% infrastructure, 75% service, if you break it down. In a world where we are providing Fanatical Support on top of OpenStack deployments inside of our customers’ data center, obviously, to add capital is the customer’s capital, not our capital. So the return on capital looks a whole lot better because we are still capturing the Fanatical Support service margin without having to make the capital investment in the infrastructure and gear itself.

We will always be running a large cloud inside of our company’s facilities, then it’s just about how far we extend our reach inside of our customers environments, how we can [figurate] their OpenStack deployment with an OpenStack cloud that we are running here at Rackspace, and over time, we believe we will improve our business model. We feel like we have a good business model today, we want to go to great one.

We believe that extending Fanatical Support into our customers’ data centers really reinforces our standard as the service leader in cloud computing we think providing that service layer helps customers sleep at night. Customers are looking for a partner they can trust while they make this shift, so we see it as a business model that shift and overtime it makes our business more capital efficient as well.

Jonathan Schildkraut – Evercore Partners Inc.

You know, Lanham may be if you could dive a little deeper into where you’re talking about between matching up say open stack or Rackspace private cloud editions with your public crowd architecture what are the challenges with managing across our private and public cloud architecture to something you are prepared to do today, how important is due to have a proximity in that type of situation?

A. Lanham Napier

Okay. For a lot of those questions the answer as it depends so it depends on the answer depends on the customer requirements, the way to characterize it at this moment in time is its early days. This is a vision that when we share with customers, customers want it. It’s a vision that adds a lot of value to them so we want to provide it for them. This Rackspace cloud private edition is our first step to figuring that out a critical element here is getting our Cloud onto open stacks having the customers run that prescriptive architecture as well because when we get the architectures aligned it enables this in a way that’s repeatable for us.

We want to stick with our discipline of building a repeatable lean services model we don’t want to end up with everything custom as a job shop we want to have standard series and processes that we can stamp out at a high quality level so it’s important that we get the architecture right. This is why our sponsorship of the OpenStack project is setting a partnership with NASA and now a 130 other companies really gives us an intellectual advantage actually rolls us out. So these are interesting challenging technology problems. We understand where we need to go in the path we’re just holding on the pack.

Jonathan Schildkraut – Evercore Partners Inc.

Great. Lanham, if you could just tell us where we are on the slide chose to OpenStack transition?

A. Lanham Napier

Yeah. Short answer is, we’re still working on it, Jonathan we continue to make progress on it, we have some elements in Alpha, we have some elements in Beta, this will continue here for the near period of time. But right now, we go through our road maps, we are confident in our ability to deliver it. We’re just going to make sure that when we deliver it, it’s in a fanatical fashion.

Jonathan Schildkraut – Evercore Partners Inc.

All right, great. We’ll circle back on that next quarter. Thank you for your time and questions.

A. Lanham Napier

Thank you.

Operator

Our next question comes from Mitesh Dhruv with Bank of America.

Mitesh Dhruv – Bank of America/Merrill Lynch

Thank you so much for taking my questions. Lanham if you can just comment little bit more on the managed cloud side. Does it give us some growth parameters around that? Last quarter you did say that the new business in managed cloud is up 2X, so this time around just frame it for us how the business for managed cloud and also now that you have couple of quarters of managed cloud under your belt, what are the difficult used case you are seeing for the managed cloud?

A. Lanham Napier

Okay. So we will start with some basics, if you look at the ARPU rate for managed cloud versus our quoter cloud, managed cloud customers are paying two to three times the typical core cloud customer, so what is driving this is the value we are adding at the service layer, that relationship has been consistent through out the couple of quarters that we’ve had managed cloud in the market place.

Second point is that the take rate of managed cloud has increased each quarter that has been the market place as well. So if you look at managed cloud as a percentage of our incoming in cloud revenue, we continue to make progress of that and we are proud of that. So I think generally speaking when you look at the used case it hasn’t changed a lot from the last time we were on the call. These are customers that one additional level and amount of help, so it has to be who the end user is at the customer that requires the system, this gives toward a more technical system administrator that requires a managed level, managed level inside their cloud experience.

