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Executives

Mark Barrenechea - CEO

Madhu Ranganathan - CFO

Nicole Noutsios - IR

Analysts

Tom Curlin - RBC

William Chiew - Cowen and Company

David Duley - Merriman

Shelby Seyrafi - Caris

Louis Miscioscia - Cowen & Company

Rackable Systems, Inc. (RACK) Q4 2007 Earnings Call February 6, 2008 12:00 PM ET

Operator

Good afternoon and thank you for joining us on today's conference call to discuss Rackable Systems fourth quarter and fiscal 2007 year-end earnings results. (Operator Instruction).

At this time, I would like to turn the call over to Nicole for opening remarks and introductions. Please go ahead.

Nicole Noutsios

Good afternoon. Thank you for joining us to discuss our press release of this afternoon, which is available on our website www.rackable.com. I am Nicole Noutsios and I will be managing the call. On the call today are Mark Barrenechea, our President and Chief Executive Officer, and Madhu Ranganathan, our Chief Financial Officer.

Before I turn the call over to Mark, I would like to bring the following to your attention. The date of this call is February 6th, 2008. The call is the property of Rackable Systems and any recording, reproduction, or transmission of this conference call without the express prior written consent of Rackable Systems is strictly prohibited. This call is being webcast live and a replay will be available on our website for at least 90 days.

Our presentation today contains forward-looking statements reflecting Management's expectations about our market, 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 and intend and other statements in the future tense are 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 that Rackable Systems operates in a very competitive market and increased competition has in the past, and may continue, because pricing pressure on Rackable Systems products, which would negatively affect Rackable Systems growth and operating margin, as well as other financial measures. 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 significant negative effect on Rackable Systems financial performance. Accordingly, we caution you not to place undo reliance on these statements.

These risks and uncertainties are set forth in our quarterly report on Form 10-Q under the caption, "Risks Factors", which was filed with the Securities and Exchange Commission on November 8th, 2007 and is available at www.sec.com. Accordingly, we caution you not to place undo reliance on these statements. We expressly disclaim any obligations to update or alter our forward-looking statements, whether as the result of new information, future events or otherwise.

We'll be disclosing non-GAAP financial measures in this presentation. For reconciliation of these non-GAAP financial measures to the court funding GAAP measure, please see our press release of today, which is posted on our website at www.rackable.com, as well as our press release of October 26th, 2007, the respective Q3 non-GAAP financial measures are also posted on the website.

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

Mark Barrenechea

Thank you, Nicole, and welcome to our call. Please note that we have updated our corporate presentation, which will be available on our investor relations website, I believe it's posted now if you all want to go up and take a look at that.

Today, I would like to spend some time reflecting on 2007, and then I'll discuss highlights from Q4, with Madhu providing greater detail on the quarter and fiscal year 2007. Finally, I would like to take you through our themes and goals for FY08. I have been CEO for approximately nine months and I can say with confidence that we have a stronger foundation and our ability to create long term shareholder value increases with time.

The team committed to a fiscal 2007 plan, and we delivered to that plan. We delivered to that plan in the midst of Management change, growing economic uncertainty, and enhancements to our strategy. We also surpassed cumulative historical sales of over $1 billion.

Our product differentiation is at the heart of our ability to compete and win. We won multiple industry awards, won numerous performance benchmarks. And we placed the Visionaries Quadrant of Gartner's Magic Quadrant for Worldwide Server Vendors.

In addition, we were issued three key patents in the area of DC power, air louvers for cooling and storage design. On the operational side our improvements in manufacturing and supply chain efforts are being reflected in our P&L. As acting Head of Sales, I have had the pleasure of getting to know the sales team better, getting closer to our customers and more fully understanding our challenges and opportunities. Walking in the shoes of our Accounts Executives has most certainly helped me build a better corporate strategy and plan for 2008.

