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Rackspace Hosting (NYSE:RAX)

Q3 2012 Earnings Call

November 06, 2012 4:30 pm ET

Executives

Jason Luce

A. Lanham Napier - Chief Executive and Executive Director

Karl Pichler - Chief Financial Officer, Senior Vice President and Treasurer

Analysts

James D. Breen - William Blair & Company L.L.C., Research Division

Christopher M. Larsen - Piper Jaffray Companies, Research Division

Gray Powell - Wells Fargo Securities, LLC, Research Division

Rob Sanderson - ABR Investment Strategy LLC

Thomas O. Seitz - Jefferies & Company, Inc., Research Division

Simon Flannery - Morgan Stanley, Research Division

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

Jonathan Atkin - RBC Capital Markets, LLC, Research Division

Colby Synesael - Cowen and Company, LLC, Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to Rackspace Hosting's Q3 earnings release. As a reminder, this call is being recorded. [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 third quarter ending September 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 Investor Relations 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 will 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 or assumptions underlining 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 time and launch of new platforms or 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 June 30, 2012, which was filed with the SEC on August 9, 2012, and our Form 10-Q for the quarter ended September 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 reason 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?

A. Lanham Napier

Good afternoon, everyone, and thank you for joining us today. In our previous calls this year, we told you that our #1 priority for the year would be our platform shift to OpenStack and open sourcing the cloud. We explained that the open cloud would become the largest, most strategic technology investment that Rackspace has ever made, and we also explained that there could be some short-term product cycle fluctuations as we introduce the new platform. We're excited to report that the rollout of our new Open Cloud platform is finally complete, and that the cloud is now open.

The open age started with Linux, next came Android, then Rackspace and NASA created OpenStack and open sourced the biggest platform of them all. It's called the Open Cloud. Now you're not locked in to the pricing, the strategy or pace of innovation of any one vendor. You're free to run your own cloud anywhere you want; in your data center, in our data centers or with any other provider. Only open source platforms allow you to keep up in the open age. Now we all have a choice. Welcome to the open cloud.

Beginning in August, and culminating last week with the launch of cloud networks, we released the following 7 new products that comprise the Rackspace Open Cloud platform: number one, Cloud Servers, powered by OpenStack; number two, Cloud Database, powered by OpenStack; number three, Cloud Monitoring; number four, Cloud Backup; number five, Cloud Block Storage, powered by OpenStack; number six, Cloud Networks, powered by OpenStack; and finally, number seven, a completely new control panel for managing the elements of the new Open Cloud platform.

With these products and offerings now in production, Rackspace offers a better, faster and more valuable cloud experience built on an open platform that gives our customers true choice and control without the fear of being locked-in to one vendor's technology. Rackspace customers can choose how, where and with whom they deploy applications, as well as the deployment option that best fits their needs, whether that's public, private or a hybrid cloud infrastructure, all backed by our unmatched culture of customer service known throughout the industry as Fanatical Support.

We have gone all in on the OpenStack technology because we believe it, number one, enhances our differentiation and competitive position in the market; number two, advances the technical capabilities of our public cloud platform; number three, greatly expands our addressable market by allowing us to extend Fanatical Support to on-premise workloads; number four, improves the capital efficiency of our model; and number five, enables us to deliver our solutions the way businesses want to consume technology, i.e. in an open format.

Looking at the competitive landscape today, the public and private cloud markets have each been largely pioneered by single vendors, Amazon and VMware, respectively. Amazon capitalized on being first-to-market in public cloud and has executed extremely well at attracting early adopters and evangelizing the potential of public cloud infrastructure. VMware pioneered the x86 virtualization market and built a multibillion-dollar business selling proprietary software to companies building their own small private clouds. However, both Amazon and VMware are pushing the legacy model of using proprietary technology to lock in their customers.

We think the world is moving in a different direction. We think the world wants choice. We think the world wants more open technologies and less complexity. This is why we are taking the open cloud approach. We believe the cloud computing era will be characterized by customers that want IT outcomes, not inputs; a superior server experience, not vendor lock-in; and a partner whose business model is built on loyalty and trust, not proprietary technology.

Our mission is to make sure that Rackspace is that partner. We are going to aggressively seize the leadership position in OpenStack, and that will include investing boldly for the long term. We believe that fully leveraging the OpenStack platform tremendously improves the technical capabilities of our offerings. From just a scaling perspective alone, our new Open Cloud has eliminated bottlenecks that prevented us from running large deployments on our legacy platform and inhibited some of our customers from growing bigger with this.

With these scaling barriers removed, we believe we are now able to compete for and run very large and complex production deployments. Our confidence in the scalability of our open cloud offering originates from the extensive testing regimen we put the platform through prior to production, and it is further supported by the early performance metrics. For example, our customers have built more than 1 million instances on the new platform, and we've handled more than 120 million API calls since the alpha release of the product. During this period, we have added thousands of customers, and the platform has delivered its targeted uptime SLA.

We believe large, complex workloads represent the fastest-growing sector of the cloud computing market. And for the first time since the market's inception, businesses have a viable alternative to Amazon. Although our offering has only been available since August, early indications of demand have been strong. In the first month of its availability, we added about as many new cloud server units as we did in the best months with the legacy platform. To be clear, it's still very early, and units do not always track directly to revenue. And even though the full product offering is now fully available, we still have more work to do. Specifically, we're now working on building muscle around higher service levels on the cloud. This is really the never-ending work of evolving to meet the performance needs of our customers. So any acceleration of growth isn't guaranteed to be overnight. That said, given all the information available to us through the end of September, we feel as if the launch of the new platform is going very well.

