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Rackspace Hosting, Inc. (NYSE:RAX)

Q2 2012 Earnings Call

August 7, 2012 4:30 PM ET

Executives

Jason Luce – VP, Finance

Lanham Napier – CEO

Karl Pichler – SVP and CFO

Analysts

Tom Seitz – Jefferies & Company

Gray Powell – Wells Fargo

James Breen – William Blair

Patrick Walravens – JMP

Chris Larsen – Piper Jaffray

Rob Sanderson – ABR Investment Strategy

Jonathan Atkin – RBC Capital Markets

Simon Flannery – Morgan Stanley

Jonathan Schildkraut – Evercore Partners

Frank Louthan – Raymond James

Operator

Welcome to Rackspace Hosting’s Second Quarter 2012 Earnings Conference Call. As a reminder, this call is being recorded. At this time, all participants are in a 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

Hello, everyone, and welcome to Rackspace’s quarterly conference call. Today we will cover Rackspace’s second quarter ending June 30, 2012. We hope that you have had a chance to read our press release, which we issued earlier today. If you do not have a copy, please visit the Investor Relations page of our website, at ir.rackspace.com.

This call is also being webcast online and can be accessed through our IR site. For Rackspace, on the call today will be Lanham Napier, Chief Executive Officer; and Karl Pichler, Chief Financial Officer.

I need to remind you that some of the comments we’ll make today are forward-looking statements that involve risks, uncertainties, and assumptions. If such risks or uncertainties materialize or such assumptions prove incorrect, our results will differ materially from those expressed or implied by such forward-looking statements and assumptions.

All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any statements concerning expected operations and financial results; growth plans; the impact of new platforms, products, or services; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing.

These risks, uncertainties, and assumptions include, one, the market acceptance of our new public cloud platform and product set; two, the successful and timely launch of new platforms and products; three, increasing competition in our industry; four, the adoption of OpenStack as the open-source cloud computing platform standard; five, unfavorable economic conditions; and six, other risks that are described in our Form 10-Q for the quarter ended March 31, 2012, which was filed with the SEC on May 9, 2012, and our Form 10-Q for the quarter ended June 30, 2012, which will be filed with the SEC later this week.

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 actual results differ materially from those anticipated to be forward-looking statements, even if new information becomes available in the future.

Please also note that certain financial measures we will use during this call, such as adjusted EBITDA, are expressed on a non-GAAP basis. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings release for the second quarter of 2012, which is currently posted on the Investors page of our website, at www.rackspace.com. After our prepared remarks this afternoon, we will be happy to take your questions.

I will now turn the call over to Lanham. Lanham?

Lanham Napier

Good afternoon, everyone, and thank you for joining us today. In February, we explained that 2012 will be an important year for Rackspace, as we manage the demands of a fast-growing billion-dollar business while simultaneously launching our new open cloud products. With just over half of the year completed, we have made good progress on our development goals and expect to be largely through the product launches soon.

The technology industry is in the early rounds of a massive secular shift that will change the way businesses consume IT. More and more companies are discovering that using a specialized service provider is the most effective way to address their IT capacity needs.

In addition, we believe the economics of the cloud will drive an explosion of new demand for computing, just as iOS and Android have driven huge new demand for applications development. Massive technology disruptions like this create opportunities for companies to seize the moment, disrupt the status quo, and lead to revolution. We believe Rackspace faces one of those opportunities and that we are in a position to lead this revolution.

In order for us to capitalize on our long-term potential, we need to execute extremely well now. Our execution in 2012 will influence our competitive position for years to come. Amazon has been effective at attracting early adopters and evangelizing the potential of the public cloud. VMware pioneered the x86 virtualization market and built a multibillion dollar business selling software to companies building their own small private clouds.

However, both Amazon and VMware use the old model of proprietary technology to lock in their customers. We are taking a different approach. Our strategy is to leverage the OpenStack technology to create a cloud operating system that can run anywhere, one that will give freedom and choice to customers and drive unconstrained innovation. We will adopt this powerful software system, integrate it with modern infrastructure, combine it with passionate and knowledgeable Rackers, and back it up with service level agreements, all to deliver world-class technology outcomes to our customers.

In a world that uses proprietary technology to create customer lock-in, we will differentiate through a superior service experience and build a model based on customer loyalty and trust. As the pace of innovation continues to move rapidly, we believe companies will want a reliable partner to deliver the technology they need to run their business and help them navigate to the cloud. Our mission is to make sure that Rackspace is that partner.

Among Rackspace’s newest customers is Circuit of The Americas in Austin, Texas, a new venue that will host the Formula 1 United States Grand Prix this November and a number of motorsports and entertainment events in the coming years. Rackspace hosts the company’s website, www.circuitoftheamericas.com, that is crucial to the Circuit’s online ticket sales. Rackspace allows the company to quickly adjust compute capacity in conjunction with customer communications and sales offers that generate rapid spikes in visitor traffic to the site.

That’s just one example highlighting the importance of our new open cloud platform. As of today, we are extremely proud to report that we are more than halfway through our product transition schedule for the year. Last week, we achieved a significant milestone in our 2012 plan by launching Cloud Servers powered by OpenStack.