Our regional vice presidents are fully empowered on the resources they need to grow our strategic accounts, base markets and channels and we have a 2008 sales compensation plan, as aligned with our corporate goals.

Additionally, Rackable is committed to corporate governance. As you saw from our release today, we had added independent esteemed individuals to our Board of Directors. General Mike Hagee was most recently the Commandant of the Marine Corp and a member of the Joint Chiefs of Staff. Douglas King was the Managing Partner of our Ernst & Young San Francisco office. We look forward to the contributions of General Hagee and Douglas King.

2007 was a transitional year for Rackable. We focused on assembling a world class management team, fixing operations, expanding our supply chain, accelerating products delivery, remodeling the sales force, focusing the company on one theme that is relevant to our customers, enabling the ecological data center.

Finally, Madhu has decided to leave Rackable. We have engaged the search firm to find her successor. We will keep you informed that to our progress. But Madhu will continue as CFO for the next three to five months to ensure smooth and seamless transition. Madhu has been valued partner to me. She has made very important contributions to company and we all thank her greatly.

Onto Q4 results, Q4 was stellar. We reported record revenues of $111.7 million non-GAAP gross margins up 21.7%, non-GAAP operating income of $6.6 million and non-GAAP EPS of $0.18 per share. In addition, our cash performance was solid accreting near $20 million.

Our revenue performance during the quarter continues to highlight Rackable's current strength in the core internet market, while growing stronger in important verticals such as financial services, federal and enterprise. We also had wins with new search companies, social networking businesses, Web 2.0 content providers and travel providers.

Also one of our Ice Cube modular data centers went live at Yahoo [carrying] project M45, a joint effort between Yahoo and Carnegie Mellon focusing on HPC research. Our product line of chassis adopted the latest technologies form Intel; they are about exit a strong R&D cycle on storage.

Madhu will now discuss the fourth quarter in greater detail and full year results. Madhu?

Madhu Ranganathan

Okay. Thank you, Mark. And before I begin, please let me add to what Nicole said earlier about our use of non-GAAP financial measures. Our 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 margins, operating expenses, and similar items on a non-GAAP basis, which are reconciled in those tables. I will provide you with additional details at the end of this call.

Q4 revenue was up 4.5% compared to Q4 of last year. We continue to see strong bookings during the quarter from our customer base. Amazon, Microsoft and Facebook were greater than 10% of revenue during the quarter. We were pleased with our gross margin performance during the quarter and steady improvements throughout the year.

Q4 non-GAAP gross margin of 21.7% or 250 basis points higher than Q3 and for the year we ended at 18.4%, slightly above our previously communicated outlook of 16 to 18%. Some of the key drivers of gross margins include improvement in our procurement effort, supply chain efficiencies, and decreases to our overhead costs in the year.

And now turning to expenses for the fourth quarter, our non-GAAP operating expenses were higher compared to the third quarter due to higher investments in engineering and products and higher sales commissions and bonuses for year end achievements and expenses related to year end compliance effort.

As a reminder, our Q3 expenses were lowered due to onetime savings related to settlement of patent litigation costs. We also recorded $23.9 million of goodwill impairment charge relating to Terrascale acquisition as well as the pre-IPO of Rackable. The impairment was triggered by the decline in our market valuation and acquired by FAS 142. Please note that we are conservatively recording the maximum charge required by this provision based on our preliminary analysis. Our final analysis will be filed with our Form 10-K in early March.

Q4 non-GAAP income from operations was $6.6 million compared to non-GAAP operating net income of $2 million during the third fiscal quarter. Despite higher operating expenses during Q4, our higher gross margins during the quarter resulted in 5.9% operating margin, compared to 2.3% in the third quarter and negative operating margins during the first and second quarters of 2007.

