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Executives

Erik Bylin - Investor Relations

Mark J. Barrenechea - President, Chief Executive Officer, Director

James D. Wheat - Chief Financial Officer, Senior Vice President

Analysts

Louis Miscioscia - Cowen & Co., LLC

Mark Kelleher - Canaccord Adams

Doug Reid - Thomas Weisel Partners, LLC

Alex Kurtz - Merriman Curhan Ford & Co.

Rackable Systems, Inc. (RACK) F3Q08 Earnings Call November 3, 2008 5:00 PM ET

Operator

Thank you for joining us on today’s conference call to discuss Rackable Systems’ third quarter fiscal 2008 earnings results. I would like to remind you that this call is being recorded and simultaneously webcast at www.rackable.com.

At this time I’d like to turn the call over to Mr. Erik Bylin for opening remarks and introductions.

Erik Bylin

Thank you for joining us to discuss our press release of this afternoon which is available on our website at www.rackable.com. I’m Erik Bylin, Investor Relations for Rackable Systems, and I’ll be managing the call. On the call today are Mark Barrenechea, our President and Chief Executive Officer, and Jim Wheat, our Chief Financial Officer.

Before I turn the call over to Mark, I’d like to bring the following to your attention. The date of this call is November 3, 2008. This call is the property of Rackable Systems and any recording, reproduction or retransmission of this conference without the express prior written consent of Rackable Systems is strictly prohibited. This call is being webcast live and a web replay will be available on our website for approximately 90 days.

Our presentation today contains forward-looking statements reflecting management’s expectations about our markets, business, products, operating plans and financial performance as well as events and circumstances that have not yet occurred. Statements containing the words such as will, expect, believe, project and intend and other statements in the future tense are forward-looking statements. Any statements contained in this press release that are not statements of historical fact may be deemed forward-looking statements.

Actual outcomes and results may differ materially from the expectations expressed or implied in these statements due to a number of risks and uncertainties including Rackable Systems operates in a very competitive market and increased competition has in the past and may continue to cause pricing pressure on Rackable Systems’ products which would negatively affect Rackable Systems’ gross margins and operating margins as well as other financial measures, and a significant portion of the company’s revenues come from a small number of customers so the delay in placing an order or the failure of a significant customer to place additional orders could have a significant negative effect on Rackable Systems’ financial performance.

Accordingly, we caution you not to place undue reliance on these statements. These and other risks and uncertainties affecting Rackable Systems are set forth in our annual report on Form 10K under the caption Risk Factors which was filed with the Securities and Exchange Commission on March 13, 2008 as updated by Rackable Systems’ subsequent filings with the SEC, all of which are available at www.sec.gov. We expressly disclaim any obligation to update or alter our forward-looking statements whether as a result of new information, future events or otherwise.

We’ll be disclosing non-GAAP financial measures in this presentation. For a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures, please see our press release of today which is posted on our website at www.rackable.com.

Now I’ll turn the call over to Rackable Systems’ CEO, Mark Barrenechea.

Mark J. Barrenechea

Thank you for joining our FY08 Q3 earnings call. I’d like to spend some time on our financial results, company innovation, the economy, and our vision of the market and how we intend to address our customers’ needs.

As mentioned in our press release on October 13, we adjusted our full fiscal year guidance after observing an abrupt slowdown in the economy and corporate purchasing. Our full fiscal year guidance remains unchanged from our October 13 press release: Revenue between $275 million and $300 million, non-GAAP gross margins between 16% and 18% points, negative non-GAAP EPS between $0.08 and $0.16, and end-of-year cash and investments balance between $175 million and $200 million.

During fiscal year ’08 Q3 reported revenues of $65.3 million, non-GAAP gross margins of 17.6%, a non-GAAP loss of $0.05 per diluted share, and ending cash and investments balance of $184.6 million. The quarter-over-quarter cash change is primarily due to funding of inventories and manufacturing capabilities necessary to address ICE Cube order backlog we expect to deliver in Q4.

