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Executives

Mark Paisley – Senior Director, IR

Mark Barrenechea – President & CEO

Jim Wheat – CFO

Analysts

Mark Kelleher – Canaccord Adams

Alex Kurtz – Merriman Curhan Ford

Doug Reid – Thomas Weisel Partners

Rackable Systems, Inc. (RACK) Q4 2008 Earnings Call Transcript February 12, 2009 5:00 PM ET

Operator

Good afternoon, and thank you for joining us today’s conference call to discuss Rackable Systems’ fourth quarter and 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 conference over to Mr. Mark Paisley for opening remarks and introductions. Mr. Paisley? Please go ahead, sir.

Mark Paisley

Good afternoon. Thank you for joining us to discuss our fourth quarter, fiscal year 2008 earnings press release of this afternoon, which is available on our Web site, www.rackable.com. I’m Mark Paisley, Director of Investor Relations for Rackable Systems, and I’ll be managing the call. Joining me 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 February 12, 2009. The call is a property of Rackable Systems and any recording, reproduction or transmission of this conference without the expressed written consent of Rackable Systems is strictly prohibited. This call is being webcast live and a web replay will be available on our Web site 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 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 and operating margins as well as our other financial measures, and a significant portion of the company’s revenues come from a small number of customers so the delay in placing 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 10-K 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 Web site at www.rackable.com.

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

Mark Barrenechea

Thank you, Mark, and thank you everyone for joining us today. Today I will speak about economy and market conditions, Q4 and fiscal year 2008, as well as our strategy and guidance for 2009.

2008 was a very difficult year for Rackable, and the hardware and semiconductor industry. We are in a deflationary economy, supply chain challenges are increasing and component pricing volatility is high. Industry reports highlight a wide range of potential CapEx contractions for 2009, ranging from 10% to 25%. We are seeing this in our business, especially with large customers, and expect the volatility to continue as our customers work through their 2009 operating plans. And looking back on 2008, we have a mixture of positive and negative metrics. Our fiscal year ‘08 annual revenue was $247 million, non-GAAP gross margin was 17.1%, ending cash and investments balance was approximately $181 million representing about a 9% cash burn in 2008 to fund operations.

Year over year, we saw revenue decline 29% and 65% for the year and fourth quarter, respectively. A primary source of our decline was two large customers, whose spending decreased 5% year over year. Excluding sales to these two customers, our revenues for fiscal 2008 were up 5% compared to fiscal year 2007, our storage sales were up 23% year over year, our service business grew more than 40%.

We have strong installed base and we have tailored our product roadmap to be targeted to the relevant investment projects for 2009. This is timely, given we are exiting a strong R&D cycle. Over the last six months, we introduced the XE series, or extreme efficiency servers; the C2005 as a core to our build-to-order 2U solutions; the C1002, as a highly flexible web server; the CloudRack, as a scalable cost-effective solution for large-scale cloud environments; MobiRACK for mobile solutions; and our latest offering MicroSlice, for cost-effective web-based applications.

Let me spend a moment on MicroSlice and discuss the strategy behind it. There is a large class of enterprise workloads that do not require expensive virtualization software, expensive quad-core technology, and high-end data center server features. We found a path to provide the benefits of virtualization and data center features without all the costs. We were able to remove so much cost while maintaining the critical features that the result is a sub $500 server price. MicroSlice delivers an estimated 65% lower price and 28% lower power use than Dell’s Energy Smart server for the same performance.

I’d now like to turn the call over to Jim, and I will be back to discuss our plans and guidance for 2009.

Jim Wheat

Thank you, Mark. Before I begin, please let me add what Mark 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. In addition, all numbers stated will be based on containing operations.

Our revenue for the fourth quarter came in at $38.8 million compared to $111.3 million in the year ago quarter. Although our fiscal year 2008 came in at $247.4 million versus $350.7 million for the prior year, we can point to several positive indicators within our revenue mix for the year. As Mark mentioned, customer concentration was the principal reason for the revenue decrease. Two customers took $114 million less in product in 2008 than 2007. So, excluding those we would have been up 5% year over year. We recognized revenue from more than 100 new customers in 2008, and we are focused on growing these small customers for future periods. As we have spoken off in previous earnings, we are focused on the financial and oil and gas verticals and they are up 58% and 126%, respectively. This is a positive early indicator that our focus on more verticals is beginning to pay dividend.

