Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Rackspace Hosting, Inc. (NYSE:RAX)

Q2 2008 Earnings Call

September 10, 2008 4.30 pm ET

Executives

Karl Pichler - Vice President of Finance

Lanham Napier - President, Chief Executive Officer

Bruce Knooihuizen - Senior Vice President, Chief Financial Officer

Analysts

Jason Armstrong - Goldman Sachs

Chris Larsen - Credit Suisse

Thomas Watts - Cowen & Company

Jonathan Schildkraut - Jefferies

Kash Rangan - Merrill Lynch

Devang Kothari - JMP Securities

Erik Suppiger - Signal Hill

Matt Kather - WR Hambrecht

Matt Therian - Renaissance Capital

Operator

Welcome to the Rackspace’s second quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce Karl Pichler, Vice President of Finance for Rackspace.

Karl Pichler

Welcome to Rackspace’s first ever quarterly conference call as a public company. Today we will cover Rackspace’s second quarter ending June 30, 2008. My name is Karl Pichler and I’m Vice President of Finance. We hope that you have all had the 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 broadcast online and can be accessed through the Investor Relations page on Rackspace’s website. From Rackspace on the call today will be Lanham Napier, President and Chief Executive Officer and Bruce Knooihuizen, Senior Vice President and Chief Financial Officer.

I need to remind you that some of the comments we’ll make today are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 that involve risks, uncertainties and assumptions. If such risks or uncertainties materialize or such assumptions prove incorrect, the results of Rackspace Hosting could 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 operational and financial results, long-term investment strategies, growth plans including international expansion plans to performance or market share relating to products and services, any statements of expectation or belief and any statements of assumptions underlying any of the foregoing.

These risks, uncertainties and assumptions include the effectiveness of managing company growth, infrastructure failures, changes in the economy, technological and competitive factors, regulatory factors and other risks that are described in Rackspace’s amended registration statement on Form S-1 filed with the SEC on August 5, 2008. Additional information will also be set forth in Rackspace’s report on Form 10-Q for the quarter ended June 30, 2008, which will be filed with the SEC in September of 2008.

These forward-looking statements speak as of today. Except as required by law Rackspace assumes no obligation to update these forward-looking statements publicly or to update the reasons and actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. After our prepared remarks this afternoon, we’ll be happy to take your questions.

I will now turn the call over Lanham.

Lanham Napier

Welcome to Rackspace’s first ever quarterly conference call to discuss our second quarter 2008 results. This is an exciting time at Rackspace and because this is our first quarterly conference call, I’m going to spend some additional time providing insight into our business and some characteristics we believe sets apart in the industry.

Just a little over a month ago, we successfully completed our initial public offering and listed on the New York Stock Exchange. Listing on the Exchange has strengthened our position and provided us with the capital to invest in the long-term growth of our business.

I’m going to focus on four things upfront and then provide some additional color and detail on our performance before handing it over to Bruce. First, our outline and incredible growth opportunity in Hosting, why Rackspace has been able to grow more than 50% each year for the past five years and why Rackspace is best positioned to capitalize on this opportunity in the future.

Second, I will discuss our disciplined approach to capital allocation and velocity of managing for the long-term. Third, I will talk about Fanatical Support and why we believe this serves as a significant competitive advantage and differentiates our customer value proposition in the marketplace. Fourth, I will outline the metrics we believe will be most important for judging our business performance on an ongoing basis.

To our first point, there is incredible growth opportunity in hosting and we believe Rackspace is extremely well positioned to capitalize on it. Tier-I research estimated the worldwide hosting market to be $12.3 billion in 2007 with projected annual growth rates of 26% to $24.4 billion in 2010. In 2007 we were the world’s largest hosting provider by revenue based on the same data set.

Looking at our business from a long-term perspective, we believe that growth in hosting will come in many forms. Businesses have very diverse IT needs and we believe that over time more of them will be delivered over the web making hosting a basic foundation for IT which we deliver as a consumable service.

Hosting means computing as a service and it is growing fast because it is becoming a new and better way for businesses to efficiently buy IT and computing. Hosting makes IT easier to use, more valuable and cheaper as technology becomes more prevalent for businesses, yet at the same time more complicated and expensive. The typical approach for the internally managed sever closet is clumsy, expensive and difficult to maintain.

Our differentiator in the marketplace is Fanatical Support. Fanatical Support is designed to generate more of customers. As a hoster we are service focused and strive to deliver world class experience for our customers. Fanatical Support starts with engaged Rackers volunteering their best. We combine engaged Rackers for their proprietary toolsets and systems to transform IT into a pleasurable service experience.

Overtime we have launched new hosting services, including our e-mail hosting service and our crowd hosting system. Today these services account for less than 10% of our overall revenue, but they are growing very rapidly. We will add more services in the future and continue to build out the capability of our existing services.

These terms are not limited to the United States. We have a very successful business in the U.K. that’s strong and steadily contributes to more than 25% to our consolidated business. Customers appoint us to where they need our services and as a result we are excited to have opened our Asia facility in Hong Kong just two day’s ago. We will continue our global expansion, paying particular attention to Europe and Asia.

We have also historically been able to grow faster than the overall market and our competitors and continuously capture market share. All revenues have grown rapidly and consistently. Other than the small revenue increase due to our webmail acquisition in late 2007 virtually all this revenue growth has been organic. We believe that this is a direct reflection of the demand for our customer value proposition, which is founded on our serviced approach which we called Fanatical Support.