After recording interest and other income of $2.4 million and using a non-GAAP tax rate of 40.9%, we reported non-GAAP net income of $5.3 million or $0.18 per share compared to a non-GAAP net income of $2.6 million during the third quarter or $0.09 per share. This is a 100% sequential growth quarter-over-quarter. At the end of the fourth quarter, total employee headcount was 378, up 11 employees from the prior quarter and 28 from the prior year.

And now turning to the balance sheet, total cash, cash equivalents and investments grew to $198 million, up $38 million or 23% compared to FY06. Cash flow from operations for the 12 months of 2007 was $46.1 million, compared to a negative cash flow from operations of $17.6 million for 2006.

Our metrics for working capital during the fourth quarter were strong. DSO of 41 days, DPO was 40 days and days in inventory were 57 days. The resulting cash conversion cycle was 58 days, down from 126 days in Q1. This was great progress for FY07.

And now I will discuss our full year of fiscal 2007 results, for the full year our revenues were $353 million, inline with our goals of $340 million to $360 million and gross margins were 18.4%, exceeding the high end of our goal of 16% to 18% and EPS finished positive at $0.17.

As mentioned earlier, the items requiring reconciliations from GAAP to non-GAAP included the following for the fourth quarter. The goodwill impairment of $23.9 million, stock-based compensation of $4.1 million and amortization of intangibles of $1.5 million and recoveries from previously written down inventories $4.2 million, this is a benefit that were excluded from non-GAAP and retention incentives related to Terrascale acquisition of $1.3 million and GAAP to non-GAAP tax impact of $2.3 million.

And at this point, I would like to extend my appreciation and thank you, to all of those who supported me during the last three years at Rackable. As Mark indicated I will be transitioning over the next 3 to 5 months, while remaining fully dedicated to Rackable during this time.

I would now like to turn the call over the Mark. Mark?

Mark Barrenechea

Thanks Madhu. On to 2008, I am focusing the company on four themes: optimize our model, expand our reach, extend our lead, and deliver results. And we take them one by one - optimize our model. Our first focus is centered on enhancing our service offerings and delivery, increasing the productivity of our small, but well formed work force, [tailoring] new products to market and continuing to attract the industry's best talent.

We're off to a fast start on this, we recently hired [Ken Murrie] as VP of Service. Ken comes to Rackable from NetApp. Ken established NetApp's Global Services Organization, for their strategic account program. Ken will help Rackable to scale and improve its service offerings.

Expand our reach - Rackable will use in 2008 three means to expand our reach. Product lines, market approaches and geographies. As for product lines, our 2008 goals, include having three demonstrable product lines in the market. X86 Compute, Storage and Data Center Infrastructure offerings.

As for market approaches, we are investing in multiple industries, resellers, large scale system implementers, as well as our direct sales force. We anticipate adding two to three new large scale partners in 2008 and at least two dozen resellers, worldwide to our calendar 2008.

As for geographies, our international strategy has completely changed. Our international teams are now supporting channel partners and this is making a dramatic difference. For example, we recently signed up computer center in the UK as a reseller.

Extend our lead - we pioneered power cooling intensity, we continue to push the envelope. In 2008, Rackable intends to advance density and efficiency well beyond where we are today; drive the transition from traditional data centers to containerized data centers and to add new offerings in virtualization, de-duplification and block level and clustered file storage. We are focused on large markets, with growth rates.

The x86 markets are adding $9 billion in additional spending over the next five years. And the shift to high performance quad-core processors favors Rackable. We are also exiting a strong R&D cycle for our storage products for full NAS protocol and support, and generic iSCSI block support. The iSCSI block access market is currently a $1.5 billion market and growing at over 50% CAGR. We intend to get a full storage portfolio in 2008, both by providing our own technology and reselling others.

Lastly deliver results - while the economy seems to be moving into an uncertain environment, our value proposition puts us in an advantageous position. In down economies, companies are looking to save facilities and operating expenditures. Our value proposition is aligned to this. For 2008, we will only get annual outlook consistent with 2007 and not break out quarterly details. That said, our FY08 financial outlook includes revenue flat to 10% growth, non-GAAP gross margins 17 points to 20 points, while being EPS positive.