While the economy remains uncertain and corporations are evaluating their cost structures and strategic projects, we are managing costs prudently and investing intelligently in Rackable’s future. With that we are prioritizing our strategic initiatives in repurchasing dollars to increase our R&D investments and sales force coverage. Rackable has a solid balance sheet that affords us long-term staying power and strategic flexibility which will help us invest for long-term growth and an outstanding customer experience.

I’ve been in the technology sector for near 25 years and I’ve experienced up economies and down economies. In down economies you focus on what you control; costs, relevant innovation and the customer experience. Rackable is in a strong position to invest in short and long-term innovation projects. Down economies increase the rate of change and during this economic downturn I believe the pace of change for data center transformation will continue to accelerate. CIOs and data center directors seek technologies that will transform the IT landscape, and the data center is at the heart of this.

In 2009 progressive data centers will have the following characteristics: Maximum energy efficiency, extreme compute and storage density, facility cost reduction, greater utilization, integrated compute storage and networking systems running heterogeneous workloads for the Internet, content delivery and enterprise applications and build-to-order environments. Why buy from a catalog when you can design your data center exactly the way you want it? Some call this Data Center 3.0.

We are keeping a rapid pace of innovation. Our engineering is focused on delivering products that allow CIOs and data center directors to deliver on the promise of modern data centers. Rackable is well positioned to do well in tough times.

Last quarter we introduced our XE series focused on server and cabinet level energy efficiency and the requirements for pod core technologies. Our new power supply line provides over 96% efficiencies. The XE series powers web-based applications and servers, video content as well as enterprise applications leveraging database centric architectures such as ERP, CRM and email solutions.

We recently announced the C2005 and the CloudRack. The C2005 is like the Swiss army knife of chassis with all the efficiency of the XE series. It is a 2U chassis that supports many motherboard configurations, compute architectures, 2.5” and 3.5” drives including solid state, networking flexibility for our 10G through [effiniband], and creates an ideal platform for data center consolidation.

The CloudRack is transformative. It supports over 700 compute cores or 352 terabytes of storage in a single cabinet. It is ideal for cloud computing and HBC deployments. The CloudRack enables configurations never thought possible before. We removed 75% of all chassis metal and changed the enclosure mechanism to low profile trays. Further, we removed all localized air flow and created centralized heat exchangers.

The end result is extreme configurability, a long service life, improved reliability, ease of service and manageability, and our greatest energy efficiency and density designs to date. The CloudRack is at the intersection of Eco-Logical, it’s economical and truly represents the next generation of cabinet level designs.

We feel so confident about the above designs, their serviceability and manufacturing quality as well as our current product pipeline that we will begin to offer a new program over the next 60 days; a lifetime product warranty program. Rackable will warranty all components for factory parts and labor for the practical service life of the product. Details of the program will be announced in the coming weeks.

We continue to build momentum with our containerized data centers. For example, we recently introduced a new and radical UPS system design. The current UPS systems are centralized, overbuilt and expensive with no ability to tune the power requirements to a server, cabinet or application. We think there is a better way. The better way is to decentralize and create an inexpensive approach inserting passive charging battery technology into each cabinet. We call this the PECO approach and our UPS systems are now available to customers.

In Q1 we plan on expanding our addressable market by introducing an air-based container. The air-based design will be as revolutionary as our water-based design. With our XE series, C2005 scale-out CloudRack, [J-bod] and [R-bod] Omni store solutions, [inaudible] partnership, expanding ICE Cube configurations, our product line card going into 2009 has never been stronger and never more focused on the Data Center 3.0 transformation.

With that I would now like to pass the call over to Jim for an in-depth discussion of our financials.

James D. Wheat

Before I begin, please let me add to what Eric said earlier about our use of non-GAAP financial measures. Our non-GAAP financial measures appear in our press release issued today along with the required reconciliation tables. In this call I will be discussing earnings, gross margin, operating expenses and similar items on a non-GAAP basis which are reconciled in those tables. If an item is not specified as non-GAAP, then I am referring to a GAAP number in my remarks.

Although our revenue came in light for the quarter at $65.3 million, we can point to quite a few positive indicators within our revenue mix. Our sales team continues to strengthen our position in non-Internet verticals including financial services and proximity computing. We also delivered our largest deployment to date in the oil & gas vertical with a Top 10 integrated energy provider.