This new offering embeds the latest version of the OpenStack software to combine the on-demand scalability of modern cloud infrastructure with the flexibility benefits of open-source technology. This product launch represents the culmination of nearly two years of hard work by Rackers throughout the company, and it will serve as the core of our new open cloud platform. In addition to the new Cloud Servers, we also announced the general availability of Rackspace Cloud Database and a Rackspace Cloud Control Panel.

Taking the powerful capabilities of the OpenStack platform and productizing them into a service that is easy for businesses to use is one of the most difficult, exciting, and strategic challenges that Rackspace has ever pursued. It is the largest software investment we have ever made, and it has required us to build new competencies, particularly in the areas of product development. It will be the foundation for Rackspace to deliver Fanatical Support on a much larger scale and in a more capital-efficient manner than currently possible. In short, OpenStack is the enabling technology for Rackspace to become a much larger business.

As you know, we don’t simply aspire to be big. We are striving to become big and great. Very few companies have been able to accomplish both, and we believe the combination of the rapidly growing cloud computing market, the capabilities of the OpenStack technology, and the power of Fanatical Support provide us with a once-in-a-lifetime opportunity to join that elite class of companies that are both big and great.

While we are excited about the successful launch of the first three elements of the new open cloud platform, we haven’t fully completed the rollout. Specifically, we plan to launch Cloud Monitoring, Cloud Backup, and Cloud Block Storage during the remainder of the third quarter, and Cloud Network early in the fourth quarter.

The product development work we are doing is all about delivering Fanatical Support across our portfolio of dedicated and public cloud products that enable large, high-performance workloads to run on our cloud. The new open cloud platform has added features and eliminated bottlenecks that our larger customers found to be cumbersome on our previous cloud platform.

Given all the progress we have made up until now, we are confident that we will hit our product roadmap launch dates for the rest of the year. Although we expect the majority of the new open cloud platform to be released in the third quarter, we do not expect to begin capturing the financial benefit of the new offering until the fourth quarter at the earliest. From an adoption standpoint, given that the new offering was just released on August 1, we believe some customers may wait for us to publish performance metrics before they commit to using the open cloud platform to run large-scale mission-critical workloads.

At the halfway point of the year, we have made good progress toward our 2012 plan. We have set an aggressive rollout schedule for 2012, and we are proud of the way Rackers have rallied to deliver on our commitments. We expect to complete the vast majority of the open cloud launch during the remainder of the third quarter, and we look forward to updating you on our progress in November.

I’ll now hand this call off to Karl to review our financial results. Karl?

Karl Pichler

Thank you, Lanham. Let me review the detailed financial results. For the second quarter, total revenue was $319 million, representing 5.9% growth from the first quarter and 29% growth compared to the second quarter of 2011. Exchange rates had a slightly positive impact on the revenue of approximately $600,000 compared to the first quarter, and a negative impact of $2.3 million compared to the second quarter of 2011. On a constant-currency basis, revenue grew 5.7% sequentially and 30% year-over-year.

As we have discussed in the past, sales to enterprise customers have provided a strong source of revenue growth for us, and this trend continued in the second quarter. One recent example of this is Fox Networks Group. Fox Networks Group includes units that produce, program, and transmit many of America’s most popular shows via TV networks, video-on-demand, and other media platforms.

Fox selected Rackspace to host some of their top Web properties, including FOXSports.com and AmericanIdol.com. Fox needed to ensure that these websites would not suffer performance degradations at times of peak load, while maintaining flexibility during periods when traffic was lighter. Our hybrid hosting offering was the perfect solution for Fox’s needs.

Fox is leveraging our Critical Sites service-level agreement to ensure the highest level of performance while also utilizing our public cloud platform to handle demand spikes across the different web properties. Fox is a great example of the progress of our enterprise sales efforts and the success of our hybrid solution.

In addition to new sales to enterprises, sales to existing customers is another important growth driver for our company. During the second quarter, installed base growth averaged 1.0%. This is an improvement from 0.7% in the first quarter and is in line with the monthly average for 2011.

One notable upgrade in the quarter came from the United Service Organization. The USO is a nonprofit organization that provides programs, services, and live entertainment to United States troops and their families. The USO operates more than 160 locations in 14 countries, serving more than 8 million visitors.

The USO initially chose Rackspace to host its main website in 2008. Since then, it has steadily expanded its footprint and is now moving its entire corporate infrastructure into our cloud. When completed, the USO configuration will include Dedicated Cloud, SharePoint, Exchange, and Private Cloud.

Moving on to revenue by product, Dedicated Cloud revenue increased to $246 million, representing 4.1% sequential growth and 21% growth on a year-over-year basis. Public revenue cloud for the quarter was $73 million, representing 12.1% sequential growth and 69% growth on a year-over-year basis.

Although our new open cloud platform and products were not available in the second quarter, and we don’t expect to begin to see the full revenue benefits until the fourth quarter at the earliest, we are seeing some early reasons to be optimistic about the new platform and products.

One example of why we are optimistic is illustrated by a company called SOASTA. SOASTA is the leader in cloud testing and was one of the early adopters of our open cloud products. Our OpenStack cloud enables them to simulate massive volumes of web traffic, which is used to ensure that its clients’ web and mobile applications are ready for production. They have used our services to test applications for the 2012 Olympic Games.