Once we bring new customers on-board, we strive to keep them for life and continue to sell them additional services overtime. From our perspective it’s pretty simple; if we serve our customers well, they will stay with us and buy more services.

Let me talk for a minute about the target market and how we reach it. Our service portfolio and our global footprint allow us to market our business all over the world without the need of being a pushed proximity from a fiscal standpoint. Evidence of this can be seen by the fact that we serve 33,600 customers in more than 100 countries while our physical locations only reside in four places.

Our offering, like a colocation approach takes care of the complete stake of infrastructure and software to define our customer business critical hosting infrastructure. Of the 33,600 customers we serve not a single one makes up more than 1% of our business. Given the economic headwinds all businesses are currently facing, we are excited to post revenue growth numbers for the second quarter and for the first half of 2008, each in excess of 50% relative to the same period in 2007.

Moving to the second point I mentioned. We have a disciplined approach to capital allocation that drives attractive returns for our shareholders. For us everything is about maximizing sustainable long-term results. We define our long-term results as a sustainable growth of our economic profit, well profit that exceeds our cost of capital. We will continue to make aggressive investments where we see a high likelihood of attractive returns.

The key to managing our long-term growth in a profitable manner is to align our corporate resources with the demand we are facing. Given our service focus, headcount requirements are significant and we hire employees, we call them Rackers when we need them to support revenue growth or develop new capabilities, technologies and markets.

With respect to infrastructure requirements, such as data centers and office space, we strive to follow a similar just in time approach. We build out data centers and stages to minimize the amount of excess capacity; however, these kinds of data center builds are longer and require large or upfront investments. While we do try to stage investments as much as possible, we realize that these lead times depress margins and returns in the short-term. We are confident that those investments will payoff in the medium and long-term in the data center space that’s utilized.

An additional key principal of our approach is to strive for profitable growth on every customer relationship and every product we sell. We don’t want to loss leaders, normally we’ve been acquiring on profitably customers. Our sales force has been sent out to bring in profitable revenue and we see this as a key factor in establishing a corporate discipline for profitable growth. As a general principal, we commit to grow profitably as fast as we can so long as we maintain our commitment to Fanatical Support.

Third, I’d like to tell you about what we believe are very real points of competitive advantage and differentiation for Rackspace. We believe the strong financial results are the results of Rackers giving their very best everyday and ultimately doing whatever it takes to satisfy our customers. Complete customer satisfaction is our sole ambition and anything less than that is unacceptable. These are not just for us who work at Rackspace, they are culturally and operationally embedded value systems that are measured and rewarded. This unique culture is at the core of everything we do.

As mentioned before, we call our source approach Fanatical Support. It’s a major different share in the marketplace and one reason for our financial success. While Fanatical Support helps us earn our customers royalty, it also applies to all Rackers and everything they contribute to Rackspace. We relentlessly focus on the quality of the service we provide and we will not take shortcuts that will harm our customers.

Rackers and the Fanatical Support they provide drive customer royalty, which in turn lead to sustainable profits. All of these concepts become real to the continuous measurement of metrics that allow us to monitor the quality of service and progress we are making as a company.

Finally, on my fourth point, I’d like to outline the measures we believe will be most important for evaluating our business performance on an ongoing basis. Revenues are a good indicator of attraction we generate in the marketplace and the success of our service approach.

Revenues growth is achieved in two ways; through the acquisition of new customers, even our installed based customer purchase more from us, growth of the installed basis, an indicator of our success to serve customers and to keep them for like, specifically this measures how our existing customers are growing net of churn.

In our financial statements the key metrics, we provide several profit metrics such as adjusted EBITDA, income from operations and net income. Those profit metrics are useful to monitor how we deploy resources to manage our growth. Obviously, profit metrics and associated margins are all impacted by our investment base, but these are investments we make to lay the foundation of continued growth in the future.

Capital turnover and return on capital measures our success in deploying capital and in generating revenues and profits from it. On our current turnover and returns we are affected by our infrastructure projects that are currently under construction.

With respect to our data center investments, we focus on our revenues per square foot and our inflation rate. Revenues per square foot measure our ability to successfully deploy our data center space, whereas the utilization rate shows how much power capacity we have left before we need to bring new data center space online. Those debts to utilization rates are measured as power demand relative to power supply. A reasonable limit for a data center utilization rate is approximately 90%.

One last point to emphasis on our management approach is that we will not provide earnings guidance. We have a highly dynamic business with lots of growth opportunities ahead of us. We want to give you the all the information necessary to evaluate our performance. We believe not providing guidance will help us to maintain a long term perspective.

Now I’d like to provide you with some of the highlights from our second quarter and the year 2008. I’m pleased to report that as a result of our Rackers hard work and dedication to Fanatical Support, we achieve solid growth and continue to execute our long term strategy, specifically we deliver strong revenue growth during the quarter with an increase of 9.4% sequentially and 55.7% year-over-year. Given the challenging macro economic environment we believe this demonstrates the strength of our customer value proposition and our ability to execute.

We now have over 2400 Rackers serving more that 33600 customers and managing more than 42400 servers worldwide. We added almost 2000 new customers in the second quarter. Approximately 27% of our revenues were generated outside the United States as we continue to nurture our business overseas.