While we continue to diversify our customer base, we are still expanding our reach in our historical strength, the Internet vertical. Amazon and Microsoft were each greater than 10% of revenue during the quarter and we recently just won an exciting opportunity with myyearbook.com. All totaled, we added 25 new customers in the quarter.

Further, we excelled internationally with 17% of revenues from international shipments, and as we diversify our product mix we are pleased to report that 21.5% of our revenue in the third quarter came from storage. In fact, through the first three quarters of this year on an absolute scale, we have shipped 45% more storage than during the first three quarters of 2007.

We are also announcing today Rackable equipment leasing. Rackable has supported third-party leasing options for many years. Over the next 60 days we will be offering a Rackable branded leasing program providing for easier access to capital equipment financing for our customers. The Rackable leasing option will be a Rackable branded offering underwritten by a global leader in equipment leasing. Our partner would own all the leasing obligations and we anticipate no changes to our revenue recognition policies for long-term obligations. This is a true win-win for our customers, Rackable and our leasing partner.

Now turning to a financial overview for the quarter. Gross margin for the third fiscal quarter of 2008 was 17.1% compared to 21.6% in the year ago quarter. Non-GAAP gross margin for the third quarter of 2008 was 17.6% compared to 19.2% in the year ago quarter. Our margins this quarter were impacted by customer product mix.

R&D expense was $5.7 million compared to $6 million in the year ago quarter. Sales and marketing expense was $6.1 million compared to $8 million in the year ago quarter. G&A was $5.8 million compared to $7.6 million in the year ago quarter.

Operating expenses were $18.3 million compared to $21.5 million in the year ago quarter. Non-GAAP operating expenses were $14.6 million which excludes $2.4 million of stock-based compensation charges, $630,000 of tariff scale related amortization charges, $663,000 of impairment of long-life assets compared to $14.7 million in the year ago quarter.

We expect our spending in R&D and sales expense to pick up through the rest of this year and into the next however as we continue to invest in future growth.

As mentioned in our prior earnings calls, we were actively seeking some alternatives for our rapid scale business and we made the determination in October that we will be discontinuing the operations of this business. We wrapped up all details this quarter which should further add efficiencies to our cost structure.

Q3 loss from operations was $7.1 million compared to operating loss from operations of $2.7 million in the year ago quarter. Non-GAAP loss from operations was $3.1 million compared to non-GAAP operating profit of $2 million in the year ago quarter.

We reported a Q3 net loss of $6 million compared to a net income of $5,000 in the year ago quarter. Non-GAAP net loss was $1.4 million compared to non-GAAP net income of $2.6 million in the year ago quarter. Q3 net loss was $0.20 per share for the third quarter of 2008 compared to net income per share of break-even in the year ago quarter. Non-GAAP net loss was $0.05 per diluted share for the third quarter of 2008 compared to a non-GAAP net income of $0.09 per diluted share in the year ago quarter.

at the end of the third fiscal quarter, total employee headcount was 325 down 42 employees year-over-year. The year-over-year decrease can primarily be attributed to consolidating our manufacturing facilities, reduction of labor through greater systems automation, and outsourcing certain processes. Looking to the future we anticipate investing in functions that will help us drive long-term growth such as sales and R&D.

Now on to the balance sheet. Total cash, cash equivalents and investments decreased during the third quarter to $184.6 million, down $21.6 million compared to the end of Q2. Our cash was impacted by our inventories which increased by $16.6 million and our accounts payable which was reduced by $10 million from the second fiscal quarter. As Mark stated earlier, our inventory reflects buildup for ICE Cube orders we expect to ship in Q4.

Now I will turn the call back over to Mark to provide some closing remarks.

Mark J. Barrenechea

In closing, we are a focused nimble company. Our ability to compete, win and grow is predicated on our ability to out-engineer multibillion-dollar competitors and to use our unique build-to-order capabilities to deliver mass customization to each of our customers. We have never been more aligned with our customer needs. Our balance sheet gives us staying power to weather tougher markets, gives us strategic flexibility, and we intend to invest intelligently while carefully managing our costs.