Moving on to profitability, adjusted EBIDTA came to $112 million in the second quarter, representing growth of 11.1% from the first quarter and 37% on a year-over-year basis. Our adjusted EBIDTA margin was 35.1% in the second quarter, up from 33.4% in the prior quarter and 33.0% in the second quarter of 2011.

Depreciation/amortization expense came to $62 million in the quarter, representing approximately 19% of revenue. Although this is up from 18% of revenue in the first quarter, it is back in line with the 19% to 20% range that it has been tracking since the beginning of 2009. Net income came to $25 million in the second quarter, representing growth of 8.3% from the first quarter and 43% from the second quarter of 2011.

As we have indicated in the past, our profitability margins tend to fluctuate from quarter to quarter because of a variety of factors, including revenue growth, hiring performance, and resource prices. This is normal for our business, and we expect margins to continue to move around based on these factors.

Capital expenditures totaled $82 million. Of this amount, we spent $54 million on customer gear, $3 million on datacenter build-outs, $4 million on our consolidated headquarters facility, and $21 million in capitalized software development and other projects.

Return on capital came to 15.5% in the second quarter, compared to 15.0% in the prior quarter and 14.4% in the second quarter of 2011. Average monthly revenue per server grew for the 12th consecutive quarter, to $1,270, from $1,238 in the prior quarter.

We generated a company record for adjusted free cash flow of $29 million in the quarter. We ended the quarter with a total cash balance of $215 million. Our total debt outstanding, including capital leases, was $149 million, which translates to a net cash position of approximately $60 million.

Given our ability to generate free cash flow, our strong balance sheet, and through access to an additional $200 million through our credit facility, we believe that we are well-funded to operate our business at these growth rates.

In summary, at the halfway point in the year, we have made a lot of progress in our plans to broaden our products and services portfolio while simultaneously managing the rapidly growing business. Keep your eyes open for more product announcements in the coming weeks, and we’ll look forward to updating you on our progress in November.

This concludes our prepared remarks. We are now ready to take your questions. Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we’ll take our first question from Tom Seitz of Jefferies & Company.

Tom Seitz – Jefferies & Company

Yeah, thanks; two, if I could. The first is, Citrix was really bullish on its call regarding the initial traction of CloudStack, and I’m wondering if you could update us on your views on the competitive environment for open-source platforms and maybe give us a view on timing as to when you think the winner will ultimately be decided. And then, secondly, how big of an impact to your conservative views regarding revenue recognition are due to the stacks that have yet to be rolled out, such as monitoring and the like, that you mentioned? Thank you very much.

Lanham Napier

Okay. This is Lanham. So let’s deal with the first question about Citrix, and the question really being about the competitive environment for open-source platforms in the cloud. As we sit here today, our belief is that OpenStack is rapidly emerging as the de facto standard for open-source technologies and cloud computing. Our belief here is based upon the traction in the community, the rate at which the code is advancing, the number of companies that have announced their intention to deploy OpenStack or that are deploying OpenStack.

So we are seeing across the board, from our perspective, (ph) great work in the community. We are seeing traction in the code. We’re seeing the code advance. And the release cycle is pretty darn effective. It’s a big milestone for us, obviously, to roll out our open cloud powered by OpenStack. The community has been waiting for a big deployment like that. As we sit here today, we’re running the largest open cloud in the world, to our knowledge. We think the community will continue to advance the code, and the community needs a big service provider like us to do that.

Right behind us, it’s our understanding, is HP. So we’re starting to see lots of traction in the community. This summer, the community picked up some great wins with Red Hat and IBM joining. So, from our perspective, CloudStack is absolutely in the marketplace. It just doesn’t have the momentum and traction behind it that OpenStack does.

The second question, to make sure I get this right, is about our comments in the prepared remarks about when we receive the benefit of the new product launches and what are we thinking there. Okay, so from our perspective, it’s the following. We recently launched the first wave of our open cloud. The second wave is approaching, as we roll out the next batch of products. The timing on this is such that every 30 days or so, we’re going to have another release.

What that means is that, really, until the fourth quarter, we don’t have the whole platform in place, so we don’t want to create confusion in the marketplace around the timing of when these things actually hit. We have never been more proud of the products that we’re producing. The feedback we’re getting from customers is positive. If you go out to the Twitterverse and look at the streams, talking about the new control panel and the ease of use of the interface and the comments coming out of customers, it’s already really positive.

So we’re pretty excited to be able to finish all this work. The reality is we have some big work ahead of us. It’s going to take us a few more months to complete everything, but by the end of this year, we should have it complete, and that should dramatically increase our competitive position in the marketplace.

Tom Seitz – Jefferies & Company

Thanks. That’s great color.

Operator

And moving on, we’ll go to Gray Powell of Wells Fargo.

Gray Powell – Wells Fargo

Great. Thanks for taking the call, just had a few questions. Can you help us frame up the longer-term opportunity with OpenStack? And I know there are a number of things we can talk about, but maybe to start, can you give us a sense as to how we should think about the opportunity to address larger server deployments with OpenStack and how new features such as database-as-a-service and Cloud Block Storage should drive new customer adoption and increase spending from existing customers?