We intend to transition out certain unfavorable revenues in 2008, because of this transition our growth rate is flat to 10%. If not for this transition, our growth rate would otherwise be greater. With respect to gross margins, achieving the higher end of the range is dependent on the introduction and adoption of new products among other factors. We intend to maintain non-GAAP EPS profitability within this framework on an annual basis.

Non-GAAP EPS for 2008 is expected to be flat, just slightly below non-GAAP EPS for 2007. On an annual basis, we should accrete cash. Further, while we are not providing Q1 goals, I'd like to highlight that Q1 is seasonally weak for the industry. We've factored the seasonality into our annual guidance.

With that, we will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Tom Curlin with RBC.

Tom Curlin - RBC

Hey, just quickly a clarification, did you just give a non-GAAP EPS guide or did I misunderstand or miss here those last few comments on non-GAAP?

Madhu Ranganathan

Tom this is Madhu. We said non-GAAP EPS positive for FY08.

Tom Curlin - RBC

Okay. The transition in terms of the revenue mix, can you comment on what you are assuming from your historically largest customers?

Mark Barrenechea

Tom, hi, it's Mark. We're not breaking out customers or amounts, if you will. And I think all companies have histories and unfavorable revenues. We are focusing '08 on profitable growth. It seems like a good opportunity for us to begin this transition. And I also think it reflects good corporate discipline and a culture and tone that we're setting in the business. So, we're not getting down to customer or dollars specifics.

Operator

We'll take our next question from Louis Miscioscia with Cowen and Company.

William Chiew - Cowen and Company

Hi, this is [William Chiew] for Louis Miscioscia. I guess my question would be, if you can add a little more color on the gross margin benefit this quarter, whether it will looks like it could be sustainable towards 2008. What are other components of it, and maybe so we understand better, what does your business model in '08 look like? Thank you.

Mark Barrenechea

Yeah, sure thanks. I will take part of that and Madhu, if you want to add, obviously feel free to do so. Q4 was a stellar quarter for us. We had strong sales across our installed base. We executed well in the supply chain, and many of our operational improvements in '07 started to flow through the P&L. So, it's just a real solid quarter for us.

As I look into '08, obviously revenue and gross margin are always tied together. And I'm focused on two items, really the higher end of our range and items in my control. We don't control the economy or rational competitors or market mood; what is in our share of influence is ensuring that we've new product lines to the market in '08 and our newly product introduction goes extremely well around deduplification, virtualization, new form factors, cost control in '08 and with good to great execution there is a path to the higher range, higher range of that 17% to 20% in '08.

Operator

We'll take our next question from David Duley with Merriman.

David Duley - Merriman

One quick housekeeping and then I'll get into to more significant questions. You mentioned that your 10% customers work. Could you just list those names again and perhaps give us the percentages?

Madhu Ranganathan

Sure. Dave, this is Madhu. So, we said three customers that over 10% in the fourth quarter was Microsoft, Amazon and Facebook. We did not share the percentages of those customers individually or an aggregate for the fourth quarter. But for the year, since we finished our year, I'd say that our historical top three customers were slightly lower in concentration than 2006.

Mark Barrenechea

Maybe I'll just add a little piece to that. Year-over-year, we got a start in '07 with our top customers concentrate in the high 60s. We ended the year in the low 60 on a year-over-year basis.

David Duley - Merriman

Thanks.

Operator

(Operator Instruction) We'll go next to Shelby Seyrafi with Caris.

Shelby Seyrafi - Caris

Yes. Thank you very much. So, can you talk about the March quarter at all, I mean last year in the March of the second quarters, there was a revenue decline like 30%. Can we think about the big step down and then flatten and come up in the back half. I'm trying to figure out the past of revenue throughout the year. Do you expect to be in a decline and also do you expect to be EPS positive in the March quarter as well?