I look forward to sharing our progress with you in the coming quarters.

With that Jim and I would now like to open the call to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Louis Miscioscia - Cowen & Co., LLC.

Louis Miscioscia - Cowen & Co., LLC

Maybe you could just clarify on the inventory line, was all of the increase in inventory or almost all of it from the containers?

James D. Wheat

Yes. I would say almost all of the inventory increase in Q3 was from the buildup in the containers that we expect to ship in this Q4.

Louis Miscioscia - Cowen & Co., LLC

Did you have firm P.O.’s for that that aren’t cancelable or how would you characterize that business?

Mark J. Barrenechea

We feel pretty confident on the deliverables. We have P.O.’s in hand for Q4 delivery.

Louis Miscioscia - Cowen & Co., LLC

Can you just maybe paraphrase back to some of the conversations you had with customers as you went through September and October, and actually now that we’re here in November has the environment started to ease up a little bit as maybe credit is starting to get a tad bit easier and maybe people are starting to realize the environment we’re in is maybe not as horrible as it appeared two months ago?

Mark J. Barrenechea

In relation to the economy, I would say from the Rackable perspective we’re certainly not soothsayers on the economy but not much has changed. If I look through September and October, it’s really still the same dynamic. It remains tough and we don’t necessarily see any indicators that are going to change that here in the short term. Companies are prioritizing their projects, looking for greater return and in many cases purchasing in smaller increments. We feel we’ve reacted and adjusted pretty quickly here given that we’re in a very strong R&D cycle and well positioned to compete and win. In summary, October feels a lot like September.

Operator

Our next question comes from Mark Kelleher - Canaccord Adams.

Mark Kelleher - Canaccord Adams

Could you tell us how many containers you shipped in Q3?

Mark J. Barrenechea

We didn’t ship any containers in Q3. Our P.O.’s in hand are for Q4.

Mark Kelleher - Canaccord Adams

In the past you’ve said 20 to 50 containers this year. Is that still a reasonable number?

Mark J. Barrenechea

If I look at the ICE Cube overall, we’re certainly making progress. As we just spoke about, we’ve got firm orders for Q4, we have a new water-based design that we think’s going to be best in show, and our air-based container’s going to expand the market for us. Our goals certainly were $20 million to $50 million revenue related to the ICE Cubes and at this point we’re sort of anticipating being on the lower end of that range. But more important I think as the adoption is beginning now that we have firm orders in hand for Q4 delivery and revenue.

Mark Kelleher - Canaccord Adams

One quick question on the storage. That storage strength you’re seeing is from NetApp, right? That’s the NetApp relationship/partnership that you’ve been cultivating?

Mark J. Barrenechea

Actually no, not yet. Our storage strength has been primarily due to our R-bod and J-bod solution, and with the C2005 and XE series chassis and densities it’s from the Rackable Omni store product line.

In relation to NetApp we’re very optimistic about the potential here. NetApp is a great company, we’re an ideal distribution partner for them in relation to their enterprise class nads and storage virtualization, and when integrated with our compute solutions we provide an enormous amount of value add. So our strength right now is primarily based on Rackable product. The sales force is trained, our agreement’s in place, we’re building a pipeline with NetApp, and we’re looking forward to a pretty strong ’09 in storage and Q4.

Operator

Our next question comes from Doug Reid - Thomas Weisel Partners, LLC.

Doug Reid - Thomas Weisel Partners, LLC

Can you talk specifically about what you’re seeing within the Internet vertical specifically with respect to negative impact from economic concerns?

Mark J. Barrenechea

I’d say I see two different things. One element is a very positive indicator which is in the Cloud. If you think of a startup today who doesn’t necessarily need to provide their own capital but can go into the cloud to provide storage and compute solutions on a get-to-market fairly rapid with low capital investment, that’s a real positive and a positive for Rackable because we power some of the most advanced storage and compute clouds in the market today.

The other side of that is we can all read the reports on advertising and retail that are anticipated to be down in Q4 and how that all balances out is yet to be seen.