In June 2008 the company added 18,713 technical square feet to the new U.K. Data Center, which will partially replace our existing colocation facilities in the U.K. and two days ago we announced the opening of our Asian headquarters in Hong Kong data center. This new was about meeting strong customer demand. Rackspace already has more than 500 customers based in the Asia Pacific region. This is an important next step in our ability to meet that demand by strengthening the company’s presence in that market. We plan to offer a full range of Rackspace services to meet customer demand in the region.

Finally, I’m proud to report that we weren’t the only ones that recognized the valuable work environment we provide in our cultures. We remain one of the best places to work in information technology by computer world magazine. With that I’d like to turn the call over the Bruce who will provide some of the key financials in context around our performance in the second quarter.

Bruce Knooihuizen

I’ll provide some addition detail perspectives on the quarter’s financial results. Before I begin our second quarter discussion I want to highlight again that our IPO provides us with the financial flexibility to pursue our growth plans. Proceeds of this offering together with funds available through our committed credit facilities allow for the necessary infrastructure investments and the development of new products and technologies in all of our current geographies and markets and now onto our second quarter results.

As Lanham discussed we delivered strong growth during the second quarter with net revenues of $130.8 million up 9.4% sequentially and up 55.7% over the same period last year. Recurring revenue accounted for 96.2% of revenue with the remaining non-recurring revenue primarily a result of usage charges and set up fees associated with the increasing customers.

Our net revenue for the first six months in 2008 was $250.4 million, an increase of 57.3% over the same period of the last year. The increase in net revenue was primarily due to increased volume of services provided both due to an increase in the number of customers and incremental services rendered to existing customers.

On a net basis, we have added almost 2000 customers in the second quarter, of which over 1400 customers were in the managed hosting business. In addition, the revenue from our installed base grew by approximately 1% up in the quarter.

Adjusted EBITDA, which is defined as income from operations before depreciation and amortization as well as non-cash charges to stock-based compensation was $33.8 million for the second quarter of 2008, which was a 5.9% increase over the previous quarter and a 56.5% increase over the same quarter last year. Our adjusted EBITDA margin was 25.9% for the second quarter.

Income from operations was $8.4 million for the second quarter and this was a 17.2% decline over the previous quarter by the 7.1% increase over the same quarter last year. Net income was $4.2 million for the second quarter, a 23.2% decline over the previous quarter and a 13.1% decline over the same quarter last year.

Note that both income from operations and net income are temporarily affected by our infrastructure projects that we are undertaking and are associated from increased depreciation and interest expenses. Our total capital expenditures were $66.3 million for the second quarter; of this $32.8 million was funded by cash closed from operations. An addition of $26 million was funded through vendor financed equipment purchases.

The balance in the second quarter was financed withdrawals in our credit facility. As of the end of the second quarter we had drawn $98.1 million of the total 245 million facility. The $66.3 million in capital expenditures breaks out as follows: $27.3 million was for purchases of customer gear, $18.5 million for data center build outs, $12.8 million for renovations for the new headquarters facility and $7.7 million for other expenditures.

The company is reducing its anticipated capital expenditure estimate for 2008 from $335 million to $310 million. $10 million of the reduction is for office space that has been deferred to 2009. The remaining $15 million is in other capital that was originally budgeted for unspecified price increases that the company no longer anticipates to occur.

This new estimate also improves the capital to build out Hong Kong. Of the $20 million investment referred to in our September 8 press release $10 million is scheduled to be spent this year, most of which is capital.

Our capital base grew to $301 million. Included in this capital base are assets that are not yet being fully utilized. Prime examples are U.K. Data Center facilities in Slough, which added approximately 19,000 square feet of data center space at the end of the quarter.

As a result, our capital turnover and our return on capital are temporarily negatively affected. Our turnover ratio declined to 1.98 from 2.1 times in the first quarter, likewise our return on capital decline to 7.6% from 10.6% in the first quarter. This also explains the reduction in our data center utilization rate from 67.3% at the end of the first quarter to 59.1% at the end of the second quarter. We will consolidate some of our U.K. Data Centers into our Slough Facility, which will lead to better asset utilization and a reduction in colocation expenses that we incur for our other U.K. facilities.

I’ll spend a minute on our capitalization and our capital structure, since the IPO significantly changed the situation in this regard. Through the IPO we have raised $144.9 million; of that we have used $57.3 million through paid borrowings and we’re outstanding on our line of credit.

As a result, we currently have $87.6 million in non-operating excess cash and $195 million available and committed on our line of credit. The excess cash is temporarily invested in treasury money market funds and will be used to finance our ongoing expenses. Our leverage is currently approximately one-times.

In closing, I’d like to say that we are very pleased with our financial performance this quarter, yet we have room to improve. We will continue to be efficient stewards of capital as we make investments to drive through future growth. We will extend our leadership position taking advantage of the huge opportunity in IT hosting.

Now, I’ll turn it back to Lanham for closing remarks.

Lanham Napier

Taking a look at the second quarter and how efficient we are to our overall strategy, we continue to see strong demand growth rates and are doing what we need to serve it well. We are also making the right long-term investments to ensure our long way into that growth that will drive shareholder returns. We continue to focus on Fanatical Support as a competitive differentiator. In the bottom-line our strategy is working despite a tough macroeconomic environment.