Of course, our strategy for OpenStack is not just limited to the public cloud. Our strategy is to enable customers to run applications on any combination of public, private or hybrid cloud resources; that means in our data center; in their data center; or in a third party's facility all controlled by the same OpenStack layer backed by Fanatical Support.

Toward this initiative, on August 15, we announced the release of Rackspace private cloud software. This product, which is available as a free download from our website, is the same open-source software that powers our public cloud platform and makes it easy for our customers to deploy OpenStack-based private clouds in their data centers. And because we are already experts in running this software, we can provide escalation support or even manage support off-premise private cloud deployments if the customer desires.

Prior to the introduction of OpenStack, the private cloud market was essentially limited to VMware software. However, we believe there is tremendous demand for more options, especially open-source alternatives. Taking the powerful capabilities of the OpenStack platform and productizing them into a service that is easy for businesses to use has been one of the most difficult, exciting and strategic challenges that Rackspace has ever pursued. Completing the project was more complex than we initially envisioned, and it took us longer than we thought it would. It required us to significantly improve our software development and deployment capabilities, and I'm proud of the way our company rallied to meet this challenge. Teams of Rackers throughout the organization have worked extremely hard to make a dream of the open cloud a reality, and I want to make sure to recognize all of their all contributions and thank them for helping us deliver on our commitments.

Successfully deploying the Open Cloud has been our #1 priority. With the Open Cloud successfully up and running and the product transition squarely in the past, our focus now shifts to growing the new platform. This is our new #1 priority. To that end, we are planning a number of new campaigns to make sure the entire world knows that Rackspace just open sourced the cloud. We need to make sure that everyone in the IT field, from new startups to Fortune 100 CIOs, knows about our capabilities. We need to make sure that the CEO of every retail business that uses Amazon Web Services knows that they don't have to continue funding their biggest competitor. We need to make sure the world knows that the Rackspace Cloud is here, it's open and it's ready for big applications.

Having delivered on our #1 priority of executing our product launch commitments, we think it's fitting to highlight some near-term goals on the table. They are: number one, getting large reference customers to run important applications on our cloud; and, number two, reaccelerating the growth of our public cloud offerings. So those are the milestones that we will be focused on and working towards.

Now I'll turn the call over to Karl to review our financial results for the quarter. Karl?

Karl Pichler

Thank you, Lanham. Let me review the financial results in detail. For the third quarter, total revenue was $336 million, representing 5.3% growth from the second quarter and 27% growth compared to the third quarter of 2011. Exchange rates had a negative impact on revenue, both compared to the previous quarter and compared to the third quarter of 2011. On a constant currency basis, revenue grew 5.4% sequentially and 28% year-over-year.

During the third quarter, installed base growth averaged 0.8%. This is down from the 1.0% monthly average in the second quarter and the monthly 1.0% we averaged for the full year of 2011. To put some context around the difference of a monthly average of 1.0% compared to 0.8%, the revenue difference for the third quarter would have been higher by approximately $430,000 per month or less than $1.3 million higher for the full third quarter.

Moving onto revenue by product. Dedicated Cloud revenue increased to $257 million, representing 4.1% sequential growth and 20% growth on a year-over-year basis. As we have indicated in the past, large enterprise-type customers are one of the big growth drivers of our Dedicated Cloud product. One example from the quarter was Southwest Airlines. Southwest chose Rackspace's intensive service level to run the AirTran mobile application on dedicated infrastructure.

Public Cloud revenue for the quarter was $79 million, representing 9.4% sequential growth and 57% growth on a year-over-year basis. Third quarter Public Cloud revenue includes revenue from our new Open Cloud platform. However, it does not include the full quarter of revenue as our open cloud products were released throughout the quarter. Third quarter results also do not include any revenue from Cloud Block Storage or Cloud Networks as these products were not released until the fourth quarter.

As Lanham indicated in his prepared remarks, the early data points suggest that our new Public Cloud product is off to a strong start. Net units added in the month of August were consistent with the best months of our prior cloud offering and more than 1 million instances have been created on the new platform. One interesting customer engagement from the quarter that exemplifies the power of cloud computing is a company called Villy Custom Bikes. They chose Rackspace's cloud sites to power their website. When the company was featured on ABC's television show, Shark Tank, traffic increased dramatically to 3.2 million hits in 25 minutes, as well as 120,000 visitors in 1 minute. Handling such a huge amount of traffic in a very short amount of time required a strong collaboration between Villy Custom Bikes and the Rackspace Cloud Sites team. We ensured that the website had the robust infrastructure needed to host this event with multiple Web servers, load balancers and redundancy. We even hosted images on Cloud Files to ensure the event went well.

Another customer example from the quarter is a company name gdgt, which is pronounced gadget. On gdgt, you can find reviews, recommendations and pricing for almost all the latest electronic products and gadgets available. gdgt also hosts live stream events, including the new product announcements, and they chose Rackspace's Public Cloud platform to handle the live stream of Apple's launch of the iPhone 5. The event produced a massive volume of traffic, approximately 55.4 million page hits and more than 500,000 live blog updates per minute, all without any degradation in website performance.

These are just 2 examples of the type of capabilities that we can enable with our cloud product offerings. In the future, we would like to share more of these cases -- case studies, and we are working on winning some very large deployments. We are pursuing various opportunities for larger production apps that our legacy platform could not handle, and we are excited to have a shot at winning these new prospects. We'll keep you informed on how these play out throughout 2013.

Moving on to profitability. Adjusted EBITDA came to $122 million in the third quarter, representing growth of 8.8% from the second quarter and 38% on a year-over-year basis. Our adjusted EBITDA margin was 36.2% in the third quarter, up from 35.1% in the prior quarter and 33.3% in the third quarter of 2011. Depreciation and amortization expense came to $64 million in the quarter, representing approximately 19% of revenue, in line with the 19% to 20% range that it has been tracking since the beginning of 2009.