Mark Barrenechea

Well, I think the short of it, I'll give a part and Madhu you can jump in, we are not giving quarterly guidance right. Q1 is always seasonally weak. We factor that into our annual outlook and we're staying on the discipline of annual outlook.

Madhu Ranganathan

Right. And Shelby, from a volume perspective, certainly at a market color on the seasonality; when you talk about EPS positive, there are cost enough structures particularly above the line that are fixed and variable. And to the extent we're planning on an annual basis since that's the right way to think about it. We still maintain EPS positive on an annual basis of the quarter-to-quarter fluctuations, if the volume can, in fact, occur on any of those metrics.

Operator

Moving on, we will take a follow up question from Tom Curlin with RBC.

Madhu Ranganathan

Yeah. Hi, again, Tom.

Tom Curlin - RBC

Hi, sorry, you caught me by surprise.

Mark Barrenechea

Operator please, if folks want to ask a follow-up question, let's have them do that.

Tom Curlin - RBC

Okay. So, you are not commenting on specifics with respect to your larger customers, but the tone of the comment on profitability, I am assuming that you are willing to forego historical customers if you feel like the pricing environment within that customer just no longer makes sense. Is that part of the way to interpret your comments?

Mark Barrenechea

Tom, every company has unfavorable revenues and we want to set the tone and culture of our business, that business needs to make sense for multiple parties and we will make those judgment calls along the way, but we are factoring into our 2008 plan, transitioning out certain unfavorable revenues.

Tom Curlin - RBC

Okay. And is that, well maybe, only ask about specifics.

Mark Barrenechea

It is across customers, right, and across product lines. I don't want to necessarily focus into certain customers or segments. We are not going to get to that level of specificity.

Tom Curlin - RBC

Well, that was my next question, so its more than one customer and it is…?

Mark Barrenechea

Yes.

Tom Curlin - RBC

And it is not one specific product.

Mark Barrenechea

Correct.

Tom Curlin - RBC

Okay.

Mark Barrenechea

We surveyed our installed base. We have been in business for seven years, right? We have hundreds and hundreds of customers, and we are making this quest check, we are answering this question across customers and across products.

Tom Curlin - RBC

Okay. On the storage side, can you give us any sort of directional thoughts on. How much you think storage contributes in '08 versus '07? Do you expect it to be up as a percent of the mix, meaningfully, moderately, how does that look?

Mark Barrenechea

Sure. Well, there is no doubt that 2007 was a disappointing year for us in storage and there is just no other way to say it. When I look into '08, our plan is looking at storage to be between 10% and 20% contributor to our business. Well, that's what our plan is looking like in '08.

Tom Curlin - RBC

Okay. And last question, so a lot of commentary about, I'll call it indirect channels; do you have a target or range you are thinking about in terms of what indirect as a percent of revenue will look like in '08?

Mark Barrenechea

Sure. We are certainly setting internal goals and if this is our Q4 call, out in 2009, I'd look back in 2008 very favorably, if our channel business was in the mid to high-teens or the upper range of 20%. I would be very proud of that, were we to meet those metrics.

Tom Curlin - RBC

Okay. Thank you very much.

Mark Barrenechea

Thanks, Tom.

Operator

We will take a follow-up from David Duley with Merriman.

David Duley - Merriman

Hello, a couple more questions from me and hopefully I won't get cut-off right as I am spitting up the next one. I know you probably don't want to talk about products or customers, but clearly, when we look at the markets that you serve, my impression would be that your revenue will grow faster. And you mention that you are kind eliminating some revenue sources. Can you help us understand the magnitude of the types of revenues that you are walking away from? And what is the threshold of pain to determine that you are walking away from it? In other words, roughly, is there margin target you no longer accept, or help us understand what the perimeters are for walking away from certain types of business?