I give you some customers for example, one recent customer is [Tom Suess] they are recent one for us and the managed cloud environment. So I think that gives you a feel for it. I would say, generally speaking it’s progressing like we thought it would. This is an important business for us, because it’s really an offering that gets to the heart of our differentiation in that marketplace in that, we are able to sustain a 2 to 3X ARPU level here with managed cloud, which has proved positive in the Fanatical Support matters.

Mitesh Dhruv – Bank of America/Merrill Lynch

Understood and so if you look at the enterprises as well the growth in the enterprise segment aren’t they also looking at managed cloud or deploying managed cloud or is that segment growth coming more from the managed hosting side?

A. Lanham Napier

They are looking at both. I mean if you look at it today in terms of total dollars, I think more of the enterprise business is coming from our traditional managed hosting side, but really what they are doing is it’s a hybrid environment. Its one part dedicated gear, one part cloud infrastructure in their solution so it’s a – the best way to characterize it is they are capping the whole portfolio. This is part of reason they select us, is that we can bring your dedicated environments on (inaudible) dedicate adjust to them and cloud environments stitch those together for them in a hybrid environment, where they end up getting the best of those world. We expect that will continue to be a big driver in our enterprise.

Mitesh Dhruv – Bank of America/Merrill Lynch

Got it and question for you, Karl. If I look at the return on capital very, very good income in results there and this is one of the metrics people used to look at a lot when you guys went public I remember and so just tell us – talk to us a little bit more on how do, how should we think about incremental return on capitals from this point on, because as you move the cloud on the one hand you get better returns per box and also, but on the other hand you also have to make investments on the cloud, so in some I regard this return on capital or other incremental return on capital as a precursor to your future profitability, so just help us frame where you think this metric could go, that’s it for me. Thank you so much.

Karl Pichler

Okay yeah, we mentioned this a couple of time, there is basically the biggest drive for future changes in ROC will be the way as we layer service on top of infrastructure, if you want. So all the capital it goes into our business studies that is around the bottom end of the layers around the DC, around the dedicated equipment is really kind of probably changes in that business model, in those business model perspectives will change or will make our ROC changes. We are a service company that has a capital intensive layer in its business.

So as we work on decoupling those two things you can see massive changes in ROC. And at the same time software development cost are capitalized, so they basically hit our capital account if you want and they flow into our ROC calculation as you know. And so it’s basically a combination then as we develops those future products and we spend today you really have a capital base that does not really reflects current revenue.

And so this is when you see incremental capital from an economic perspective, the transition from managed to cloud these higher capital utilization, the transition from everything doing our own to leasing models is higher capital utilization, that the Rackspace Private Cloud Edition that Lanham talked about is another potential for very much higher ROC components in our business. But then at the same time we spend to build those products and stay at the capital base as well. So depending on the [Thailand], the momentum in the revenue of these new products and business lines almost more so than product is really what derives the happening of those ROC increases to take place.

Mitesh Dhruv – Bank of America/Merrill Lynch

Actually, just one clarification, that was very helpful actually by the way. But one clarification on the balance sheet side, you had a big spike is non-current assets. I think you did allude to that that you prepaid some of the licenses, but just if you can just clarify a little bit more that would be great?

A. Lanham Napier

Yes. We prepaid some licenses that we deployed on behalf of our customers.

Mitesh Dhruv – Bank of America/Merrill Lynch

Okay, got it. Thank you so much.

Operator

Our next question comes from Henry Ellenbogen with T. Rowe Price. Our next question comes from Simon Flannery with Morgan Stanley.

Simon Flannery – Morgan Stanley

Thanks a lot. Good afternoon, Karl, if you can stay on the CapEx, very helpful in terms of thinking about the drivers going forward. When do we start to see this turn, you've obviously just raised your CapEx guidance with strong growth, but you're indicating that for next year, we won't see the data center spend that we sold this year and as you migrate to your Private Edition and more OpenStack that's going to be less capital intensive. So are we, in the sort of the latter half of '11 and the early part of '12. Is that sort of when the capital intensity sort of peaks, when can we start to see this really starting to see through the numbers materially. And then I think you said in your comments that you're looking at chain in the utilization calculation perhaps you can just give us a bit more clarity on that. Thanks.