Net income came to $27 million in the third quarter, representing growth of 8.2% from the second quarter and 36% from the third 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 $85 million. Of this amount, we spent $51 million on customer gear, $6 million on data center build-outs, $3 million on our consolidated headquarters facility and $25 million in capitalized software development and other projects.

Return on capital improved to 16% in the third quarter compared to 15.5% in the prior quarter and 14.8% in the third quarter of 2011. Average monthly revenue per server continued to increase to $1,287 from $1,270 in the prior quarter and $1,155 in the third quarter of 2011.

We continue to generate strong cash flows. Adjusted free cash flow was at $34 million for the quarter, which was our best result ever, in which pushed our cash balance up to $258 million. Our total debt outstanding, including capital leases, was $150 million, which translates to a net cash position of approximately $108 million. Given our ability to generate free cash flow, our strong balance sheet and our access to an additional $200 million through our credit facility, we believe that we are well funded to operate our business at the current growth rates.

In summary, we are very pleased with our execution and the results we have delivered so far in the year. We have successfully enhanced our product and services portfolio, while managing a rapidly growing business and building a better economic model. We believe the work we've accomplished so far in 2012 increases our competitiveness in this massive cloud opportunity. We look forward to updating you on our progress in February of next year and sharing our annual goals for 2013 at that time.

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 the first question today will be from James Breen from William Blair.

James D. Breen - William Blair & Company L.L.C., Research Division

Lanham, can you just talk about sort of what's happened over the last few months? It seems like you're closing the product gap with Amazon, which potentially is allowing you to do some larger deals in the cloud space. Can you talk about the focus on serving that larger Web scale apps? And then, maybe from a financial standpoint, if you think about a guy, like a Netflix, doing a couple of million dollars a month within Amazon, do you think you can be headed in that direction in terms of some of the enterprise penetration?

A. Lanham Napier

Sure. Let's go back a little bit in time and talk about how we've gotten here. If you recall, in prior calls, we discussed how our original cloud platform was really good at scaling out simple things, but that it lacked some of the capability to serve more complex workloads and applications. Our -- the genesis of OpenStack, in our thesis, there was really about, "How do we create a collaborative community to help with the development and creation of an open source standard in the cloud?" Our belief being that with the establishment of that standard, the community can innovate faster than we could on our own and that we could capitalize on that to expand our addressable market. So that work started in 2010. Here we sit in November 2012, the OpenStack community is thriving. The new products we released, the 7 that I went over in our prepared remarks, are all based upon the OpenStack community and the development of that code. Within that code and technology set, we've expanded our ability to serve complex workloads dramatically. Whether you want to look at the network capability or the storage capability as 2 prime examples, we've now put in place the necessary ingredients to be able to run a much more complex workload for customers. What's happened here inside of our company in the past couple of months is, with the execution of that roadmap, we started some conversations with large enterprise customers that we just weren't having a year ago. A year ago, the conversation would pop up, and we would gracefully bow out because we couldn't look them in the eye and tell them we could serve them appropriately. Now we can. So some of these conversations, I'm involved in personally, and we look at what's happening in the marketplace today. For example, I was on the East Coast a couple of weeks ago right before the storm hit. During those conversations with CIOs, CIOs are looking for someone to come in there and teach them how to get to the cloud. It's no longer about, "Why should I use the cloud? Why should I think about it?" It's about, "How can I get to the cloud? How should I start implementing these tools?" This is where our expertise as running the largest open cloud in the world and our position as a service provider really work effectively. The reality is, with the rise of digital commerce, IT departments need to become tech engines in the business and the cloud is a great tool to do that. So as CIOs are thinking about, "How do I become innovative in the company? How do I deliver more value for my internal customers," open cloud hits a lot of those primary items on their checklist. I feel like our company now -- given the execution of the roadmap and the conversations we're having, we now have a seat at the table from a thought leadership position that we haven't had historically. It used to be that our company integrated the technology of others and productized it to deliver it as a service. We still do a lot of that. It turns out we also create a lot of technology now ourself, and this is showing up in the OpenStack community and all the work we've done there. So I feel like now we qualify for these larger applications. We have a thought leadership position in the mind of CIOs when we talk about open cloud technologies. We're running the largest open cloud in the world. This should all translate into Rackspace earning their trust to run more complicated workloads. In the question you referenced Netflix and potentially paying millions of dollars a month. The analog there being does our new service set position us for that type of workload? I think the answer is yes. Have we won any of those yet? No, sir, we haven't but we are in conversations with them. I think this is a traditional enterprise sales cycle with some of the stuff. These customers are testing us today, okay, but we don't have that big reference win to tell everybody on the call about yet, but we are focused on it that's why we put it in our prepared remarks as one of our near-team priorities. I -- so I think your question around how's the addressable market changed? I think the new products that position us to serve these larger workloads -- it is a strategic focus of ours to win some of these customers. At what pace will they come? I don't know exactly. We've literally just completed the rollout here over the last week or so. These are big decisions that people are making, the test and dev stuff comes pretty quickly. I think the larger apps take longer to germinate on the platform.

Operator

Moving forward, we will hear from Chris Larsen with Piper Jaffray.

Christopher M. Larsen - Piper Jaffray Companies, Research Division

A couple of questions. First, your ROI continues to move up. I don't want to read too much into it. I know you've talked a lot about the capital efficiency of the cloud. You've only really gotten 2/3 of the quarter with the OpenStack. But is this a function of OpenStack in allowing you to do more with less capital? And if that's the case, where can this go as you, at some point, have greater than -- after revenues come in from the cloud? And then secondly, I wonder if you could talk a little bit about pacing through the quarter in terms of where did you see the revenues? I'd imagine that you saw slower revenue growth in, say, July, as you were preparing for the OpenStack rollouts and then possibly faster in September. Or if you could just talk a little bit about how the pacing toward the cloud revenues came into the quarter?