In closing, I’d like to take a moment to thank the Rackers around the world for their hard work and dedication to driving our business through an exciting and challenging time. We are proud with what we have achieved together and excited about our position in the market and the opportunities ahead of us.

Now we’ll be happy take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jason Armstrong - Goldman Sachs.

Jason Armstrong - Goldman Sachs

A couple of questions, first maybe on just the macro-environment specifically as it relates to small business. We’ve head a lot recently about small businesses facing a ton of macro pressure; it really seems to have gotten worse since the end of 2Q. Can you give us an update from where you said you are saying this maybe comment on churn or client failure rates or any sort of bad debt expense that you’d like to flag to investors as we think of that 3Q and going forward?

In the second question I just wanted to clarify in the capital spending; the $15 million decrease as it relates to pricing, anymore clarity on what that actually is? Is that expected server pricing, were the price hikes weren’t what you expected or just more granularity there would be great?

Bruce Knooihuizen

Okay, yes why don’t we start with the CapEx, the $15 million? While it was located in our other capital it really was a reserve for the things like customer equipment or data center costs. As you know early in the seasons or early in the year we are seeing price increases in steel and copper and everything else and so we’re anticipating that throughout the year some of our costs would increase, we are just not seeing that and so we back out that contingency in our CapEx.

Jason Armstrong - Goldman Sachs

So, Bruce there is no volume component attached to that? It sounds like success based CapEx is coming down to that number?

Bruce Knooihuizen

No, it just purely price related.

Lanham Napier

With respect to the macro environment, we are absolutely feeling the headwinds like every other company in the States today. The good news here is that hosting is a high growth category, we are the leader in that category, so when you think about things like relative market share and the growth and the traction that we have in the marketplace, we feel like we are absolutely outperforming, so that while our growth has slowed we still for the second quarter of 2008 hosted growth rate in excess of 50%.

If you look at the key metrics phase which we provided in our press release and there is some great data there with respect to churn and what’s going on; if you look at the metrics line there is a line called net upgrades followed by churn, followed by growth in our installed base, we’ll just talk through contextually these numbers.

Looking at what’s happened in our installed base growth rate, we have experienced a slow down in that and really two components; one component is the net upgrades. A year ago for the six months ended June 30, 2007 that was at 2.6%, today it’s at 2.1%. What that represents is that customers business is not growing as fast, so they are not signing up for additional services from us as quickly.

If you look at the churn that’s at 1.2% for the six months ended June 30 ’08, a year ago it was a 1.1%, so the churn represents customers that have left us. So I think what’s happening there is because things are tougher our churn is up a little bit. I think the bigger driver here is that the upgrade rate, the take rate with customers adding more services based on the underlying growth in their business, that’s the bigger impact here. We are still serving customers and serving them fanatically, but in their businesses their growth is down, so they are not adding as much with us.

Jason Armstrong - Goldman Sachs

The 1.1% churn that’s in the June 30 numbers, in your mind is that already a rate that sort of accommodates the economic weakness we are seeing and because of that, that’s sort of a good rate to look at going forward or because a lot of the data points that have serviced post 2Q at lease from a macro perspective seem like small businesses have gotten a little bit worst. Does 1.1% in your mind sort of accommodate that?

Lanham Napier

Well, I think were the Q2 ended at 1.2%, I think that’s a better reflection. The number 1.1% was where we were year ago, in 2007, so our churn is up a little bit this year. As far as when will the economy turnaround and all that kind of stuff, like you’ll we don’t have that crystal ball. We are doing everything we can to fight churn to serve our customer well and keep them. We are comfortable that we did a good job on that in the second quarter.

Operator

Your next question comes from Chris Larsen - Credit Suisse.

Chris Larsen - Credit Suisse

Actually, I’ve just been looking at the total right now and maybe I’m misreading it, but the way it reads to me, it looks like churn was 1.2 in the first quarter and 1.1 in the second quarter, so actually it’s a take down; am I misreading the table or is there a misprint or is there something else going on there. I mean to go more into that same macro thing it seems to be about 99% of what people want to talk about today, have you seen anything in terms of DSO’s or those that have outstanding or delays in payments or bad debt in the numbers that would suggest material changes that we should be aware of and then compute on losses. Third question, on the deferred office space what was the rational behind differing that?

Lanham Napier

Let me start with the churn piece; on the detection churn of those folks who are leaving us, quite honestly if it’s 1.2 or 1.1 that’s relatively the same number because of rounding the things and so we don’t really see much of a change from Q1 to Q2 generally.

Now when we look at some of the other things within the company that might be leading indicators, things like day sales outstanding and bad debt, we are seeing through the first quarter and the second quarter that our bad debt continues to run less than 1%, which actually is better than what we have seen last year and we’re not seeing any lengthening in our day sales outstanding. So, some of those factors have really held up so far.

In terms of the office space and the delay, really it’s just the timing difference. As you know with CapEx as you get closer to the end of year, something starts slipping into the following year and so it’s just really a case of the dollars not being spent in ’08, but will be spent in early ’09. So, it really is just the timing difference from that standpoint.

Operator

Your next question comes from Thomas Watts - Cowen & Company.