Lanham Napier

Yes. This is Lanham again. At a macro level, the investments we’re making in OpenStack are really about driving differentiation. If you look at the cloud market today, there’s an emerging segmentation, and so if you compare the competitive attributes that Rackspace brings to the market versus the competitive attributes of other players, let’s just go through some of them. So when you think about a company like AWS, who’s done great, they are a generalist in this game. They can sell you books, they can sell you microwaves, they can sell you videos, they can sell you social games, and they can tell you cloud services.

We are a specialist. All we bring is a portfolio of dedicated and cloud services to customers. AWS is using closed technology. We are using open technology. They are playing a scale game, and we are playing a service game. So, for us, this is about running an open portfolio, powered by OpenStack, backed with Fanatical Support. We believe that that positioning in the market gives us a lot of differentiation, a lot of power, and it’s going to lead to a class of customer that’s going to fit us very well. The investments we’re making today are about reinforcing that point of position and differentiation in the marketplace. The results we’re having on the products give us a lot of optimism, which Karl said in his remarks.

So, macro, it’s about differentiation. If you want to boil it down to what does this mean for running more complex workloads on our cloud, what does it mean for serving bigger customers, what does it mean for handling larger apps; up to this point, if you looked at our legacy cloud platform, it was a platform that was excellent at doing simple things. It did not have all of the features and functionality for us to deliver high service levels for complex Web apps.

The platform and products that we are launching today give us a much better shot at doing that. In fact, they are critical to being able to do it. As we continue to roll out this platform launch, we have a much greater ability to run complex workloads at a Critical Sites type SLA ,which we referenced in our prepared remarks earlier, on the new platform than we did on the old platform. So I would say OpenStack, the differentiation around OpenStack, the capability of the new services and products we’re rolling out, give us an ability to run much larger complex apps.

The other thing that’s exciting here is our ability to run private clouds on-premise for customers based on the same technology. It is early days in that game for us, but we’re working on it. Through our cloud-building efforts, we already have customers paying us to do this today. That’s a whole another option and avenue that’s going to open up for us here. Right now – we have a saying around here: the main thing is the main thing. The main thing is continue to execute around our product launches. We’re very excited about that.

As we execute these launches, we can run bigger workloads, which increases our market opportunity. This new platform is more capable, which gives us better scale and efficiency, which we believe translates into potentially better economics in the long run, and it’s going to create some other avenues of growth for us. So we recognize the opportunity in front. We realize we’ve got a lot of work to do. Launching this stuff is complicated, so we’ve got to keep our head down and keep doing it, but we have great confidence based on the recent progress and traction we’ve had.

Gray Powell – Wells Fargo

Got it. That’s very helpful. Thank you very much.

Operator

Our next question will come from James Breen of William Blair.

James Breen – William Blair

Can you just talk a little bit about your confidence level in launching the next phases for the products that you haven’t launched yet, and then maybe, just a little bit of color on EBIDTA margins this quarter, as we saw a pretty good step-up from the first quarter numbers? Thanks.

Lanham Napier

Okay. This is Lanham. I’ll handle the first piece about confidence level in launches and then let Karl do the margin stuff because he’s the margin guy around here. So on the confidence level with product launches, our confidence is high. We base that upon the project management plans we have in place, the progress and traction we’ve had on those plans here over months. So we feel very good about the technology itself. We feel very good about our ability to hit our timelines. Our company is rallying on this in a significant manner. I would just sum it up by saying we feel confident about those timelines and like the spot we’re in.

Karl, why don’t you take the margins.

Karl Pichler

Yeah, sure. So our profitability margins tend to fluctuate from quarter to quarter. We’ve seen this, as we all know, Q2 margins are higher than in Q1; in Q1, they were lower than in Q4. This is normal for our business, and we would certainly expect that to continue. Q2 was a good quarter, and it was driven by all three major cost categories, which is not usually the case. But in this case, cost of revenue got leveraged on our fixed cost structure, but as we add new datacenter space in future periods, this can also go the other way.

For sales and marketing, our Q2 spend was flat relative to Q1, where we had a significant step-up, so that explains a little boost. And then, in G&A, we continue to invest in our product capabilities, but had some good expense management opportunities within our corporate costs. So all these fluctuations are natural, and our general business strategy is to have those margins flat, but they fluctuate just as a matter of execution throughout the period.

James Breen – William Blair

Great. Thank you.

Operator

And we’ll go now to Patrick Walravens of JMP.

Patrick Walravens – JMP

Oh, great, thank you. So, first of all, congratulations on launching the open cloud servers. My question, Lanham, is about VMware’s acquisition of Nicira, and I’m wondering, what does that acquisition mean for OpenStack, and is there a possibility at some point of VMware perhaps joining OpenStack?

Lanham Napier

Okay, good question. It’s one we’ve gotten a lot here lately. In general, just so everybody understands, Nicira has done great work in OpenStack. If you go out to the community, you’ll see the code contributions they’ve been making. We are fans of that technology. We think it’s great technology. So we are pleased with all the work we’ve done with them. We’ve worked closely with them over time to adopt that technology in our network. We’ve also worked closely with VMware over time as well. If you go into our enterprise business, we run a lot of VMware environments for large customers here at the Rack.