A. Lanham Napier

Okay. This is Lanham. I'll start, and Karl can chime in on this. When you look at return on capital, an easy way to think about it is return on capital equals turns times margin. In our business, the technology advances of the cloud help us with the turns. So in the question when you're talking about capital efficiency, for example, we believe that part of what OpenStack is going to deliver here at Rackspace is a more capital-efficient foundation for compute. That drives turns and helps us capture that efficiency in a metric. The second component is margin. Margin around here is really driven by the service levels that we deliver to customers. The higher service level we provide, the more value we create, the more potential and opportunity we have for capturing that value, which shows up in our margin. We've been able to increase ROC meaningfully here since we've been a public company. I mean, if you look over the last 4 years of being a public company, we've gone from high-single digits to now we're in the comfortable mid-teens from an ROC point of view. That's been driven by a few things. Number one, I would look at our product map and point out the incremental service levels we've added over time, things like Critical Sites. I'd look at the turns and look to the growth of our cloud and the expansion of our cloud in the revenue stream on a global basis, whether it's in North America or Europe, for example. We certainly have a lot more work to do there. We look at ROC in a disciplined manner. Today, we are not trying to maximize or optimize ROC when we do our financial planning. At the same time, we're an EDA shop and so, we're going to be real disciplined about it. In the long term, when we think about this, I mean, we are here to create economic value for our stockholders. ROC is absolutely an important metric to us when we look at our ability to create economic value added above our cost of capital. So we will continue to focus on that. I think it's still early. I think we could do a lot better on this metric. Ultimately, for us, it's not necessarily about the rates of return. It's about the aggregate economic value that we can add. So that gets into how large of a capital base can we deploy, how much incremental returns can we create on top of that capital base and how do we optimize those outcomes. So I think ROC is a good indicator of progress, it’s just not the whole story yet. We feel like our company is just a fraction of the size that it can become when we hit our potential, and we want to hold ourselves to creating value along the way, which is why we publish ROC in our key metrics. The way we will invest in this is we'll continue to try to get more efficiently in our base compute foundation and storage levels, which you'll see in the turns, and then we'll try to increase the margins or service levels. And ultimately, the mix here gets determined not necessarily by what we roll out, but what customers buy and drive loyalty around. So we will shake this to the best of our ability. But ultimately, customers get to decide what services they like the most. So that would be my thought around ROC. Do you want to talk about quarterly revenue?

Karl Pichler

Yes, sure. So as you pointed out, we've made a couple of comments over the last 2 quarters that we expect some volatility in the cloud as we go through this transition, and that's exactly what we're seeing with an increase in sequential growth rate in the second quarter and the slight decrease in the third quarter. And this third quarter is really where the -- this transition took place, and the key parts of the new cloud are now launched as Lanham pointed out. Everything is out there to be consumed, and we will now work towards acceleration again. And that's our, as stated, #1 goal.

Operator

At this time, we'll move to Gray Powell with Wells Fargo.

Gray Powell - Wells Fargo Securities, LLC, Research Division

I just had a couple of them. I know you guys touched on this in the prepared remarks, but I just wanted to kind of circle up on it again. It just definitely seems like there are some verticals, particularly on the retail side, where customers may not want to use Amazon AWS because they compete directly against Amazon. Are you having any meaningful preliminary discussions with existing AWS customers today? And is there a potential to market more around this message?

A. Lanham Napier

Okay. So the short answer is yes. We are having conversations in some of the -- in the vertical you referenced, specifically. Is there an opportunity to have some competitive wins there? Yes, think there is. I mean, we are working hard on it. We're having some great conversations. We just don't have that final win on a silver platter to talk about right now. I do think that all of the activities that generally lead to good outcomes are taking place. We're excited about the traction we've had and the conversations we're having. We're just not all the way through it yet. In terms of additional marketing activity, and we've talked about this in our prepared remarks, we think there's a category opportunity right now in positioning ourselves as the company that open sourced the cloud and leading the open cloud revolution. I mean, we are the birth mother of OpenStack, and so that is absolutely a marketing initiative. It's on our mind, and we're talking about it every day with existing customers and prospects. So I definitely see that as a marketing activity. I think our current line of thought on this is to start with the category itself around open cloud and then tailor-messaging more specifically to other verticals. This is just all work that we have to do. And so, when we talk in our prepared remarks about investing boldly to seize the leadership position in open cloud, these are some of the thoughts that occur to us and that we are contemplating.

Gray Powell - Wells Fargo Securities, LLC, Research Division

Got it. That's very helpful. And then just one more, if I may. In our field checks, we've heard some discussions from pure-play colocation providers looking to deploy OpenStack and potentially Rackspace Private Cloud Edition into their data centers as a way to differentiate themselves from other providers that purely provide space and power. Is there anything you can say there? And do you see a meaningful opportunity to partner with pure-play colocation providers in this manner?