Mark Barrenechea

Yeah. I know it's probably a recurrent theme maybe today and through time; I don't need to dissatisfy everyone, but we are not going to get into specifics, right. We factored in to our '08 plan, the transition of this unfavorable business across customers, across products. We are not going to breakout the amount. We have factored this into our growth rates of flat to 10%. I am focused, both on the revenue and gross margin side, on the path to the upper end to ranges for 2008. And I do think to get to those high end of the ranges, is about us delivering on the market three demonstrable product lines, product introductions in the first half of this year, around deduplification and new form factors.

Now, at the end of the day, when I even look close to the end of '08 and start looking in to '09, it's about scaling the business, about scaling Rackable. And we see a path in doing this, right? This was a business historically that had one sales model, right, direct North America. And we are moving, in '08, to have multiple sales patterns.

The second aspect of scaling the business is moving from one product line, which is X86 Compute to multiple product lines. That includes Compute, Storage and Data Center Infrastructure. Dave, I think the other historical element of the business, as we transition in to '08 and beyond, is being focused in one industry the internet and focusing in multiple industries, internet, financial services, enterprises and federal. Our federal pipeline is growing. It's very impressive. Our relation with Raytheon continues to build steam having General Mike Hagee join us is both the reflection of governance and ability to execute in federal.

And lastly scaling the business is looking at one geography historically North America and building partners. We will wakeup every day on behalf of Rackable and help us expand our reach internationally. I think the computer center is a real good start to '08 and we're setting goals of having 2 dozen of those resellers internationally at the end of '08. So, that's all factored into our '08 plan in laying the investment for '09.

David Duley - Merriman

So, we don't want to talk about the size of what we're eliminating. Could you talk about what's the perimeters are for eliminating it?

Mark Barrenechea

It's obviously related to margin cost and sort of distraction to other areas of innovation. When I look out to new workloads, we want to focus our resources on new style data centers like the Ice Cube. We want to focus on new workloads, such as virtualization and deduplication and if anything that gets in our way from that focus is a distraction.

David Duley - Merriman

Now along those lines you are eliminating the lower cost, lower margin business as you makes this transition you're referring to. But your gross margin guidance reflects flat, just put up 18.5% and that's kind of the midpoint of the range or roughly. So, I'd expect the gross margin guidance will go up if you are eliminating low margin products. So, help me understand that math.

Mark Barrenechea

Again, to get to the high end of range, right, and to beat '07 is about product introduction, cost control and good to great execution.

David Duley - Merriman

Okay. Well let me ask some questions you might be able to answer more specifically. What are you seeing from the macro environment from your customers and would you think that 2008 or 2009, may be pick one of the years, which year would you see a major upgrade cycle to the datacenters?

Mark Barrenechea

Yeah, sure. So, again I don't mean to frustrate folks, but we made a decision on what we are communicating and I certainly can appreciate being asked the questions in a couple of different ways.

So, I think there are a couple of very favorable trends. One is movement of Quad-Core. So, it's a very, very important transition. It's allowing customers to consolidate space. It's allowing customers to consolidate to virtualized environment, to save facilities costs, etcetera. So, that's a very favorable trend.

In terms of sort of macro environment, I see a very, so far here in '08 fairly healthy environment around demand. The internet keeps growing. Federal needs keep growing. Certain aspects of financial services such as productivity, computing is very healthy, where we focus in. So, I see the demand still very health. There is no doubt in down economies that people are looking to cut costs.

But I think our value proposition of being able to reduce facility space, reduce electricity, reduced acquisition costs, and offset any other type of price negotiations. And also the Ice Cube is about selling on value. When we can cut electrical costs in half and cooling cost by 80% and facilities cost by 50%. So, I think in short, I see still a very healthy demand environment.

David Duley - Merriman

Okay. Third question from me and I'll turn over to somebody else is the impairment charge that you took related to one of the acquisition, is there a relationship to your storage acquisition? So, should we view that the assets that you bought will no longer produce what you thought? How should we view you writing this asset off?