Karl Pichler

Yeah. So okay, on the current basis model, the couple of components that we’ve always mentioned, if we basically perform or execute on the same type of business model that we’ve done in the past, we have this relationship where basically the free cash flow, neutral growth rate is roughly around 35% depending on margins and economic et cetera of the underlying business, and then you know this is a general relationship that does not necessarily hold, for example, if we do a pre-paper customer licenses because that’s reducing operating cash flow and this kind of a little bit outside of this general relationship.

As Lanham before said, it will take time before those newer type business models will actually contribute a significant contribution to revenue, and therefore it will take time for those to really significantly drive the cash flow the CapEx needs them. However, if you look at any of the efficiency metrics or you know, revenue per server, it continues to go up, utilization rates go up, both the contribution of cloud, the bigger contribution of cloud into our business with inherently higher capital turns and then the continued addition of services to our customers on top of existing infrastructures is what drives those productivity metrics if you want up.

So, it’s the constant steady path and then you have a couple of transforming business model changes, but they will take time because we have such a big revenue base that until the new kind of model start taking on really changing the economics; it will take some time.

Simon Flannery – Morgan Stanley

On the utilization; calculation?

Karl Pichler

Utilization; basically what we’re going to do is, we’re going to switch to a power-based utilization to both capacity and demand is going to be megawatts based rather than space based which is current not very, very relevant. So, it’s megawatts available versus megawatt utilized.

Simon Flannery – Morgan Stanley

Not only next quarter?

A. Lanham Napier

Yeah, we will start doing that for 2012.

Simon Flannery – Morgan Stanley

Okay. Thanks a lot.

A. Lanham Napier

Sure.

Operator

We will take our next question from Frank Louthan with Raymond James.

Frank Louthan – Raymond James

Great, thank you. On the Private Edition Cloud, can you give us an idea of how have you approached this from a business model standpoint, where in the past you’ve shyed away from operating customers infrastructuring your data centers, now you have to sort of take along some of their sort of disparity in different architectures and builds. What did you built into the approach there that will avoid from potential issues from a hardware perspective working with the customers’ equipment?

A. Lanham Napier

Sure. Okay. The first thing I’d say, we are using a reference architecture for the deployment of OpenStack. The way to think about this is, through the OpenStack project we have published the code, we are now sharing with customers, the software and hardware architectures that we use in practice. Okay. So this reinforces our commitment to open source, it also helps the customers get inside a sweet spot, where we can serve them.

Basically if they’re using our prescriptive architectures, we will be doing things like updating the versions, and upgrades for OpenStack, will be performance tuning the customer and deployments so they can run their cloud optimally. We’ll be looking at system issues and developing fixes when there is an OpenStack bug, we’ll be doing security patches.

So basically, the answer is, once you get customers on that reference architecture, from a remote locations we could do a lot of things for them. The physical part of it, the customer will be doing because it’s inside their own facility. So provisioning that gear, setting up that gear, they can hire a Rackspace cloud builders to help them do that, they can line up with other partners to keep it running specifically when we talk about Rackspace Cloud Private Edition it’s that service later on top when we talk about OpenStake upgrades and version upgrades, and helping performance tune that environment, the key that unlocks this is the fact that they are running our reference architecture.

Frank Louthan – Raymond James

Okay, so that’s requirement to be able to take them on as a customers?

A. Lanham Napier

That’s correct with out their reference architecture, it’s amalgamation of a bunch of different form factors that we would not be able to run reliably.

Frank Louthan – Raymond James

Okay, great. Thank you. And then, from a customer concentration standpoint, has that shifted any change in your largest customers as a percentage of revenue, and what sort of your top ten customers represent your revenue running currently?

A. Lanham Napier

No sir, nothing changed here. We don’t have a large concentration and any given customer.

Frank Louthan – Raymond James

Okay, thanks

A. Lanham Napier

I think a lot customer today is still what, fewer that 2% of sales, so there you have it.

Frank Louthan – Raymond James

Great. Thank you.

Operator

This concludes the Q&A portion of the call. Thank you, and have a good evening.

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