A. Lanham Napier

Okay. In our prepared remarks, we referenced this notion of customers being able to use the open cloud in their data centers, in our data centers or in a third-party facility. The colocation example you're using right now is really that third-party facility. What this does for our company is dramatically expand our addressable market. Up until just recently, our company -- we were only relevant in running workloads that ran in our -- in Rackspace data centers. I think, with the standard architecture of OpenStack and our expertise in OpenStack, we can now provide services and on-premise infrastructure. So when you talk about a colocation company wanting to enter into the cloud opportunity, in running OpenStack Cloud, we can now extend our service and extend Fanatical Support to that infrastructure. This is, for us, we believe, an exciting opportunity. Now it's admittedly brand new, and so this is going to take a while before it has a big impact around here. But in terms of increasing our reach and scope as a company into relevant services that we could provide, this a meaningful step for us. It's a big expansion in our addressable market. It started with the availability of downloading our cloud software off of our website. So if you go to rackspace.com today, you can go out there and download the open source bits that are running our cloud. That is a really cool proposition for customers. It's been downloaded thousands and thousands of times. It's triggered a series of conversations, and this allows us to start having that on-premise conversation with customers. And now, you're doing channel check to pick up colocation companies that are also interested in running OpenStack clouds in their facilities, and then we can extend our extend Fanatical Support service set to keep that up and running inside that facility. This is an exciting expansion in our market opportunity for the company. It's early days in it, so I don't what everybody to get too pumped up and get ahead of themselves. It's just something that we view as strategic that we will make meaningful investments in.

Operator

At this time, we'll move to Rob Sanderson with ABR Investment Strategy.

Rob Sanderson - ABR Investment Strategy LLC

A question on -- just extending on that private cloud thought there. So you just mentioned thousands have downloaded your code, but where is it going? Is it SMBs? New websites or companies, Fortune 100s, potential competitors maybe? That's the first part. Second, how should we think about that opportunity you mentioned? Is that something that you think will be a material component of your business in maybe a 3-year time frame? And then finally, are there any instances where this is actually happening today?

A. Lanham Napier

Okay. Yes, you had lots of questions there. I'll try to hit them all. If I forget any, please just jump back in and remind me. With respect to the private cloud opportunity in the horizon, who's downloading all this stuff, the downloads, I would say, are a good cross-section of just about everywhere. There are a lot of downloads in North America. There are downloads internationally. There are downloads in Fortune 100 companies, and there are downloads in SMBs. I haven't personally studied the list of downloads in a while, so I couldn't tell you everybody who has downloaded it. The last time I looked, it's a good cross-section of the global economy that are looking at it. I think that just speaks to the fact that this is a technology that has a lot of interest and following. It's on people's minds, so they want to go investigate. By opening this up, we’ve made it easy for people to consume it and investigate it, and that naturally triggers some interesting conversations. So that's what I would say in terms of the downloads. With respect the timing of when this will have a material impact on our company, from a financial point of view, given this is our stockholder call -- investor call, I think you're absolutely right. I think it's a few years out. We're a company growing at a good pace today. Our sales are north of $1 billion. So to get to a material threshold where this business alone is hundreds of millions of dollars which is what I would say that materiality threshold is. From a financial point of view, I think that takes a few years out. I think if you look at from a market influencing point of view and when it becomes an important element of our strategy, I think that's happening right now, and the evidence is the downloads and the conversations we're having with people. So I think it's one of those things that we believe there's an opportunity to differentiate in the marketplace by taking a long-term view in building the open cloud leader, so that even though it may not generate material financial gains for a few years, I think the strategic gains we're having with the quality of conversations with prospects, as well as existing customers around this technology, it's already paying off for us today.

Rob Sanderson - ABR Investment Strategy LLC

And any instances where you're selling Fanatical Support outside your data centers today?

A. Lanham Napier

Yes. We announced on a call -- I won't get the timing exactly right, a little while back, the creation of Rackspace Cloud Builders, and this is a unit inside of our company that has been deploying OpenStack private clouds on-premise for customers, and then we have support offerings that follow that and we are doing that for a number of customers today. So it is in place.

Operator

Next question in queue will be from Tom Seitz with Jefferies.

Thomas O. Seitz - Jefferies & Company, Inc., Research Division

Can you talk a little bit about your strategy related to getting that first marquee customer or several of them even better? Given how aggressive AWS is on the -- on price, do you think you'll have to pull that lever initially, or is the OpenStack capability enough in itself to win customers? I guess what I'm asking is, should we expect any material change in the margin profile as you launch the full-blown sales effort behind OpenStack?

A. Lanham Napier

Okay. I'll -- this is Lanham. I'll start with this one. And, Karl, if you want to chime in about margins. The strategy is pretty simple and straightforward. We believe that, with OpenStack, we have a unique and compelling and differentiated offering. When you look at the position of Rackspace versus Amazon, Rackspace uses closed and proprietary technology, we're using open. Amazon is a generalist. We are a specialist. Amazon is playing a scale game. We are playing a service game. So from our perspective, we’re about playing this service game and delivering incredible value to these large wins so -- in these large opportunities. So I think that what's happening here from our perspective is it's a really cool conversation around thought leadership and how we can help CIOs make the leap into the cloud and move their incremental workloads onto the cloud, so that they can deliver real innovation inside of their companies. And being able to do that in a private cloud inside of our facility or a private cloud inside of their facility, it's basically saying, "Look, you can have your cloud wherever you want it." The nice thing about it, because of the OpenStack community, there's no vendor lock-in. You can run it at Rackspace, you can run at other OpenStack companies, and so this gives CIOs a pretty compelling proposition to compare relative to other offerings out there, whether it's an AWS offering or an offering based on some other technology that's available. I think that difference is more than enough to get people's interest. We're seeing that today. And now, it's just about execution where people are in their decision-making. We're running up to end-of-the-year stuff. Do they want to go it for this year? Do they want to wait until next year? We're going to have all of those types of variables that start to come into play. The answer on those variables really just depends on the customer and what they have going inside of their company versus what we can line up and do for them. So my -- our basic belief is that OpenStack and open offering, no vendor lock-in, specialization in playing the service game is going to be what wins the day here, and it won't be based on price or pulling a price lever. Karl, you want to make any comment on margins?