On an absolute basis, our fiscal year 2008 international revenue was up slightly and our storage revenue was up 23% over fiscal year 2007. Among our 10% customers in the fourth quarter were Amazon, Conoco Philips, and Microsoft.

Gross margins for the fourth fiscal quarter was negative 15.5% compared to 25% in the year ago quarter. Non-GAAP gross margins for the fourth quarter of 2008 was 15.1% compared to 21.5% in the year ago quarter. And on a year-end basis, we reported fiscal 2008 non-GAAP gross margins of 17.1% versus 18.0% in the year ago quarter. Our margins this quarter were impacted by customer product mix and sales volume.

In the fourth quarter, R&D expense was $3.2 million compared to $3.7 million in the year ago quarter. Sales and marketing expense was $5.1 million compared to $9 million in the year ago quarter. G&A was $5 million compared to $7.6 million in the year ago quarter. Fourth quarter operating expenses were $13.3 million compared to $23 million in the year ago quarter, down 42%. Excluding impairments, operating expenses decreased 34% year over year. Non-GAAP operating expenses were $13.7 million, which excludes negative $300,000 of stock-based compensation charges, compared to $16.5 million in the year ago quarter.

As the economy slowed, we reacted quickly. Our fourth quarter fiscal year 2008 operating expenses were 34% less year over year excluding impairments. Our capital expenditures for fiscal '08 were $4.3 million less than fiscal year 2007. As the economic decline continues into 2009, we made the difficult decision to further lower costs, and in January executed a 15% reduction in force.

During the fourth quarter, we had excellent cash and working capital management. Our accounts receivable decreased by $17 million due to solid collections, and we continued to de-risk our business by decreasing accounts payable by $24 million. We are running leaner and more efficient.

Q4 operating loss was $19.4 million compared to operating profit of $4.8 million in the year ago quarter. Non-GAAP loss from operations was $7.9 million compared to non-GAAP operating profit of $7.5 million in the year ago quarter. We reported a Q4 net loss of $18.2 million compared to a net income of $4.7 million in the year ago quarter. Non-GAAP net loss was $5.1 million compared to non-GAAP net income of $5.8 million in the year ago quarter.

Q4 net loss was $0.61 per share, compared to net income of $0.16 in the year ago quarter. Non-GAAP net loss was $0.17 per share in the fourth quarter of 2008 compared to non-GAAP net income of $0.20 per share in the year ago quarter.

At the end of the fourth fiscal quarter, total employee headcount was 318, down 60 employees or 16% year over year. This was before the reduction in force we announced and completed in January. The year-over-year decrease can primarily be attributed to streamlining actions we discussed in our prior earnings call.

As for the balance sheet, total cash, cash equivalents and investments decreased during the fourth quarter to $180.6 million, down $17.5 million compared to the year ago quarter. For more modeling purposes, assume our interest income will remain at very moderate levels in fiscal year 2009.

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

Mark Barrenechea

Thank you, Jim. I would like to outline our strategy for 2009. We think this is the right point in time to expand our investment in the business on two major fronts. First, let me speak to our stock repurchase announcement. Today, we announced the Board of Directors has authorized the company to repurchase up to 40 million of the company's common stock through open market transaction and privately negotiated purchases. The duration of the program is open-ended. At current price levels, we believe Rackable's common stock represents an attractive investment opportunity for the company. Please see our press release for full details.

Second, we intend to invest up to 10% of our cash back into the business to expand new product offerings and our sales and service capabilities. Risk consideration of these investments – we are maintaining a strong balance sheet, remain debt free, and continue to operate with strategic and financial flexibility. We believe strongly in the company's future with cost controls, a focused R&D investment plan, and solid sales and service execution, we have the ability to gain markets are. We will invest money in the business this year ahead of revenues. We remain focused on large scale customer-owned data centers, while we are expanding our efforts into co-location businesses, hosting facilities, and smaller and formal data centers.