So, from our perspective, we believe this could actually open up additional opportunity for us. As that transaction closes, it will pull VMware closer to us and to OpenStack. We look forward to having conversations with them about that at some point in the future. So, from our perspective, as we sit here today, we’re optimistic that this can end up being a good thing for us and for OpenStack in general.

Patrick Walravens – JMP

Great. Thank you.

Operator

And we’ll take a question from Chris Larsen of Piper Jaffray.

Chris Larsen – Piper Jaffray

Hey, thanks, and a couple questions. First, if you could just talk a little bit about now the abilities of OpenStack today as it compares to Slicehost, and I guess really what I’m thinking is, are there any capabilities that Slicehost had – or the old platform had that you don’t have today until you launch some of the new products, or will all these products be new and incremental on top of this? And then is this consistent with what you had anticipated all along?

And then secondly, there was some talk recently that eBay had adopted OpenStack. I’m wondering if you could just comment on that. And then the third question, if I can – I apologize – but was there any delay in hiring or any slowdown in hiring that led to a higher margin this quarter? I know, Karl, you gave really a lot of detail on that, but I’m just wondering if there was any head count issues that we should think about as having an impact on margins this quarter. Thanks.

Lanham Napier

Okay. Let’s start with OpenStack versus our legacy platform. The best way to generalize it today is that we are in territory that’s all new and incremental capability from where we used to be. There are still a few look-and-feel things that we’re working on, but generally speaking, where we sit today and going forward, it’s all new territory and new opportunity for us, which is part of the reason why we’re pretty excited about it.

Up to this point, we’ve had situations with large customers that we literally just couldn’t deliver Fanatical Support to them, running a large app in our cloud, because we didn’t have all the features that we needed. If you roll the tape out here for just a few weeks, we’re going to start to resolve and address a lot of those gaps, which means we’re expanding our addressable market. Thus, from here on out, we think it’s new and incremental, and we like our opportunity on that.

The second question was about eBay adopting OpenStack. There was a release – it was running in the news, I want to say, just 48 hours ago – about eBay adopting OpenStack and running OpenStack internally. We think that’s another great sign for the OpenStack community.

Earlier in the call, I got a question about OpenStack versus CloudStack, what’s going on in the competitive environment, how do you know OpenStack is emerging. I think anytime you get a company like eBay running it, which is really a Web giant, it reinforces the fact that this technology is real and that enterprise buyers are comfortable that it is production-ready. That just makes us really happy about eBay and others adopting this technology.

The last question you had was about a delay in hiring this quarter, did that impact margin. I wish we had a crystal ball in hiring, but we don’t. And the reason we don’t is we go after talent in the marketplace, and we put our best foot forward and we try to attract as many as possible at any time. In the first quarter call, we talked about how we had been more successful hiring people. This quarter we hired fewer people. We were just under 200 Rackers joining for the quarter.

There’s always a few ancillary factors here where you have people wanting to move when school’s out and get settled before school starts. People don’t want to move in the holidays, that kind of stuff. I don’t have any big earthshattering news to share with you other than we will continue to aggressively pursue talent. Inside of the tech world, there’s a battle for talent. We love our spot in San Antonio because here in South Texas, we get our pick of the litter. We have expanded our talent pool by opening offices in San Francisco, Atlanta. We look at our datacenters; that also provides an expansion in talent pool. And then we have a great development center right up the road in Austin, Texas.

So we will continue to be aggressive on the talent realm. We actually think talent is a place where we could create competitive advantage. If you recall, in prior meetings and earnings calls, we’ve talked about the importance of our culture, the importance of being recognized as a great culture. Our culture enables us to attract incredible talent. We think that advantage is important. The intellectual property in this business is the code we write for our cloud, it’s the processes we have to deliver Fanatical Support, and it’s the IQ points of Rackers.

So we will continue to be aggressive. I just can’t point to you exactly how it’s going to go in terms of how many we will hire per quarter. We’ve got our targets, and we’re aggressive, but we just want to make sure we keep the right quality level and ever increase our talent base.

Chris Larsen – Piper Jaffray

Thanks, Lanham. That’s really helpful.

Operator

We’ll take our next question from Rob Sanderson of ABR Investment Strategy.

Rob Sanderson – ABR Investment Strategy LLC

Thanks. And good afternoon and thanks for taking my questions. Just two questions. First, can you help us think about public cloud revenue going through Q3 and Q4; some tailwinds, now that you have the initial products launched, but you’ve still got halfway to go, and certainly some overhang in Q2, but you still grew 12% sequential, so how does that really – how should we think about linearity Q3 versus Q4?

And then second question, on open cloud, just can you comment on any early response from the Web 2.0, more complex scale environment, these crowd of people? Do you feel there’s a real big opportunity for any competitive displacement wins here going forward, or is it really more about improving your position for new opportunities in this segment?

Lanham Napier

Okay, good questions. I’ll start with the second one about the commentary around our competitive position, specifically with open cloud and its attraction to Web 2.0 big, complex workloads, and whether that is all for new opportunities or also some competitive displacement. At this time, I would say there’s a little bit of each. In the long run, because cloud is in its early days, I think it’s really about new opportunities. We’re in the early innings of game one of a seven-game series as technology makes this shift into a cloud world, where people consume technology as a service. Therefore, the future revenue is vastly larger than any current revenue taking place in the industry, which means it’s really about new opportunities.