Thomas Watts - Cowen & Company

It’s two questions, one just a little more clarity in the insurance and plus that other concern is have there been any more changes since the end of the quarter, I’m not sure I understood that exactly if you’ve seen any increased activities, but second could you give us an update on just the e-mail business and also the cloud computing business and the progress there?

Lanham Napier

Sure, with respect to the update on churn, we’re going to share the Q3 here with everybody a little bit, so this called is really a little bit a typical of the regular schedule that will follow. I think that we want to leave you with is that the churn this year is higher than a year ago and I would expect that to absolutely continue relative to our performance a year ago. We are doing everything we can so fight it, but the reality is the condition this year are worst than last year. So, I think the headwinds show up in the churn, it also shows up in a slower upgrade rate.

Heading into this year, we felt like this was going to be a recession, so when we looked at our growth plans to offset what we felt were going to be slower upgrade rates in the base, we increased our marketing spending, so that basically what we did was we said we’re going to grow our new customer acquisition to offset the slowdown what we have in our current take rate in our existing customer base and so when you look at our win rate with our revenue growth with the new customers, we are growing significantly faster than a year ago.

So, going into the softness we are still looking at a recessionary environment; everyone is shopping, we’re going to go grab more than half of your share. We are the leader in the marketplace, so it’s a chance for us to grab market share. We are doing that today. I’m happy that we made that decision last November, because as predicted the economy has been tough this year and we’re feeling that in the upgrade rates in the churn.

With respect to the Email and Cloud businesses, those businesses are a bright spot in our future. They are each growing at triple digits today. We continue to have a remarkable traction there. Email in particular, we made an acquisition last year of a company called Webmail that we are sitting there lead by Pat Matthews. Pat there completes the superstore and he is making it happen over there.

Our Cloud business with Mosso, is also grabbing pretty good revenue traction today. These are businesses that the way we evaluate them we are not trying to make these businesses profitable today, these are our seeds that we are planning for the future and so what’s happening is we have a lot of OpEx investments with respect to the sales and marketing spend, as well as the developers that we’re employing to develop the course of these offerings and so what happens in these offerings today, is that it’s about traction in the marketplace. It’s about are we winning customers, are we leading this charge and across both of them we are.

The nice thing about Cloud offering today is you here a little of price point. So, if you go online to Mosso which is our brand for the Cloud offering, they are hitting a lower price point than our traditional managed business, that’s nice in a recessionary environment. So those two businesses are growing rapidly, we’re going to continue to make the investments there, because we’re pleased with their progress.

Thomas Watts - Cowen & Company

Okay and could you also just comment on sales force expansion, how it’s tracking relative to your goals and also how sales is going really in the quarter, for sales people?

Lanham Napier

I guess the first part of the sales force question is how are we doing in terms of ramping our quarter bearing headcount? We’re on track with where we want to be with that. Right now we’re making sure that as we enter this space of the year, we are thinking about next year and beyond.

The reality is when we bring a rep into Rackspace, they have a ramp period, we’ve got to train them on our service set, and we’ve got to indoctrinate them into our culture and understanding the Fanatical Support, so it takes a while for us to get them fully up to speed. So, the investments we are making now on the sales force are really not going to impact this year at all, it’s about impacting next year. That is primarily driven on the new customer acquisition and then partially driven by the existing customer operate right. Okay so, we feel very comfortable that where we are in that.

With respect to where we are in terms of goal achievement, without getting to specifics, I’ll tell you that contextually how we think about it; we have a celebration here called Rackstar, which basically our sales reps hit their numbers, this is our celebration for that achievement. We are pleased with the number of reps hitting Rackstar on a quarterly basis and so its one of those things that you never want it to be 100%, so that means your goals not high enough, you don’t want it to drop below 50%, because that means people are demoralize. So we are happy with that achievement in our teams and we manage it for that outcome.

Operator

Your next question comes from Jonathan Schildkraut - Jefferies.

Jonathan Schildkraut - Jefferies

I wanted to ask about what the economy is doing to your competition. You had mentioned that you stepped up some of your marketing spend and we understand that you do compete with some national players, but a lot of time you are competing with maybe the local integrator who may not be as well capitalized certainly after IPO as Rackspace is. So, I’m wondering about the competitive landscape and what you’re seeing from the small regional guys that you compete with; thanks.

Lanham Napier

Sure, I think there are a couple of things going on. Anytime the market gets tough likes this it’s a sorting mechanism. Within our traditional competitors many of the folks that we compete with are journalists Jonathan, so we are a specialist, hosting is all we do. When we compete with big players today, the AT&T, etc, they are like every other company I think really focused on their core business. So, the secondary step like hosting has to end up on the buck-burn.

When you get down to the regional guys, mom and pops as you identified in your question, I think they are rapidly becoming capital constrained. I don’t have great evidence to share with you on this call about how they are having to stop expansion activities; they can’t afford to go along customer gear, but I have no doubt that for folks they went along significant data center capacity a year ago, borrowed money to do that and are having trouble throwing it up. Now I’m hopeful that there will be assets sale in the future.

Operator

Your next question comes from Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

My question for you is that it certainly looks like your taking advantage of the market conditions to be more aggressive. Lanham and Bruce maybe you could identify in the short-term what are the hits you are taking as you embark on this aggressive expansion strategy along the line of the metrics that you are going to be reporting.