Our industry orientation is not changing for 2009 – large-scale Internet, US Federal, DoD, and intelligence agencies, financial services, oil and gas, digital media, and high-tech companies. As a special note, we remain 100% committed to the Internet vertical, even as margins and profit potentials decline. Our go-to market approach is expanding for 2009 with new leadership already in place for EMEA, Japan and APAC. Also, we announced last week, a new channel program with new tools and new automation. As we look to grow our new verticals it is important to attract new partners across the US, Europe and Japan with a well defined program, a self-service portal for partner qualification and deal management, as well as a self-service coding tool.

Our customer solution approach is well redefined for 2009; cloud computing; web-based application; enterprise application, including database and email solutions; high performance computing; low-cost expandable bulk storage; and a growing interest in thin client computing.

As for 2009 guidance, visibility is limited and the economy remains uncertain. Having said that, we are providing directional guidance as follows. Q1 revenues – we expect revenues to be flat to slightly up from Q4 fiscal year 2008. 2009 ending cash and equivalents, excluding the repurchase program, fiscal year-end cash plus investments to be to be in the range of $160 million to $170 million. In terms of annual non-GAAP OpEx, down approximately 10% from fiscal year 2008 from fiscal year 2009. As to non-GAAP EPS, we expect our loss in fiscal year 2009 to be larger than fiscal year 2008, given our level of investment in the business.

It is times like this, that those that can invest do invest in order to be in a stronger competitive position when the economy recovers. This is the approach Rackable is taking.

Mark Paisley

Thanks, Mark. We are now ready to begin the Q&A portion of the call. Operator, let's go to our first question.

Question-and-Answer Session

Operator

(Operator instructions) We will take our first question today from Mark Kelleher, Canaccord Adams.

Mark Kelleher – Canaccord Adams

Thanks. Guys, I noticed you didn’t talk about the container business. How is that going?

Mark Barrenechea

Mark, thanks for the first question. As I said in my opening remarks, CapEx spending is certainly contracting and this is slowing big ticket purchases and certainly delaying some large-scale data center construction. We have seen certain large projects delayed, rather than canceled. And I think part of our disappointing news in ’08 is that we haven't recognized any revenue for the ICE Cube, and that’s certainly a disappointment. We remain a 100% committed to the solution. As we look out into the year, we are hopeful we will win business. But as for ’08 we didn't recognize any revenue for the ICE Cube.

Mark Kelleher – Canaccord Adams

All right. And at your largest accounts, do you think that was all market driven or there is some market share shifts?

Mark Barrenechea

We see it primarily as market-driven not market share shift. And one of our major issues in 2008 was concentrated to two large customers whose revenue contribution was down near over $110 million year over year. And if it weren’t for those two customers, our base markets grew 5% year over year, storage up 23%, and service up 30%.

Mark Kelleher – Canaccord Adams

Okay. And maybe a question for Jim. The R&D line came in a little bit from $5 million to $3.4 million, is that a quarterly effect or with your comments on investing in R&D, should we expect that to go back up again?

Jim Wheat

We will continue to redeployed resources into R&D and to technology. I think the specific answer to your question, it was probably just a quarterization. And again remember, we have pulled out from continuing operations – the effects, Mark, of our RapidScale business.

Mark Barrenechea

Mark, thanks for sending the question to Jim as my voice was – so, I appreciate that. Just to make sure that I was heard clearly, so one of our major issues in ‘08 was concentrated to two large customers whose revenue contribution was down about $110 million in the year. When we look to some of the bright spots in the year, our base markets grew 5% in the year, our storage business grew 23%, and our service business grew over 40% in the year. And certainly, the concentration was the major contributor to the revenue decline, not market share shifts.

Mark Paisley

Next question, please?

Mark Kelleher – Canaccord Adams

Okay, thanks.

Operator

Next we will hear from Alex Kurtz, Merriman Curhan Ford.

Alex Kurtz – Merriman Curhan Ford

Yes, thanks. Can you guys hear me okay?

Mark Barrenechea

Yes, we can.

Alex Kurtz – Merriman Curhan Ford

My first question is on your Q1 guidance of flat to slightly up. I think most other vendors in the tech space are seeing a lot of slippage on, especially in the first half of ’09, so what gives you the confidence in that guidance?