I’d also tell you, though, because we have had to say no to customers up to this point and that we weren’t able to serve all their needs, I do think there’s a competitive displacement opportunity. It’s just not as big as all the new stuff we’ll get in the future. So that’s how I would summarize that.

With respect to the linearity question around public cloud revenue for Q3 and Q4, I’ll let Karl talk about the outlook in general on an annual basis and how we’re thinking about things. We have never gotten into the level of detail around trying to break out a segment’s growth for one quarter versus another, and we don’t want to start doing that today. The context here is that we have a billion-dollar business that’s growing at a good rate while we’re launching new products, so we’ve got a lot going on here. We’re proud of the progress. And we – as your question said, we’re halfway through, so we like our chances finishing the rest of this.

And so, Karl, why don’t you talk about the annual -?

Karl Pichler

Yeah, let’s address how we see the full year evolving here. So, as you know, we’re not giving specific earnings guidance, but we’d like you to know where we see the year and what we’ve seen so far. So, first off, we are pleased with the financial results we have generated year-to-date. We have managed the company well financially and operationally, and we will continue to do so throughout the year.

Second, we launched three critical parts of the next-gen cloud, one of which is Cloud Servers, which is at the core of our offering. We’re very excited to have this milestone behind us and see it perform in the marketplace. Further exciting product launches are ahead of us during the second half of the year. Monitoring, Backup, and Block Storage are scheduled to be released during the third quarter, and Cloud Networks is scheduled for the fourth quarter. Since these products work together, we don’t really expect any significant revenue benefits to materialize before the fourth quarter, and that at the earliest.

Third, from a full-year perspective, we would like to reconfirm our capital expenditure range. At the beginning of the year, we outlined our capital expenditures budget. Within that budget, we expect to spend between $210 million and $250 million on customer gear. As you know, we make these investments in customer gear primarily to provide for revenue growth. And with half of the year complete, we expect to be within that range, and more specifically, we think we are going to come in fairly closely to the midpoint of that range.

Jason Luce

Thanks, Rob. Operator, can we have the next question?

Operator

Yes, we’ll go next to Jonathan Atkin of RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

Good afternoon. I was wondering what drove the rebound in installed base growth during the quarter. And on the capacity side – or I guess on the utilization side, that the megawatts increased more than usual during the period, and I was wondering what drove that.

Lanham Napier

Okay. This is Lanham. I’ll start with the IBG question. The IBG formula is a simple one. It’s just net upgrades minus churn. So if we look quarter-over-quarter here, a couple things to point out. Number one, churn stayed at a pretty low level, and we are very happy about that. Churn is an indicator of how much our customers enjoy the services we provide. It’s a metric around customer loyalty. We are trying to build a loyalty advantage. Therefore, low levels of churn really matter for our economic model.

The other thing that happened here relative to Q1 is that we had an up-tick in net upgrades. So it was up 0.2% per month, which is what drove the IBG number growing from 0.7% to 1%. The factor driving this is really our enterprise business. This is where we experienced the highest levels of installed base growth in the company during the second quarter.

So now I guess, Karl, you’ll do the -?

Karl Pichler

Yeah. So, yeah, you’ve seen in the table that we’ve added about 9.75 megawatts of capacity from a contractual standpoint. So we have extended our partnership with DFT with DuPont Fabros, who has really been a very proven and successful partner for us. And we have signed up for another, call it 10 megawatts of capacity, where we have two phases. The first commencement date is January 1 of 2013, where about a little bit half of that will come online. The second commencement date is the year after, so January 1 of 2014. So we continue to make these – even in a leased model, we will continue to make these lease expenses success-based and align it with our capacity needs. The lease terms are 20 years – is a 20-year term, and the total obligations are just under $300 million.

Jonathan Atkin – RBC Capital Markets

And then I was wondering to what extent that you think that there was any kind of a slowdown in demand during the quarter ahead of the OpenStack launch. I think on the prior call you had indicated an expectation that demand might be somewhat volatile, and to what extent did you actually see that volatility?

Lanham Napier

Well, I would say it’s hard to know precisely. Okay? I think really it would be speculative for me to go a long way down that path. I think here’s what we do know for sure. We know that we’re halfway through the launches, that completing the launches increases our addressable market. We also know that the early feedback we’ve received on the launches has been overwhelmingly positive. So the hope here and the belief here is that we will start to create another lever of growth for us and a driver of growth as we complete the platform. That’s what we know for sure.

Any time there’s a new launch coming, I think it actually drives a lot of attention to what’s happening. If we looked at our metrics around news stories and social media comments, et cetera, about Rackspace during the launches, we can see all that stuff go up online. Anybody on the call can go out to TweetDeck and look at what people are saying and see the amount of buzz and energy and passion around the launches.

I think the buzz out there just reflects the fact that the marketplace wants a choice. The marketplace wants to be able to pursue an open cloud versus these other closed proprietary technology systems. Our perspective is we will balance the equation to the best of our ability and keep our head down, and launch these new products and continue to make money and build the company the best we can.

Jonathan Atkin – RBC Capital Markets

Last question is I was wondering over what timeframe you’re planning to migrate the legacy cloud deployments over to OpenStack.