But then one element is a positive as people sort of migrate to the Cloud, and with our new CloudRack offering helping folks power than pretty cost effectively. The other side being just reading the reports on perhaps the slowdown in consumer spending for retail and/or advertising.

Doug Reid - Thomas Weisel Partners, LLC

Forgive me if you addressed this earlier, but I was wondering if you could help us understand which specific verticals or customer types you’re targeting initially with the air-based containers that would not be happy with the water-based solution you’ve deployed thus far?

Mark J. Barrenechea

I think it’s the same verticals but it gives a bit more flexibility in deployment options. If you’re doing new data center construction, we think the water-based solution provides the optimal efficiencies both for density and power reduction. If you’re looking for more disaster recovery or mobility, then there’s one less connection you need to make. A waterpower network now gets reduced to network and power. So I would say it’s the same industries we’re looking to cover but it adds sort of disaster recovery opportunities and more mobility.

Operator

Our next question comes from Alex Kurtz - Merriman Curhan Ford & Co.

Alex Kurtz - Merriman Curhan Ford & Co.

On the Amazon/Yahoo statement, did you say what percentage of total revenue they represented in the quarter?

James D. Wheat

We said that they were both greater than 10% customers in the third quarter. I didn’t give a specific percentage.

Alex Kurtz - Merriman Curhan Ford & Co.

I’ll have to wait to see the Q to see the specifics there?

James D. Wheat

Yes. The Q will be coming out in a couple of days.

Alex Kurtz - Merriman Curhan Ford & Co.

Jim, can you give us a sense on gross margin? What are the drivers in gross margin the next couple of quarters and what the levers are to receive some stability in one to two quarters?

James D. Wheat

Our gross margin performance first of all clearly was significantly better in the third quarter than it was in Q2. As a general statement, what I’d say is given the customer mix and the economy that Mark spoke about and the revenue attainment that we had in the third quarter, we’re pretty pleased with the margin results. If you take the three quarter year-to-date margin average for the company, I think we’re in the high 17s and that’s at the higher end of the guidance. So we’re actually pretty pleased right now.

Alex Kurtz - Merriman Curhan Ford & Co.

Can you talk about working capital needs over the next three to six months? I know you talked about inventory for the ICE Cube. Do you see anything on the horizon where you’d need additional cash to fund operations?

James D. Wheat

Clearly we have a fair amount of cash as we have throughout the whole year and I think the general statement is that our views on capital allocation on our balance sheet haven’t really changed. We feel that the best use of the cash that we have is to fund our working capital and whatever difference is left over we want to keep a strong reserve and have the opportunity and the ability to consider strategic opportunities that might arise.

Frankly in this market it’s a really good time to be on the buy side. As Mark and I have said publicly in our confidence, we’re a young public company so to deploy the cash that we have or the working capital that we have in ways such as dividends or buy-backs seems a bit premature.

Mark J. Barrenechea

I’d add a little bit to Jim’s comments there. We carry no debt; we don’t have a bank line, ABL or otherwise; we don’t see any need for one; and our cash projections for end of ’08 are between $175 million and $200 million. We’re extremely well capitalized.

Alex Kurtz - Merriman Curhan Ford & Co.

Question for you Mark. Can you just give us a little more detail about the competitive front? Are companies like Dell and IBM getting more competitive than they were maybe in the beginning of the year?

Mark J. Barrenechea

We’ve never been in a stronger position with our product line: the CloudRack is transformative, the new C2005 XE series Net App, we’ve just announced Rackable equipment leasing and our new lifetime warranty program.

NetApp is very interesting. As we build our pipeline, we’re going into new dialogues and being introduced to new opportunities, places we’ve never gone before. Certainly in my dialogues with CIOs and data center directors they’re all looking to accelerate the benefits of quad core, power efficiency, density, facility cost reduction, lights out management, greater utilization, things that play right to our strengths. So when we’re able to get into a sales cycle early enough and establish a total cost of ownership formula as well as our BTO model, being able to provide to customers exactly what they want we tend to win.