In converse if we are to come out of a recession hopefully and get a cyclical rebounded in the economy and things start to go in the bottom next year, how should those metrics then conversely benefit from all the investments that you’re making. I aware it’s a fairly open ended question, but you can answer it anyway you would like and that will be very good color. Thanks a lot.

Lanham Napier

Yes sure, I’ll start with some context and then hand it to Bruce for the metrics. One of the things that we try to balance, is it’s not about market share at all costs or growth at all costs; we have a disciplined pricing approach. So with respect to every customer we’re winning, we are going to make sure that we earn a profit on that customer.

So, in times like this we are willing to drive up our acquisition costs, so long as that customer fully burned all of our cost to serve, our data center costs, our capital costs are covered, we are happy to win that business. So that is a trade off that our sales reps are making on a daily basis and our sales reps compensation is driven by the value of the deals that they win, okay.

So this decision takes place on the front line on a customer prospect by prospect situation. So that’s the tension we are managing in the business, it’s how do we maximize growth and manage profitability at the same time because we’re not going to grow just for the sake of growth.

Bruce Knooihuizen

Yes, in terms of some of the metrics when you look at our adjusted EBITDA for instance two years ago we weren’t having EBITDA margins that were approaching 30%, but we decided to make some investments and really plan things for the future and so what we’re seeing today is not so much on the impact of the slowing economy, but the fact that we brought down our margins a few percentage points in order to invest in some of the future technologies like Cloud and Email and so when you look at our margins in the second quarter for instance we’re right around 26% on an adjusted EBITDA basis.

I think what you should expect is that our margins will probably stay around that range, that will be banded probably pretty narrowly in that range as we go forward, as we continue to invest in some of the new products. Now obviously when the economy turns around, if we continue to grab market share, we’ll have a much larger base that we’ll go back to and leverage as we sell into that base going forward.

Kash Rangan - Merrill Lynch

Conversely your incremental return on invested capital should pick up, the churn rate should go down and the installed base business should pick up and therefore our margins should go up, right. Is that the right way to think about the different metrics that you choose to present your business on as the economy hopefully gets better?

Bruce Knooihuizen

Generally, I think that that’s true and also keep in mind that we’ve made some infrastructure investments today that have pulled down some of our returns and as we continue to go forward we’re not going to have the same level of the infrastructure investments that we have today and so our margins should improve from that.

Kash Rangan - Merrill Lynch

And finally, Bruce if you are able to answer this question, what do you consider to be an acceptable and reasonable return on your capital considering that you just went public. You’re probably using a variety of assumptions on Rack, but I’m just wondering what’s your assumption as to on Rack relative to what you think is a reasonable rate of return. Not at this point yet because I understandably you’re putting a lot of money, but as you exit this cycle what is the reasonable rate of return?

Bruce Knooihuizen

That’s a great question; in fact when you look at some of our returns on capital, historically we’ve had some close to 30%, but those are the day’s that we are getting data centers almost for free.

Now as we can replicate that, that will be terrific and we’re certainly looking for those opportunity, but if you look at our data centers today and you put them on a fully burdened basis and replicate the costs of today costs, what we are seeing is our return on capital should really be approaching between 18% and 20% on those. Now, that’s just our currant technologies.

When you start thinking about things like Cloud Hosting, actually we expect to be more efficient with our capital in those technologies going forward. What those returns might be at this point, I don’t have a number that I could share with you, but we certainly expect to be more efficient with that capital in the future.

Operator

Your next question comes from Devang Kothari - JMP Securities.

Devang Kothari - JMP Securities

I wanted to go back to the competitive environment that you are seeing out there and as you mentioned you might have some smaller competitors that maybe capital constrained at this environment. I just wanted to see if you’re seeing anything in the pricing environment where those companies are getting more aggressive or are you seeing any change in behavior there?

Lanham Napier

Yes great question, the short answer is yes. I think on the low end of our business, the entry level managed when you’re talking about an MRR, a monthly recurring revenue charge of a few hundred dollars, I would say the price competitiveness there has increased. I think that what happens is, the way the competitive dynamic works in our market is that we’re the leader and we differentiate based on Fanatical Support and so Fanatical Support is a brand promise around the experience the customer is going to have here.

Well, we are the recognized leader, we’ve got the best service in our industry and so the way that the Mom and Pops compete with us has always been on price. They’ve always tried to undercuts us to win. So now I think that their faced with the situation of demand; the only lever they have to pull is price, so they are pulling it. When we look at our business we have lots of levers to pull for growth.

We have the new customer acquisition lever which we focused on this year, we have an international growth lever which we focused on this year and we have an installed base customer growth lever and so I think that we just have more arrows in our quiver so to speak on this. I think the regional guys they really just have price and so they want to compete on price.

We’ve recognized that given our profitability levels, we have the best cost structure in our industry, so if those guys want to compete on price and cost we believe we have a real good understanding of what that looks like and we are happy to do that for a while.

Devang Kothari - JMP Securities

It sounds like there would be some pricing pressure put on you and you may not be able to sustain to same level of price that you have in the past of the environment, given the competitive outlook?

Lanham Napier

Yes, I think when you are talking about the extreme low end of our offering, I believe that’s correct, I think that’s accurate. I think what will happen though is rather that win the deal at a loss, we’ll let it go and based on our cost structure and performance as a company, we know that we had the best cost structure in the industry and so it’s not profitable for us and a competitor who wins it really isn’t going to like that business for very long.