Lanham Napier

That is still a to-be-determined for us. There are a couple of different constraints that we think about here. The first objective, any time we think about a migration, is maximizing the customer outcome, how do we do a migration in a way that minimizes customer impact and maximizes their ability to utilize all the new capability. So that’s one factor. Another factor is doing that on a timeframe that customers enjoy and appreciate as opposed to dramatically interrupting their planning cycles and lives.

Given that we have a stable legacy platform and a new platform and series of products that we are launching, we’ll balance that out over time. You will see us pursue this with rigor, but you won’t see us rush. We’ve got the benefit of time here to be able to do it well and do it in a way that generates customer loyalty as opposed to customer interruptions. So it will be something that plays out here over quarters. It’s not going to be something we try to knock out over 60 days or anything like that.

Jonathan Atkin – RBC Capital Markets

Okay, thank you.

Operator

And we’ll take our next question from Simon Flannery of Morgan Stanley.

Simon Flannery – Morgan Stanley

Thank you very much. Good evening. You talked about needing to publish performance metrics to get customers comfortable with OpenStack. Can you give us some sense of when you think you’ll have sufficient performance stats to really start having those strong dialogues and get people making purchase decisions?

And then Karl, there’s obviously a great deal of software development going on, a lot of heavy lifting right now. If we think past the deployment of the major OpenStack offerings, is there an opportunity in 2013 for slower growth in software development or some OpEx categories? Is there any peak through the pipeline right now in this year related to this transition that maybe will give you some tailwind next year? Thanks.

Lanham Napier

Okay, great questions. I’ll handle the first one and then Karl the second. With respect to performance metrics and publishing that data around new product performances, it really speaks to the segmentation in the business.

When thinking about different customer groups, customers that are entrepreneurial, risk-seeking, and looking for a quick edge – which, in our company, tends to skew toward our SMB business – these are the early adopters, and they’re jumping on the new stuff and not worried about the performance criteria. They aren’t worried about the statistics. They’re looking for an edge, and they have their risk profile and competitive profile that they’re just going for it.

The place where the performance data are more relevant is our enterprise business. These are customers that have rigorous SLA demands that we report on today in depth. They are the ones that are going to want to see more data before making all of their decisions. I suspect the adoption cycle will happen something like this.

They’ll start trying it, they’ll gather the data, and when they’re happy with it, they’ll put it all in production. We see some of this already taking place in conversations. I think more of it will play out here over the rest of the year. And then to put a crisper answer around the timing of that, once we roll everything, because we generate so much data on the new platform – the new set of products are its own big data opportunity – the data builds up real fast. So we will be able to show people, definitively, here’s what SLAs look like on the API, here’s how many calls it can handle simultaneously, here are the scaling requirements, et cetera.

So I think that it’s really about capturing a lot of that. But we can tell you, so far, with the products we’ve launched, all those metrics and performance data are very compelling and significantly better than what we had on the legacy platform. We’re in a spot today where we can launch servers of multiple – many multiple times faster when you look at the API performance, the control panel performance; we’ve done a much better job on this. And that’s really a credit to the OpenStack community because we’re building on top of that technology. I think you’ll see us build the data here pretty quickly, Simon. It’s certainly a this-year type thing.

Simon Flannery – Morgan Stanley

Great. Thank you. And on the OpEx – or the software costs?

Karl Pichler

Yeah, sure. Hi, Simon.

Simon Flannery – Morgan Stanley

Hi.

Karl Pichler

So right now, basically, the way that we think about product is that’s really our main investment area. If you think about it both from an OpEx and a CapEx perspective, obviously, depending on the work that they specifically perform, it’s going to get categorized as one or the other. We have – as Lanham said, we’re pursuing aggressively opportunities to attract this talent, and we are very willing to invest in those areas and continue to grow that cost line, if you want, but it is a key investment that we’re going to pursue, certainly this year.

The longer-term leverage will come really from two areas. At one point, we will have the development muscle that is capable of delivering the products in a continuing manner the way that we wanted. And then we also can leverage – because the OpenStack platform is supported by a big community outside of Rackspace, we basically have leverage opportunities from both ends, on our side and from the community.

Simon Flannery – Morgan Stanley

Great. Thank you.

Operator

And we’ll take a question from Evercore Partners, Jonathan Schildkraut.

Jonathan Schildkraut – Evercore Partners

Great. Thanks for taking the questions. I actually have a few. The first question – and I guess this is a buildup of Jonathan’s earlier question – is, a quarter ago, you expressed to us some concern on the multi-tenant cloud growth in front of the transition. Maybe now, with a quarter behind you, can you give us some retrospective on how that played out against your expectations?

And then I guess as a second part of that question, at the beginning of the year, the company laid out some fairly ambitious goals, including growth in line with last year and potentially a similar margin profile, and I’m just wondering where we’re tracking versus those initial expectations. And then I have a follow-up. Thanks.

Lanham Napier

Okay. On the discussion about the cloud growth and how it’s played out and what we’re thinking today, I guess, looking in the rearview mirror versus what we may have been thinking three or six months ago, here’s how I’d summarize it. The launches that we’ve had here have, I would say, gone every bit as well as we would have hoped. The technology, we were conservative with respect to keeping the technology in beta until we were really comfortable.