In terms of market dynamics with Dell, HP, Sun, IBM, there’s really no new dynamics out there than we’ve talked about earlier. The one thing that is very encouraging for me is with our product line card right now, we’ve never been more in tune with the robust product line going into Q4 and into ’09.

Operator

Our next question comes from Louis Miscioscia - Cowen & Co., LLC.

Louis Miscioscia - Cowen & Co., LLC

You mentioned in your opening remarks that you’re going to be spending more in R&D and SG&A. I guess you were referring to as you move into just fourth quarter or all the way through ’09 and could you maybe just help us out on an absolute dollar basis to what you might be thinking there?

James D. Wheat

I was speaking about as we enter the fourth quarter the trend that we want to invest in the areas of the business that will produce results in terms of sales and technology. So if you think about our Q3 results, for example take R&D, the way I might think about that going forward is our Q4 spending would probably trend closer to what you saw in the first quarter this year.

Sales and marketing, as we expect improvement in our revenue pattern the variable costs of those revenues would be expected to be increasing as well.

And sort of the way you might think about G&A, we’ve tried really hard and we manage G&A very carefully. We’ve tried to keep it pretty flat in the fourth quarter which is our fiscal year end. It requires some extra work on the part of the auditors and the service providers with respect to our year-end audit so you might see G&A flattish to slightly up.

Louis Miscioscia - Cowen & Co., LLC

When we look into ’09, is it going to continue to be investment from an absolute dollar perspective year-over-year?

James D. Wheat

Yes. I would expect especially the trend in R&D and in sales and marketing in ’09 to continue the trajectory we’d want to see in Q4.

Louis Miscioscia - Cowen & Co., LLC

On the leases program that you have, it sounds like you’re partnering with someone for that so that wouldn’t be your own capital that you’re using?

James D. Wheat

That’s correct. This is really important. We wouldn’t expect to see any change in our financial profile or on our balance sheet from this. It’s not Rackable putting in place the financing. It’s partnering with a really strong third party leasing company and then they will be dealing with the customers. So the net result will be we’ll be offering a Rackable branded product that’ll give easier access to capital equipment financing for our customers but the actual lease will be underwritten by a third party large scale global financing organization. They will take all of the leasing obligations and as a result we’ll have no changes to our revenue recognition policies or our long-term obligations.

Louis Miscioscia - Cowen & Co., LLC

RapidScale. Basically it sounds like you’re not going to sell it any more. You’re just going to close it down.

James D. Wheat

Yes. That’s correct. In my prepared remarks I think I stated that we were looking for strategic alternatives. We in fact hired an investment banking firm that was focused in the storage market. Over the last few months we could not come to terms with eligible buyers. As you probably know, the access to capital and debt financing has never been more difficult so we made the decision to discontinue operations and repurpose those dollars to more value-added areas such as engineering.

Louis Miscioscia - Cowen & Co., LLC

You also talked about the warranty. How actually are you going to account for that? Would you take a higher charge against gross margins when you actually sell the product and then the main risk would be obviously if you don’t calculate that appropriately?

James D. Wheat

Yes. That is how we calculate the warranty expense now. It’s based on a pattern of historic failures. Over the lifetime in our business if there are to be failures, most of those would tend to occur relatively early in the life cycle. So I wouldn’t expect a major change in the accounting result from the lifetime warranty program.

Mark J. Barrenechea

I’ll add to that. We’ve been very closely monitoring what’s called the [Pirato] Analysis of looking at our manufacturing, quality, service life components, cluster graphs of our failures earlier or late in the cycle. So we approach the lifetime warranty with a fair amount of analysis and we think this will have diminimus financial impact but provide a great sense of comfort to our customers that we’re going to stand behind our in-factory parts and labor for the useful life of what we sell.

Operator

That concludes the question and answer session. At this time I’d like to turn it back to Mark Barrenechea for any additional or closing remarks.

Mark J. Barrenechea

Thank you for your time and your questions today. Jim and I will be attending the UBS Global Technology Conference in New York City on November 19 and we look forward to seeing you all there. That ends today’s call.

Operator

Ladies and Gentlemen, that does conclude today’s conference. Thank you for your participation. You may now disconnect.

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