Devang Kothari - JMP Securities

Bruce, I had a question on the Slough Data Center consolidation; could you give us some idea of what kind of synergies you’ll receive once that consolidation does occur?

Bruce Knooihuizen

Currently in the U.K. we opened up the first stage of the Slough Data Center. Currently, over in the U.K., we also have multiple sites that we have data centers, where we are really in a colocation environment and so as we migrate those customers out of that data center into Slough, obviously we won’t have the lease cost associate with the colocation areas and so that should improve our income statement.

Likewise, it’s not just about truly the dollars we’ll save from a colocation standpoint, but it’s also from a quality standpoint and so one of real advantages that we have with our new data center is, it’s the state of the art data center. We built it to our specs and we just think we’ll be able to service the customer a lot better, fewer outages, fewer problems than we have in the colocation efforts and so there are multiple ways, some are easily quantifiable, some of them are a little bit more difficult to quantify, but those are the kinds of things that we look at going forward.

Now, in terms of the migration out of some of the other data centers, that will continue even through next year, so that will incur that savings over time, it’s not an immediate savings.

Devang Kothari - JMP Securities

So, we should expect utilization to stay around this area in the near future at least?

Bruce Knooihuizen

In total utilization of the Data Centers, we ended the quarter at about 59% utilized across all of our company and that utilization will go up as we start filling that with new customers.

Devang Kothari - JMP Securities

Okay and then last Lanham, you had mentioned you were pretty happy with the job your teams done up till the end of Q2 in terms of managing churn; are you still pretty happy with that effort so far?

Lanham Napier

I’ll let you know about Q3 in a little bit okay?

Operator

Your next question comes from Erik Suppiger - Signal Hill.

Erik Suppiger - Signal Hill

You had discussed total customers of 33.6 thousand, you said you’re mailed customers were 13.8; how much overlap do you have or can we assume that you’re around 20,000 for your traditional customers?

Lanham Napier

The managed hosting customers are about half of the total, the other component there is the Cloud customer base.

Erik Suppiger - Signal Hill

Okay, can we get any clarity in terms of how that breakout would have been for Q1?

Bruce Knooihuizen

Yes, it should be in the metrics page, isn’t it?

Lanham Napier

It’s in the front note on the metrics page that we handed out.

Erik Suppiger - Signal Hill

Was the break out for the Cloud customers again the difference between the -- I mean can we assume that you don’t have too much overlap between the traditional and the Emails, so again just divide it by two and assume the difference between the Mail customers and half for the traditional that would be the Cloud customers; is that the way to think it for Q1?

Lanham Napier

I’ll give you some data. If you look at March 31, 2008, the total customer account was about 31,675; of that our traditional managed hosting business was 16,365, the balance was Mail and Cloud.

Erik Suppiger - Signal Hill

Okay, can you give me what the email was for Q1?

Lanham Napier

Yes, email was right about 13,000 and you got 2000 in Cloud.

Erik Suppiger - Signal Hill

Secondly, can you give us any sense for how much you’re spending on R&D; you’d said you’ve been taking that up. Any flavor for what kind of impact that would have had on your EBIT or your EBITDA margin in the June quarter?

Bruce Knooihuizen

Generally we’ve got a lot of different bucks of R&D, some is capitalize and some is expense and when you’re looking at our EBITDA margins, again on sort of a pure play basis our EBITDA margins were run at about 20% or 29% and today they are roughly 26% and I would suggest that that 3% difference is primarily of our R&D efforts from the income statement standpoint.

Erik Suppiger - Signal Hill

And then lastly it sounds like in a tougher environment, you’re willing to spend more on sales; you’ve kept your pricing fairly consistent, but you’re willing to spend more on sales to get more aggressive to pull in more accounts. What you do to get more aggressive on sales and how do you spend more to close on those deals?

Bruce Knooihuizen

Yes, a couple of things. I think one is just the advertising rate, okay so that our social advertising, banner advertising, call campaigns would have it; we will increase that activity we try to drive incremental lead flow. Once the lead flow is in with respect to our sales activities, it’s really about having more reps working more deals and so we will absolutely push the level of activity that we’re doing. That level of activity increases the sales and marketing costs. We are happy to do that, so along as we feel like the trade offers a good one.

Right now, we talked earlier about headwind pressure on churn, headwind pressure on net upgrade rate and headwind pressure generally and so I think we are happy to do this in the push on the sales activity, so long we feel like based on our economic models that this customer is going to be profitable for us.

Erik Suppiger - Signal Hill

So that does translate into a higher sales and marketing expense though in terms of the income statement, is that correct?

Bruce Knooihuizen

Yes, if you looked at our payback today on a new customer acquisition relative to where we were a year ago, the payback has increased. It hasn’t increased at an alarming rate, which is why we think the trade is still a good one to make. We feel like if we start to push that and hit the diminishing returns, we’ll take that under considerations and start working out; its not worth the extra five points.

I mean our basic point of view is, we are here for the long haul and so to grow an extra three or four points this year and screw up our financial model isn’t worth it to us. If we can grab share at economically attractive rates, we’ll do at all day long, but we are going to follow our discipline and not violate it.

Erik Suppiger - Signal Hill

Last one, just coming back to my first question Lanham, can you tell us what the traditional customers were in the Q2; you said it was about half, if you have the actual number that will be great.