Madhu Ranganathan

Right, Dave, this is Madhu. The charge, you should view it as a purely accounting requirement. It's completely yes; the components of it came to the Terrascale acquisition and some pre-IPO at Rackable. But, Mark just shared with you the emphasis and the commitments on the company's standpoint in storage-and-storage products. So, the charge itself, view it purely as an accounting charge.

David Duley - Merriman

It's a backward looking thing and still they are basically saying you didn't produce enough revenue based on the price that you paid for that asset to keep it valued at that current level?

Madhu Ranganathan

The trigger there is more of the decline in the market cap, as it relates to where the book value of the company is. And as you know in the last quarter, the market cap has declined and that's more the trigger then the future or the commitment to the business itself.

Mark Barrenechea

It's a pure FAS 142 requirement.

David Duley - Merriman

Okay, thanks.

Madhu Ranganathan

Thanks, Dave.

Operator

We'll take a follow-up from Shebly Seyrafi with Caris.

Shebly Seyrafi - Caris

Yes. Did you say earlier that you expect the non-GAAP EPS in fiscal '08 to be less than the non-GAAP EPS in fiscal '07?

Madhu Ranganathan

We said, Shebly, this is Madhu.

Shebly Seyrafi - Caris

Fine

Madhu Ranganathan

We said the non-GAAP EPS for '08 will be positive.

Shebly Seyrafi - Caris

Right. You didn't make any comparison remarks?

Mark Barrenechea

Yes, we did. Flat to slightly down.

Madhu Ranganathan

Flat to slightly down.

Shebly Seyrafi - Caris

Flat to slightly down. Okay, that's what I was after. So, you are guiding for basically higher revenue, like 0% to 10%, so how should I think about this potentially down EPS?

Mark Barrenechea

As I sort of discussed on previous calls, we are still disproportionately investing in the business. And we are disproportionately investing in sales and products. But maintaining profitability in the business, and clearly we think the business can scale beyond where it is today; that's going to echo or shadow set of investments. So, that's how you should think of a low to lower EPS, but remaining positive.

Shebly Seyrafi - Caris

So, OpEx, which was roughly $65 million in fiscal '07, should go higher I assume to make that happen, and it's not really a gross margin. The gross margin guidance, the mid point is similar to what you had in fiscal '07, looks like the difference is in the OpEx, is that fair?

Mark Barrenechea

I will speak to a little bit of the business and then let Madhu answer the financial question. Part of what we will be doing in '08 is in our facility in China that is now operational, in Shanghai. And we will be taking certain back office functions and putting that into a more economic environment for us. We'll also be beginning to work the company 24 hours a day. I mean that quite literally. That as the sun sets over California it will rise over Shanghai. And Rackable employees and engineering will begin to do our testing, our qualification, our components work on one of our key differentiators, which is day one advantage, which at the end of the day will helps us to accelerate on new products into the market. So, we can begin to work engineering 24 hours a day. So, with that Madhu, you want to speak a little bit to OpEx.

Madhu Ranganathan

Sure. So, Shebly, you are correct, on an annual basis we are going off at the rate of about $65 million. As Mark said, we will grow our headcount in '08, but we're targeting to use off shoring as a means to optimize the spend. So, think of our OpEx in '08, as slightly higher than the annual OpEx in '07. And that's how we get to the flat to slightly below EPS in a year-over-year.

Shebly Seyrafi - Caris

Quite positive.

Madhu Ranganathan

Quite positive, right.

Shebly Seyrafi - Caris

Right. But you had basically a negative 0.1, basically breakeven operating margin in fiscal '07, I assume that will produce a more of a decline; well let me work through it later. But the point, what's your long-term operating margins targets if you have one?

Mark Barrenechea

We have one internally, but we have not discussed kind of a long-term target model, yet, externally.