Karl Pichler

Yes. Let me take a step back and talk a little bit more broadly around the way we think about margins. So I think there are 3 things here that come together in our operating model. On the one hand, internally and operationally, we constantly work on improving our cost structure. So that has to do with excess capacity, utilization. It has to do with doing things simpler and in a more automated manner and a less humanized manner. Public cloud is a much more efficient sales and marketing place. So there are lots of levers that create financial leverage, if you want, on the core operating model. And we work on that constantly basically to release funds, if you want, so we can invest aggressively and pursue profitable growth opportunities. And then thirdly, the comments we're making around with our margin objectives are, like in this year for example, that we keep margins flat. That is a self-imposed discipline and the commitment to the company and to the stockholders that we will execute on. And basically, having said that, the outcome of all of this is that we're not interested in pursuing loss leaders or growth for the sake of growth. We're very much determined to pursue profitable growth opportunities, and that's our operating mode that we'll continue to pursue.

Operator

At this time, we'll move to Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley, Research Division

You talked about some of the interest, Lanham, from international downloads of the code. Can you comment a little bit on how your international business performed this quarter? And how are you thinking about expanding further internationally now that you got this new product set? And then, just a quick question on the cost for Karl. The Rackers, I think, it was 68 added in the quarter, a little bit below the pace in the last couple of quarters. Anything notable driving that? Any change in pacing that we expect in Q4?

A. Lanham Napier

Okay. Yes. Just one quick commentary on the hiring. This is Lanham. I would just say, in the last quarter, we didn't hire as many people as we wanted to. We still hit all of our thresholds on critical areas like product development and engineering. In some of the other areas, we just didn't get everything done that we wanted to. And then Karl could talk about cost impact of that going forward. And I think from a hiring point of view, we're going to stay on it and we're going to keep going, and that numbers fluctuate a little bit. Historically, we've had some bigger quarters and some smaller quarters. So I would say that's just where we are.

Simon Flannery - Morgan Stanley, Research Division

Is that one of the qualified problems, there weren't enough qualified people? Or...

A. Lanham Napier

Well, I think we are very obsessed about the engineering software OpenStack and development hires and investments we're making. As a company, we are putting a lot of focus on it. I think what happened to us is we did really well in that area. We put our focus there and not on some other areas. In the areas we didn't focus on as much, we didn't hit all of our targets. I think that's a good trade to make given where we are. It's just not what we wanted. It's a -- I call it the lesser outcome there, still okay because we hit our critical thresholds in the OpenStack area, specifically. But just didn’t get everything done that we wanted. And so then on international, if you look back at the quarter and you look back to our call that we had 3 months ago, there's a lot of talk about Europe and what was happening in Europe, what was going to happen to our business, et cetera. And what we said is, we were hanging in there and we'll let you know if things changes. And I -- if things change, I would just echo it -- that on this call. Now more international business in the quarter performed well. It's doing what we have thought it would be doing. When we plan the company’s year-over-year, we have a max and a min. The maximum is about we're not going to grow faster than that and do things that are unsustainable, and the minimum is about an internal commitment that we're going to honor each other no matter what. And international is within that range. From our perspective, international is performing well. We're excited about it. Today, if look at our international revenue bar, we have a higher concentration in Western Europe, for example, than we do Asia-Pac. We opened our offices in London, England over a decade ago, hence the legacy of the business and the growth of the business there. The question you asked about international expansion going forward, what's on our mind today is when we look across our portfolio of businesses, Asia-Pac is doing really well. And if we had a marginal dollar of investment, we are more likely to invest that in Asia-Pac going forward than we are Europe, for example. And I think you'll see us get more aggressive in Asia-Pac over time. Europe's an important business to us. It's a growing business. We will continue to invest in it, just the incremental international expansion, given all the facts out there in the macroeconomic environment pulls us toward Asia-Pac because we have a higher growth rate there anyway.

Operator

Moving forward, we will hear from Jonathan Schildkraut with Evercore Partners.

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

A couple here. I'll just ask one at a time though. At the beginning of the year, on the first quarter results, we saw some seasonality in the business and that's something that you guys had highlighted even going back to your IPO days about a kind of fourth quarter bump and a first quarter, kind of, roll-off. What are your expectations for seasonality this year, and how might we think about it?

Karl Pichler

You're talking about margins?

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

I'm just talking about the business in general, whether there's a bump up in holiday-related demands for services, whether there's impact on margins, IBG [ph], that type of stuff.

Karl Pichler

Yes. So a lot of our customers that are in the e-tailing business obviously have a huge volume increase -- volume demand increase over the holiday, so that's kind of a typical thing. And then also, on the enterprise side, I think there's a little bit of bigger corporations are just working a little bit less over the holiday. So there's a little bit of less activity there. So those 2 things kind of come together in Q4 and Q1, and that would explain the numbers that we've seen in the past. How this will play out this year-round -- or this year or next year-round, we'll talk about it after it happens. In terms of margins, I think that -- also to Simon's point before, the 67 adds that we've seen during the third quarter has already contributed a little bit to margin increases relative to the second quarter and about 110 basis points, and it will certainly have a little bit upward lift to the margins in Q4 as well just to that people side alone. But then, on the other hand, Lanham alluded to a stronger marketing campaign coming, and we may see some spend here in -- towards the end of the fourth quarter that may counter some of this uplift.

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

That makes sense. Could you give us some color on -- you talked a lot about customers moving -- new customers moving onto the OpenStack platform. I was wondering if you could give us a little color about whether you're seeing any transition -- voluntary, obviously, transition of existing customers off of Slicehost onto OpenStack maybe to take advantage of some of the incremental service offerings. If you are seeing some of that transition, is it changing ARPU levels or spend levels with you?