Mark Barrenechea

First, we came into the year with a strong backlog and set of deferrals. So, that’s sort of the primary sense of confidence and the ongoing activity since we came out with that earlier projection. So, we have a pretty good confidence that our Q1 revenues be flat to slightly up.

Alex Kurtz – Merriman Curhan Ford

Okay. And then regarding the OpEx, Jim, how should we try to reduce the OpEx? Is it going to be front end loaded kind of reductions, backend loaded? How are you going to make adjustments to the different line items as you go through the year to get to that 10%?

Jim Wheat

I would say that we are going to take it quarter by quarter. Certainly, we've previously announced, Alex, a restructuring, and we have factored in saving from those restructurings, and we are going to redeploy those resources as necessary and as we see more visibility into our business as we go through 2009.

Alex Kurtz – Merriman Curhan Ford

And then just two last quick questions on gross margin guidance, and then the other question is when you have a lot of new products, now why not divest from the container business and focus on some of these new products? Is the R&D and support cost on managing that line small so it’s not a lot of extra OpEx, why not refocus on some of these newer product launches? Thank you.

Jim Wheat

Alex, let me finish with one thought, and then Mark can answer the second question. So you had asked me about OpEx and quarterization, I think the key thing is we are looking for that to be relatively consistent over each quarter in 2009.

Mark Barrenechea

And in terms of the container business, let me be crystal clear, we are 100% committed to the containerized solution. Even though we weren’t able to put our efforts into revenue in ’08, interest remains high. We have not seen large-scale cancellations, but rather delays of construction projects. The benefits are crystal clear of the solution of reducing power and facility cost. We remain committed to the solution in ’09.

Alex Kurtz – Merriman Curhan Ford

Okay. Thank you.

Operator

(Operator instructions) Next we will hear from Doug Reid, Thomas Weisel Partners.

Doug Reid – Thomas Weisel Partners

Thanks. Just one of you could comment on the contribution from NetApp and storage in the quarter? And any color you can give on that relationship going forward.

Mark Barrenechea

Doug, this is Mark. Thanks for the question. We expect sort of our management targets for ‘08 to see storage between 10% and 20% of our business in ’08. And we ended the year sort of right at the midpoint on storage where it contributed about 15% of the business. We are also sort of about to bring to market a new 2U solution for bulk storage that will get us close to 1 petabytes in a single cabinet for external bulk storage. So we feel pretty good about our solutions right now for what's called JBOD and RBOD external storage. And we are about to up the density plate pretty significantly here in the next 30 days to 90 days. In relation to NetApp, the partnership continues to go well. We are engaging in opportunities. We just finished big training session a couple weeks ago, and we will see NetApp revenues in 2009.

Doug Reid – Thomas Weisel Partners

Okay. Thank you.

Operator

And we will take a follow-up question from Alex Kurtz.

Alex Kurtz – Merriman Curhan Ford

Hi, just a follow up on the gross margin question I had from earlier. Is that – I think you’re at 15.1% non-GAAP in December, is there going to be some product mix improvements heading into the first half of ‘09 where we could see an uptick from that level? Thank you.

Mark Barrenechea

Thanks, Alex. We ended the year approximately 15.1% for Q4 non-GAAP. We ended the year at 17.1% blended across the entire year. At present we are not giving a gross margin guidance for ’09, but as historically has been true for Rackable, the greater the storage mix, the better the gross margin.

Alex Kurtz – Merriman Curhan Ford

Thank you.

Mark Barrenechea

Greater the storage contribution, greater the gross margin.

Operator

(Operator instructions) Mr. Paisley, I show no further questions at this time. I will turn the conference back over to you for any additional closing comments.

Mark Paisley

Thanks, operator. With no further questions, that completes the Q&A portion of our call. One final comment, Rackable systems will be presenting at the Morgan Stanley Technology Conference in San Francisco at the Palace Hotel on March 4 at 1 p.m. We look forward to seeing you there. Thank you for your attendance this afternoon, and your participation. That ends today's call.

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Source: Rackable Systems, Inc. Q4 2008 Earnings Call Transcript

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