We’ve launched it. That technology is in production. It’s being hit with heavy usage, and it’s standing up and performing well. So I’d say from a launch technology point of view, it has gone every bit as well as we would have hoped up to this point.

In terms of building upon you, what did we think three months ago versus what do we think today, I guess another way to think about that is to say, well, what have we learned over the past three to six months, and so here’s some of the stuff we’ve learned. The investments we’ve made in this technology – and we referenced this in our prepared remarks – literally are the biggest software investments we’ve made in our company’s history. It was a bet we started in 2010 when the world was choppy; we said we were going to go for it with this community, we were going to fund it, we were going to invest in this code, and make it work. So I think one thing we learned is that having a clear sense of vision around what we’re building matters.

The other thing we learned is that it’s complicated technology, which is why it’s taken us as long as it’s taken us. When we first embarked on it, we thought it would go faster than it has. While it’s taken longer than we wanted to get here, I am super happy to get here. I think that we will continue to operate the legacy platform. It’s performing well. The customer feedback remains very consistent. It just doesn’t have all the capability of the new one. So we really like our future, I guess, is how I’d put it. It’s taken us a while to get here. It’s been a lot of work. We still have some important work ahead of us. But we’re really confident about hitting those dates and releasing the products and such.

On the annual question, I would just echo what Karl said a few minutes ago, and I think Karl affirmed the CapEx and commented on how we see things going for the rest of the year. I’d just add onto it at the end that we’re proud of what we’re building here, and we’re proud of the progress we’ve made so far.

Jonathan Schildkraut – Evercore Partners

Great. Expectations haven’t changed. In terms of – there were a couple questions I had for Karl. Karl, I was under the impression that there were some new leases that went live in the third quarter, and I was wondering if that was correct and if there were any other seasonal costs we might think about as we project next quarter. And then it appears that there was another quarter of really impressive gains on the capital efficiency side as it applies to revenue growth relative to customer gear, and I was wondering if that was just an issue of timing or if there was some underlying drivers that we could think about. Thanks.

Karl Pichler

Yeah, nothing went live during the second quarter. And as I said before, the first commencement date is January 1, 2013, for the next 10 megawatts. There will be a small portion of the facility being made available to us to basically get it prepped up with respect to networking access and basically to get us ready to make it operational. But there’s not going to be any cost impact on that for the year. And the second question was with respect to CapEx, you said, right?

Jonathan Schildkraut – Evercore Partners

Capital efficiency, actually.

Karl Pichler

Yeah, it was capital efficiency. So, overall, if you look at our turns, which is the all-encompassing capital efficiency number, we’re pretty much flat relative to Q1. Generally, we want to drive this up, right, so we have a couple of things going on. You mentioned timing. Timing has a lot of impact on how this actually goes. So we had certain periods when we built up some capacity and then used it again – excess capacity, that is. In the current period, we’re building for the launches for the new products. We have multiple locations that launched the same product, so there’s a buildup there a little bit, and then in later periods it’s used again.

I think this is something that we continuously work on as a business. And we certainly expect to make continuous improvements, but there are not going to be any key changes where you have significant step-ups any time soon.

Jonathan Schildkraut – Evercore Partners

All right. Thank you so much for taking the questions.

Karl Pichler

Sure.

Operator

And we have time for one more question. Our final question will come from Frank Louthan of Raymond James.

Frank Louthan – Raymond James

Okay, thank you. Can you comment a little bit on some of the overseas expansion and what’s going on in the U.K., any other markets outside the U.S. that you’re looking at growing in the next few years?

Lanham Napier

Sure. In our business today, we have a European presence and an Asia-Pac presence. When we look at our growth opportunities, today, we really like Asia-Pac. Now, Asia-Pac’s a big word. Okay? There’s a – you fly around that place on 747s and 777s. So our perspective there is that it’s a great demographic for cloud services. Those economies are strong. We have made investments – increasing our investment rate there over the past couple of years. That’s an area that’s attractive to us, so I think it’s fair to say we’ll probably keep doing that.

When you look at Europe, our business in Europe is really clustered – or cluster’s the wrong word – concentrated in the U.K. We have our largest presence in the Europe in the U.K. There are certainly clients in Europe that cause all of us to scratch our heads and wonder what’s going to happen to the euro and the Eurozone and all that stuff. I would say, right now, is that we don’t have any new thing to share publicly about what’s going on in our U.K. business. I was in Europe just a few weeks ago, and I would tell you our business over there up to this point is performing real well, and we’re proud of the work we’re doing.

I do think that OpenStack presents an opportunity for us to expand geographically at a high rate as that community grows more from an international perspective. Given that we are a leader in that technology and we have as much or more expertise in that technology than anybody else on the planet right now, we do feel an international pull as that technology becomes more of a market standard and we’re successful in the marketplace in general.

Frank Louthan – Raymond James

Okay, great. Thank you.

Operator

Okay. And that was all the time we have for questions. I’ll turn it back over to our speakers for any closing or additional remarks.

Lanham Napier

Okay. Well, thanks to everybody for tuning into the call. We appreciate your interest in our company. I especially want to thank our customers that place their trust in us running their mission-critical workloads. And I want to thank Rackers, who are doing incredible work rallying to the open cloud in making this new platform a reality. We look forward to updating you on our progress here in November. Take care.

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