A. Lanham Napier

Okay, good question. The short answer is, yes, we are seeing some organic migration within our customer base, whether they're on Slicehost or a legacy cloud platform, onto the new open platform. This is driven, number one, I think, by the features set out there; number two, the performance of the new platform is superior to the old platform. So there's just a natural pull. So we are seeing some of that stuff. We don't want to get into all the ARPU data and stuff right now for a couple of reasons. Number one, I think it's still pretty early, so I wouldn't want investors to draw any conclusions prematurely on what the customer behavior dynamic is and how it differs from the old platform. It's pretty intuitive to say with more capability, we can run more complex workloads and therefore, our customer ARPU ought to climb over time when they're on the new platform. I mean, I think that logic holds together real well and makes a lot of sense. It's just still early to where we don't want to dig deep into that stuff yet and profess that we've figured that one out. I think there's still plenty of work to do there on it.

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

All right. Well, maybe we'll come back to that one in a quarter or so. And if I could sneak one last question in here, 2 years ago, you guys were doing 90%-plus of the development on OpenStack, and Jim and Brett [ph] have sort of indicated that other people's contributions have really stepped up. And so, maybe I don't know what the percent is today. 50% or 60% or less, I don't know what the number is in terms of your contribution to the development of OpenStack, but you've now transitioned OpenStack to an independent organization. There seems to be a tremendous amount of momentum around the community and the development and even the implementation. When we think about the investment that Rackspace is making, should we think -- in terms of capitalized software, should we think that the levels that we've seen you spent are good levels to think about? Or do we -- or should we believe that over time, given increasing contributions from other parties, that level could level out or it could fall down -- or come down rather?

A. Lanham Napier

Okay. Yes, but let's spend a minute just talking about OpenStack community and the progress the community is making. I think the progress within the OpenStack world points to the fact that this is a viable ecosystem now, that it's become the open source standard in cloud computing. In your question around Rackspace used to be the #1 provider of code, we're now something else is proof around it. The OpenStack Summit was just a matter of weeks ago. At the Summit, Rackspace still has an important presence. We still make a lot of valuable contributions to the code. We are no longer the #1 contributor of code. There are -- and what happened is -- what I mean by that is we are no longer providing the majority of code. Okay, we are now doing less the majority of code contributions. So other companies have stepped into it. We're still a hugely important factor and probably always will be. We love OpenStack. We think it's cool technology. We think humanity needs it, so we will continue to invest in it. From our perspective, on a strategic level, the more investment we could make in OpenStack that accelerates the community, that accelerates our leadership position in it, I think the better. And so, I'll let Karl talk about specific numbers.

Karl Pichler

Yes. So right now -- Lanham said before that this is not the time to optimize, and product is exactly -- product development scale is one of those muscles that we're in the process of building and we're very happy with the success we had so far and we continue building that. I mean, the point here, I guess, with the contributions of the community and of Rackspace, is really to accelerate the pace of innovation, not to create any sort of financial leverage on that. And I think that's the name of the game at this moment. So our product development efforts will increase commensurably with revenue over the next couple of quarters or so.

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

And, Karl, did you update or confirm the prior CapEx guidance?

Karl Pichler

Sorry, was that vis-à-vis [ph]?

Jonathan A. Schildkraut - Evercore Partners Inc., Research Division

Yes, I was just wondering if you had updated or confirmed the prior CapEx guidance.

Karl Pichler

No, we're still confirming the ranges originally indicated, total of $335 million to $405 million; and on the customer gear, $210 million to $250 million. And we see ourselves coming in at the mid to low point of that range.

Operator

At this time, we'll move to Jonathan Atkin with RBC Capital Markets.

Jonathan Atkin - RBC Capital Markets, LLC, Research Division

A couple of questions. On the customer gear CapEx, the below $200 million range, is that something we might be thinking about for 2013 as well?

Karl Pichler

Well, we're going to talk about that in 3 months from now when we share our 2013 outlook.

Jonathan Atkin - RBC Capital Markets, LLC, Research Division

Okay. And then, if you look at the incremental revenues coming from cloud, it seems like it's bounced around between kind of the mid-30% to mid-40% range, and I'm wondering if that's the sort of range we could expect going forward, or could that potentially ramp up a little bit higher due to OpenStack, or maybe just other factors?

A. Lanham Napier

Okay. Well, thinking about it -- generally, when you look across our portfolio of customer offerings, I think that what -- and we talked about this in our prepared remarks. We believe we have a platform in place now that positions us to serve larger workloads. We have not qualified for these larger workloads in the past, now we do. And we've had some conversation here in the Q&A session about what we have to do to win some of those customers, how long it would take or -- et cetera. I think from our perspective right now, as we continue this work, obviously, we want to grow the company at a sustainable rate for as long as possible. With cloud, it's still early days and we're still figuring some of this out. One way to look at our expansion opportunity here with the new product platform is that we've got the platform in place. However, to build on a question a minute ago, there's still a lot of investment to do to increase our service levels on that platform. And as we get those service levels in place, we can walk the margin up and the value creation opportunity up as well. So with respect to the growth ahead of us, we made one of our priority stated goals in our prepared remarks to accelerate in the growth from where we are right now. If you look at the sequential growth for cloud, it's traded within a band over the past year. Obviously, the bigger the company gets, the harder it is to maintain that band. So we're going to push hard to stay in the band. What we're talking about with the new platform is that the new platform expands the opportunity set, so we think there's a potential to stay within that band and maybe even do a little bit better. The short answer on it is we'll know when we get there. We'll know based on the adoption that we have, and we've only just launched it.

Jonathan Atkin - RBC Capital Markets, LLC, Research Division

Got it. And then, on OpenStack, I'm interested in kind of your read on the telco efforts to offer OpenStack-based services. There's a number of large telcos that are members, and are they -- do you some of them kind of moving more quickly than others? Or is this not going to be really noticeable for the next several quarters?