Shebly Seyrafi - Caris

Okay. Final question from me, you talked about three categories; the compute category, Storage and Data Centers Infrastructure.

Mark Barrenechea

Yes.

Shebly Seyrafi - Caris

And you talked about storage I think being 10% to 20% of your revenue in fiscal '08?

Mark Barrenechea

Yes.

Shebly Seyrafi - Caris

Do you have a target for data center infrastructure?

Mark Barrenechea

Sure. On the Data Center Infrastructure sides it's a mixture, right, of storage and compute, right? It depends on the work load that folks will be automating in the containers. There is no doubt that for what we are seeing right now, is that '08 will be a breakthrough year in containerized data centers. It is tough to kind of give a range of the amount or the quantity of containers, but it could be somewhere in the range of 20 to 50 for 2008. I think it will be a breakthrough year for seeing containers in the marketplace.

Shebly Seyrafi - Caris

And what's the ASP on that?

Mark Barrenechea

We don't discuss the ASP on it, but you can think of it in two categories. You can think of the container itself, plus what's in the physical container. So, whether it's the 17001Us, right, or quad-core machines, whether it be 78 petabytes of storage within a container, so you need to think of the actual servers or storage and then the physical container itself.

Shebly Seyrafi - Caris

Great. Thank you.

Madhu Ranganathan

Thank you, Shebly.

Operator

(Operator Instructions)

We will take up follow-up from Louis Miscioscia with Cowen & Company.

Louis Miscioscia - Cowen & Company.

Thank you. I have one last question on component pricing. And if you guys are seeing any benefits from component pricing, are the DRAM, motherboard or anything else in 4Q and if any of that is a part of your business models for 2008. Thank you.

Mark Barrenechea

Sure. So, there is no doubt that Q4 was another favorable market for DRAM pricing. We are starting to see some stabilization in DRAM. We are also starting to see in the marketplace, the beginnings of some solid state technologies, as well as higher speeds, and feeds on DDR2. On the motherboard side, I'd say things are price stable, but longer lead times in the marketplace. There are no longer any independent motherboard providers in the marketplace. They've all been acquired effectively as of 2007. On the hard drive side, I'd say that there is probably going to be some pricing movement in 2008, certainly how much we get to the transition point of one terabyte drives. That's what of my take on the component marketplace.

Mark Barrenechea

Operator, we might like to take a last question.

Operator

Okay. Our next question from Tom Curlin with RBC.

Tom Curlin - RBC

I think this counts as asking a question in a different way. So, we will say our jokes.

Mark Barrenechea

Go for it, Tom.

Tom Curlin - RBC

What do you view as sort of your hit the goal seasonality for a March quarter? I know, you are not giving Q1 guide but, when you talk about historical seasonality, historically, what has the seasonality been in your view?

Mark Barrenechea

Q1 is always the toughest quarter, right. So, I don't know how I have to say it.

Tom Curlin - RBC

Well I mean its range from up 32% to down 32%. So, we are talking the lower end of that range or single-digit double-digit?

Mark Barrenechea

Yeah. I think once you decide, you are on annual guidance you are on annual guidance.

Tom Curlin - RBC

Okay. Hey, I'll try.

Mark Barrenechea

Okay.

Tom Curlin - RBC

Thank you.

Mark Barrenechea

Very good.

Operator

And there appear to be no further questions at this time. I'll turn the conference back over to our speakers for any additional or closing comments.

Mark Barrenechea

Okay. We'd like to thank everyone for joining us today, and as a reminder we have an updated investor depth on rackable.com under our investor relation section, we encourage you all to check that out. With that, Madhu and I'd like to thank you for your time today. And that concludes today's call.

Operator

And that does conclude today's conference call. We thank you all for your participation. And you may now disconnect.

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Source: Rackable Systems, Inc. Q4 2007 Earnings Call Transcript
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