Rackspace Hosting, Executive Insights: Rackers, EBITDA Margins

On Monday, Rackspace Hosting, Inc. (NYSE:RAX) reported its first quarter earnings and discussed the following topics in its earnings conference call. Here’s what executives shared with analysts and investors.

Rackers

Christopher Larsen – Piper Jaffray: The first question is, can you talk a little bit about the –- you had a big jump in Rackers this quarter, I know you talked Lanham in the fourth quarter about the difficulty getting good Rackers in the third quarter, maybe just a little bit about why you did add so many Rackers this quarter and what the expectations where there? It looks like perhaps a lot of the incremental expenses were from the higher headcount plus about $700,000 increase in non-cash rent? That’s my first question.

A. Lanham Napier – President and CEO: Yes, when we entered this year, we had our eye on acquiring certain types of talent. Specifically within our investment framework, we look at the hiring of Rackers and the investment we make in human capital to be the largest investment here in the Company. When we make these investments, we are very focused on getting incredible talent and talent that shares our values and fits our culture because it’s one thing to have a great Python programmer, it’s another thing to find a great Python programmer that actually wants to volunteer their best to deliver Fanatical Support. So, as we go through our hiring process, we’re trying to find both of those. We’re trying to get both of those categories checked off in our box. So, if you look at what happened in the first quarter, we’re pretty proud of the fact that we were able to hire what we believe are some exceptionally talented folks in a good quantity, and admittedly when we do this, it does frontload our costs a bit. So, if you looked at the number of hires in Q4 of 2011 versus the number of hires in Q1 of 2012, we certainly increased our hiring in the first quarter this year. We felt like that was a really good opportunistic investment that we made, and that we will get the return and benefits of those investments here throughout the rest of the year. So, we expanded our operations here in the U.S., as well as our internationally, specifically in some of our offices like San Francisco as we were making investments in software developers.

A Closer Look: Rackspace Hosting Earnings Cheat Sheet>>

Christopher Larsen – Piper Jaffray: Just a second follow-up, if I may. It looked like the installed base growth slowed a little bit from the fourth quarter, still above the average for the last several quarters, but anything to read into that?

A. Lanham Napier – President and CEO: So, why don’t we just talk generally about IBG and then I’ll take you down into some additional details. So, if you look at our average for installed base growth in 2011, it was about 1%. So, in the first quarter of this year, we turned in 0.7% which was lower than the average for last year. So, let’s get into these details. Primarily, if you look at the breakdown here, you can see in our key metrics that churn remained very healthy at 0.8% per month. That’s actually a little bit lower than what we averaged last year. So, the difference here in the IBG number isn’t a churn issue, it’s in a net upgrades issue. So, if you recall how we do the math on this, it’s basically our comps sales ratios, it’s the growth out of the existing customers that have been online with us and what we calculate is the amount of new services (vacancies) and minus any services that we lose with them. So, when you look at this net upgrades number, what happened there is the difference in this quarter was based on some enterprise customer project downgrades. These were projects that they signed up with us on a short-term basis. We knew that they were only going to be a here for a limited period of time and then we had a few of them spin-off line here in the first quarter. So, if you remember a lot of the value in running applications with us, is that customers can spend workloads up and down and just pay for what they use. So, when enterprises can trust us to run an application like this and meet their variable computing needs with a truly on-demand solution, we’re a great fit for them. So, being able to turn things on, it turned applications up is part of the attraction to the cloud. I think as we have more success with our enterprise customers in that enterprise segment, we can expect for this to continue going forward. In past calls we’ve talked about how this is a metric that we’ll take one step forward and one step back, so we think we’re doing great work for these customers. We think there is some variability in it. Some of that variability showed up in this past quarter, but we also expect our enterprise customers to be a – continue to be a fast growing part of revenue mix because we are doing great work along.

EBITDA Margins

James Breen – William Blair: Can you talk about how you think about EBITDA margins going forward, it was up – even though down from the fourth quarter it was up from the third quarter do you expect that that can continue to increased throughout the year and you’ll see the same progression similar to what we saw last year in terms of the spending overall?

Karl Pichler – SVP, CFO and Treasurer: Karl speaking here. We are actually quite pleased with our margins research for the first quarter. Well I iterated a couple of things we said on the first quarter and in prior calls. First we do see a decline relative to Q4, but as we said in the prior call, the Q4 results were extraordinarily high and margins were not expected to remain at those levels for various reasons to be laid out back then. Second, our first quarter has traditionally been front loaded with cost, as you look back over our history, you can see that. The main driver for that is our sales and marketing muscle that we usually increase in the first two quarter, but primarily in the first quarter and you see that here as well, you have almost a percent point increase in sales and marketing cost revenue referenced to Q4 and so that strong floating of sales and marketing activities is basically what puts pressure on Q1 and possibly Q2. Third, the results of Q1are perfectly in line with our target of delivering a similar margin profile as we did for the full year of 2011 that was our stated goal. And also if you look at our investor presentation, we are exactly in those ranges that we aimed for. And last you mentioned that, before if you look at our long history you will notice that actually Q1 was a very good quarter pretty much a second backstabber depending which profit margin you look like so we are basically in line with our stated goals and in line with our range and expect that to kind of last going forward.

James Breen – William Blair: Just a follow-up to that, I know you have been launching the Block Storage products, are there additional costs that we will see in the first half of this year associated with that? Do you expect it to have an impact on your installed base growth as we look throughout this year?

A. Lanham Napier – President and CEO: Let’s talk a little bit about this transition to the next-gen platform. Based on the timing of the products that we announced at the Summit here a few weeks ago, in terms of having real revenue traction and impacts on our growth rates, personally my belief is that the products we are launching and getting to next-gen platform we won’t really see in our numbers until the back half of the year and more specifically I would say in Q4. Between here and there we have a lot of transitional work to do, we’ve opened these products up to different degrees to customers, the feedback has been fantastic so far. There is just a whole lot of work there to do to get that all the way across the line. We are very focused on doing this properly because we only get one chance to make a first impression on this next-gen platform. So, while the feedback has been positive today, we want to make it even better before we open it up on a broader basis. This platform gives us a much greater capability to run these larger scale apps, which we referenced in our prepared remarks. So, up to this point in time with the transition we are (indiscernible) where we are, we wished we were further ahead of where we are timeline wise, we wanted this to go faster, but we’ve acted prudently here to make sure that we do it really well and take great care of our customers. In terms of introducing incremental costs and such anytime we are running two platforms, the cost there is actually not a financial one, so much it is one on Rackers. It’s just harder to run two platforms at once than it is to run one platform by itself. We have been doing this now quite a while, so from a financial point of view you’re already seeing that in our numbers today. I think from an investment point of view, we’ve made really good investments around this. We’re confident in our ability to pull it off and we’ve got great customers feedback already on it.

James Breen – William Blair: Lastly, just on the installed base growth, can you talk about or give color around the customer segments in terms of if the installed base growth changed in the small, medium versus the enterprise base?

A. Lanham Napier – President and CEO: No, generally, nothing changed as noteworthy. In the prior question about IBG, I referenced enterprise project downgrades, that’s the one thing that I think is reflective of what happened in quarter that provides investors a greater level of context around what happened, but in terms of everything else in the Company, I would say it’s very similar to the last time that we talked.