A. Lanham Napier

Okay. Great question. Generally, I think the more adoption of OpenStack and the more interest in it, the more investment in it by established companies, the better it is for all of us. So techs in this weird moment in time, where across a lot of tech, everybody competes with everybody else in different lines of business. The lines of the stack are being redrawn, the competitive framework around the stack is being redrawn as a result. I think, from a community point of view, as you have the big telcos enter the community, that's nothing but a positive. In the long run, could they turn out to be competitors of ours? Sure, they could. So how does that hit me? Well, what I'm now in my heart is that we can out serve all of them. There's a viable open source community out there, and OpenStack becomes the open source standard in cloud computing, which we think it is today. I love our position and the opportunity to build the service leader in that segment. We're a specialist in this. We're playing a service game. Our brand reputation in the marketplace is fantastic around Fanatical Support. So I think our secret sauce is around Fanatical Support and the service outcomes that we can provide. Telcos, in our experience, struggle to deliver great service outcomes. They have a lot of money. They got a lot of people, but they don't have the heart of a servant. Their organization doesn't move at Web speed. They weren't born to be a cloud company. They have all sorts of businesses that they're acting in, and the cadence is different. So I think we have a cadence advantage and a service advantage as it comes. I agree with the question that different telcos, from our perspective, are adopting OpenStack at different rates. I think that's natural. I think every company has its own set of vision and adaptability and ability to make investments going forward. So I do expect them to progress at different rates in the community. We want to be an ally for them in their progression. We want to help them get on OpenStack, and there may be an opportunity us to turn them into our customers as well.

Operator

The final question will be from Colby Synesael with Cowen and Company.

Colby Synesael - Cowen and Company, LLC, Research Division

Just 2 questions, if I may. One, just a point of clarification on margins. I think the previous guidance was for flat in 2012 versus 2011. I think you may have said that on today's call, but I also thought on one of the responses to your question you may have suggested that we could see an uplift in margins in the fourth quarter based on the lower headcount we saw in the third quarter. So I just want to make sure I understood that correctly. And then the second question has to do with M&A. Historically, you've done a lot of small, what I'd call, bolt-on acquisitions, but I'm curious if the company is open to doing larger acquisitions. Obviously, you have a very strong stock right now in terms of valuation, which would most likely lead to some pretty accretive deals if you thought -- if you were interested in doing that. And I obviously know that you guys are focused on your culture there. Does the focus on the culture prohibit you from even thinking about wanting to do some of these larger deals?

Karl Pichler

Okay. This is Karl. I'll take the first one on the margins. Yes, that's a good clarifying question. My comment, with respect to the headcount, was really the headcount-related impact on current and future margins. What happens on a corporate basis depends on all of the things coming together in the fourth quarter. And so, it's not clear at this point, but we clearly expect an uplift or a down-lift. It's just -- we'll see what the outcome will be. But the uplift was really related to the 67 heads that we hired in Q3.

A. Lanham Napier

On the M&A, you had referenced doing smaller acquisitions in our past. I think we will absolutely continue to do that, and you're -- you didn't explicitly state it, but certainly, the culture risk of a smaller acquisition is a much easier thing for us to manage as a company. Since we've been a public company, we've done a number of acquisitions. They've been very successful for us. We've been able to build on their technology. I mean, really the acquisitions we've done have been technology and capability acquisitions that we can integrate into our portfolio and offer to customers. The acquisitions we've done like Slicehost and Cloudkick and others have basically been technology foundation elements that make our cloud what it is today, so we've been very proud of our track record on that. I would say we will absolutely continue to do those going forward as part of our strategic plan. The second part of your question was, okay, so are we going to do bigger deals? And how would a bigger deal fit with our culture? Were we in the “never going to happen here” camp? With respect to larger deals, I am not one to say never, but the risk sure does go up on them. Statistically, if you look at big M&A deals, they rarely fulfill their potential. The reality is, in our company, we are a leadership team and a company full of people that know how to grow organically, and an organic flywheel of growth is a precious thing that -- and so the first level of investment inside of our investment framework is always going to be around more organic growth. The wonderful thing about organic growth is we get to pick the customers. They select to be with us, and then we build Rackers around it. The problem with M&A growth of a big magnitude where you buy a big company or a company that is half the size of Rackspace or something like that, those customers didn't choose to be here, they chose to go someplace else. And now, we're going to treat them like cattle and pull them into our fold. So that's a level of the risk. And another level of risk is the same thing with the employees. If you come visit our company here in our refurnished mall technology campus, we have an interesting, unique powerful way of doing things. So I do worry about the culture risk of a larger deal. I'm not going to tell you never, but I think it's unlikely we would ever do something real large. As our company grows, the ability to do a larger transaction that's technology-based, that increases. But are we going to go and try to do a deal that doubles the size of our company and we take on 4,000 more employees? Man, highly unlikely.

Colby Synesael - Cowen and Company, LLC, Research Division

Yes. I think what was referencing, and I think you kind of touched on it though, is that from a technology perspective, as you continue to expand out the products that there's also additional adjacent industries, such as cloud management companies as an example, that are arguably larger in scope than maybe some of the deals you've done in past and whether or not you'd be interested in those, but it sounds that you could be.

A. Lanham Napier

Yes. I think the answer on that one is, yes, we would have an interest in those types of opportunities. We would not have an interest in something that's half the size of Rackspace with 3,000 employees or something. That would be horrible. We’d get indigestion on that one probably.

Jason Luce

So that's the end of our Q&A and prepared remarks. I want to thank you, all, for tuning in today. We appreciate your interest in our company, and we'll go get back to work.

Operator

That does conclude today's conference call. Thank you, all, for your participation. You may now disconnect.

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