Lanham Napier

In Q2 it was 17,220.

Operator

Your next question comes from Matt Kather - WR Hambrecht.

Matt Kather - WR Hambrecht

Just a quick question on the virtualization; I think it’s pretty early that you’ve just recently launched in last quarter or two, but can you share with us how that’s affecting your servers deployed and maybe the economics of the business as it’s being asked for by your customer base?

Lanham Napier

First thing, it is early in the game for us. What I would characterize virtualization is that in the long run what it will do is drive down the basic level cost of compute. I would say at this point in our offering, I would call it rapid traction actually. We’ve rolled it out and it’s growing pretty darn fast.

We are pleased with that growth as far as making a significant impact on the number of servers we’re deploying on a monthly basis, it’s not doing that yet. I think, it will a take a while for the offering to mature, because basically today the decision that a customer has to make is the goal standard for application up time is to really run your application on dedicated infrastructure, that’s the way to get the best performance.

When you talk about virtualization you can drive down our cost to compute by pulling resources and sharing those resources across multiple customers or just virtualizing the environment for one customer. Today what’s happening is that the virtualization offering in our traditional managed business is a virtualized offering dedicated to one customer. Okay, so we still have a customer and we’re still deploying dedicated gear by customer, but what the customers are able to do with virtualization, is get a higher utilization rate on that basic compute element, the server.

So it was not impacting our server deployment rates yet. Over time as we take virtualization to the next level, we are pulling resources to create a pool of servers and compute power and when we share that compute power across multiple customers, it will impact several deployment rates, but it’s not there yet. I’ll tell you what we’ll be happy to tell you about though is virtualization is real, the market wants it and in the long run it’s going to be a wonderful thing for us.

Matt Kather - WR Hambrecht

Sort of post the offering you said you paid down $57.3 million in debt and $187.6 million in cash, what was in about one-time leverage is it that right?

Bruce Knooihuizen

That’s correct. If you look at our balance sheet today, we’ve got about $50 million of outstanding debt, so we used to proceed to pay down all of our credit facility except $50 million that have been hedged and so we left that outstanding. In addition to that, we have leases which are a little over $70 million with the capitalized leases and a few notes payable. So that gets us to about 130 in total debt.

Now, on the plus side of that, we have $87 million of cash and $195 million available on our credit facility still and so we feel we’re well capitalized particularly with the economy and the way it is, we feel that we’re in great shape and we’ll be very careful in deploying our capital and by the way that 130 that leads us really to the total leverage ratio of one-time.

Matt Kather - WR Hambrecht

Is that what you’re comfortable with sort of going forward? Is that how you’re looking to manage the business at least for the near term?

Bruce Knooihuizen

We don’t have plans to go out and raise more debt in the near-term. I think that between our current credit facility and the cash and the availability from some of our vendors that provide regional arrangements at attractive rates, we feel very comfortable with our capital structure and the way it is today.

Matt Kather - WR Hambrecht

Last thing you didn’t mentioned the share account; is there any guidance you can give us just with all the moving pieces after the issue and all the employees exercises etc. of where your see the diluted share account shaking out for Q3? Are you going to share that with us?

Bruce Knooihuizen

Yes, that will be in the Q that we are sending out shortly.

Operator

Your final question comes from Matt Therian - Renaissance Capital.

Matt Therian - Renaissance Capital

Could you just take us through like the upfront costs your customers pay when they convert to a managed hosting solution and how are those when compared to colocation?

Lanham Napier

Yes, we’ll be happy to and we will start by the fundamental difference between our business and colocation. Colocation is a real estate business. Basically the customer does the computing themselves. They rent space inside the data center. Once they have the space the customer then has to go acquire all of the servers, all of the network devices, the racks, the cabinet, the cables, etc, so there is a CapEx investment there. Then the customer has to employ the right folks on their team to actually go deploy that gear and make that gear run on an ongoing basis.

So there is a balance sheet item there for the customer in terms all of the capital they have to buy and there is an income statement item in terms of the employees they have to have to go run this infrastructure on their behalf. So that’s colocation, it’s a real estate business in which the customer does the computing themselves.

Our business, we take all that stuff on the balance sheet and turn it all into a variable routine operating costs and so there basically is no upfront investment from the customer. They sign an agreement with us, we go purchase the equipment, so the equipments on our books. We maintain 2,400 Rackers on a global basis to run the infrastructure for the customers. It’s inside of our data center and so basically we are a turn key managed solution for the customer. So that the customer with us who’s going to enter into a contract will state a monthly fee for the services we provide.

There is a lot of discovery upfront in that sales process to make sure that we get the right fit with the customer and so ultimately when you look at the difference between co-lobby in the real estate business and our company being a service business. The average colocation company will be at $50 to $60 per square foot per month of utilized data center square footage, we are going to get eight to 10 times that. So it speaks to the fact that we are providing a service. There is a lot more value in what we are providing to the customer relative to the colocation offering.

Karl Pichler

That concludes our call today. As a reminder, please note that certain financial measures that we used on this call such as adjusted EBITDA and return capital are expressed on a non-GAAP basis. Our GAAP results and GAAP to non-GAAP reconciliation can be found in our earnings press release which is available on our website. Thank you again for your time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Rackspace Hosting, Inc. Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts