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Executive

Erik Bylin - IR

Mark Barrenechea - President and CEO

Madhu Ranganathan - CFO

Jim Wheat - Expect SVP and CFO

Analysts

Louis Miscioscia - Cowen & Company

Mark Kelleher - Canaccord Adams

Tom Curlin - RBC Capital Markets

Alfredo - Thomas Weisel Partners

Alex Kurtz - Merriman Curhan Ford & Co.

Rackable Systems Inc. (RACK) Q1 2008 Earnings Call April 24, 2008 5:00 PM ET

Operator

Good afternoon, and thank you for joining us on today's conference call to discuss Rackable Systems first quarter fiscal 2008 earnings results. I would like to remind you that this call is being recorded and simultaneously webcast at www.rackable.com.

And now at this time, I would like to turn the conference over to Mr. Erik Bylin, for opening remarks and introductions. Please go ahead, sir.

Erik Bylin

Good afternoon. Thank you for joining us to discuss our press release this afternoon, which is available on our website, 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 & Chief Executive Officer, and Madhu Ranganathan, our Chief Financial Officer, as well as Jim Wheat, who will take over as our CFO when Madhu leaves the company.

Before I turn the call over to Mark, I'd like to bring the following to your attention. The date of this call is April 24th, 2008. This 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 its 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 words such as will, expect, believe, project, 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 Rackable Systems operates in a very competitive market and increased competition has, in the past, and may continue to cause pricing pressures 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, and so the delay in placing of 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 risks and uncertainties 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 13th, 2008, and 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 will be disclosing non-GAAP financial measures in the presentation. For a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures, please see our press release today, which is posted on our website at www.rackable.com, as well as the press release of February 6th, 2008, with respect to our fourth quarter 2007 reconciliations, which is also posted on our website.

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

Mark Barrenechea

Thank you, Erik, and welcome to our call. Today, I will give an overview of our financial results for Q1, our view of market conditions, product news, customer trends and a Management update. I'll also highlight some of our accomplishments over my first year at Rackable, and conclude with our annual projections.

Our revenues were $68 million. As stated previously, Q1 is a seasonally weak quarter for us. Our revenues were below Q1 '07 by $4 million for a variety of reasons; certain purchasing decisions were delayed, but not canceled; some customers made smaller purchase decisions; and thirdly, the transitioning of unfavorable revenue as we strive for profitable growth; as well as some other factors. In achieving revenue of $68 million, our execution was outstanding.

On non-GAAP basis, our gross margin was 24%, growing from 13.5% a year ago, and 21.7% last quarter. EPS was $0.06, a $0.19 improvement from Q1 '07. We ended the quarter with well over $200 million in cash. We have streamlined our supply chain and contract manufacturing processes and optimized inventory to $36.2 million. We have proven at Rackable that an economic slowdown does not mean a profit recession.

In addition, we have realized desired positive trends in revenue mix. Base markets, those customers outside our top-three historical customers, were 59% of our revenue, which favorably compared to 37% in Q1 '07. Broadening our book of business makes us less susceptible to short-term demand swings. Our product and geography revenue mix was strong. Storage was 19% of revenue, while international grew to 7.4%, each of which increased quarter-over-quarter and year-over-year.

We continue to strengthen our international presence and we recently signed CTC ITOCHU as a channel partner, giving us reach into Japan. Japan is among the top-three countries in IT spending. CTC is a leading provider of data center infrastructure. Our joint value proposition should resonate well in Japan. Reduced facilities expense, improved energy efficiency, engineer to customer workload and high performance computing.

On our previous call, I had spoken about doubling the density of our X86 compute line of products in 2008. I am pleased to announce, our next generation technology will be generally available by the end of this quarter. Our new line of servers will dramatically change the form factor for compute and storage, achieving our ambitious goal of double-density.

Our most power tuned configuration will operate at 96% power efficiency, while our competitors are still stuck in the 80% range. Reliability will increase while reducing redundancy. Our next generation technology has built-in management technologies, lower operating cost, reduced complexity and increased capabilities.

Our internal benchmarks on both AMD and Intel quad-core technologies are very impressive. We designed this new core factor for the long-term and it is designed to support future chipsets for both AMD and Intel, with no more complexity than changing a processor.

Continuing our leadership in the Eco-Logical data center, this generation of products will work within our existing chassis and cabinets, new chassis designs, industry standard cabinets, will operate at higher data center temperatures, as well as within the ICE Cube. Our beta cycle is near complete, customers have first articles and we expect a full market and product launch within the next 60 days. Our sales force, supply chain and operations will be fully ramped by early July. I had one customer comment to me, given their application workload, that our new server power profile is equivalent to that of a light bulb. I encourage you to watch this space.

On to customers. We are seeing a broad array of market drivers that are contributing to the demand for our data center solutions; the need for additional capacity, new workloads, virtualization, facility consolidation, quad-core and energy efficiency. Part of our strategy includes market and customer diversification and we are beginning to see results. In Q1, our industry mix included Internet at 64%, media at 12%, financial services at 8%, and all other industries at 16%, with strong performance in Oil and Gas. As compared to Q1 '07, we grew our financial services business by 100%, and our media business by 80%, albeit on a smaller basis. The direction is encouraging.

Rackable has never been more in tune with the market and we have developed a suite of products that is tailored to the relevant buying trends that shape the data center landscape, and we expect these trends will continue into 2008. We also added over a dozen new customers in Q1, Repsol in oil and gas, as an example.

Rackable has made great strides in the last year in assembling our management team and Board of Directors. We have made two key additions to our management team since our last call. First, Tony Carrozza joined as Senior Vice President of Worldwide Sales and Marketing, and brings over 30 years of storage and server industry expertise to Rackable. He has already established his leadership of the sales and marketing team.

Secondly, Jim Wheat will be named Senior Vice President and Chief Financial Officer, and will assume the role when Madhu steps down. Jim joins us from Lam Research, a multibillion dollar provider of semiconductor equipment. Jim most recently served as Vice President and Corporate Controller at Lam. It takes time to assemble a world-class team. The team is now assembled, the organizational structure aligned, and it gives me great confidence in our future.

I want to continue to thank Madhu and wish her well and all the best in her future endeavors. Madhu's final day with Rackable will be May 16th. Before I turn the call over to Madhu, I'd like to provide Jim an opportunity to introduce himself. Jim?

Jim Wheat

Thank you, Mark. I am very happy to be joining Rackable Systems. I believe the team here has built a solid foundation and has developed an excellent suite of products. The company has a longstanding reputation as an innovator in the data center industry and I am eager to apply my global experience to help expand the success of our Eco-Logical line of high-performance solutions.

I have had an opportunity to spend more time with the management team, the finance and accounting staff and the Board, and feel a great deal of synergy in the way they think about the company's growth proposition. I look forward to applying my experience and skills to help strengthen this increasingly global organization.

Madhu Ranganathan

Thank you, Mark and Jim. And before I begin, please let me add to what Erik said earlier about our use of non-GAAP financial measures. Our GAAP financial measures appear in our press release issued today, and with respect to Q4 results, the press release as of February the 6th, along with the required reconciliation tables. In this call, I will be discussing earnings, gross margins and similar items on a non-GAAP basis as reconciled in those tables.

We have several financial highlights during the first quarter and have made progress on a number of fronts. We continue to expand share in base markets as we diversify our customer base. We have strong gross margins, reporting the highest non-GAAP gross margins since the end of FY 2005. Our higher margins, combined with effective cost management have resulted in strong non-GAAP EPS performance. And finally, we ended the quarter with well over $200 million in cash balances. With those highlights, let me turn to the details of our first quarter.

Q1 revenue was $68 million compared to $72 million same quarter a year ago. We had exceptional base market performance. Amazon, FaceBook, Microsoft and YouTube were each greater than 10% of revenue during the quarter. On a non-GAAP basis, gross margin was 24%, a dramatic improvement from 13.5% in Q1 of 2007, and 21.7% in Q4 of 2007. This non-GAAP gross margin improvement is attributed to improvements in our base market book of business, our mix of products such as storage, and operational execution.

And now turning to expense. Our Q1 GAAP operating expenses are $20.7 million for the quarter. Our Q1 non-GAAP operating expenses, which exclude $3.2 million of stock-based compensation charges and $2.1 million of Terrascale related acquisition charges, were $15.5 million. With respect to Q1 operating expenses, I will comment that we are a better run company today and our investment dollars in sales and R&D are more effectively applied. Q1 non-GAAP income from operations was $830,000, compared to non-GAAP operating net loss of $8 million during the year-ago first quarter. This amount translates into 1.2% non-GAAP operating margin for Q1 '08, compared to a negative 11% in Q1 2007.

After recording interest and other income of $2 million and using a non-GAAP tax rate of 40.9%, we reported non- GAAP net income of $1.7 million or $0.06 per share, compared to a non- GAAP net loss of $3.6 million during the year ago first fiscal quarter, or a negative $0.13 per share, a $0.19 increase year-over-year. We generated more non- GAAP net income in Q1 than we did in Q1, Q2 and Q3 2007 combined.

We have changed our investment approach to more conservative instruments, given the general economic outlook. This has lowered our yield during Q1. We are currently projecting approximately $1.1 million to $1.2 million of interest income on a quarterly basis for the remainder of the year. GAAP to non-GAAP reconciling items during the first quarter included stock-based compensation of $3.5 million, compared to $7.9 million in Q1 '07 and $4.1 million in Q4 '07. At the end of Q1, total employee headcount was 348.

And now turning to the balance sheet. Total cash, cash equivalents, short and long-term investments grew to $206.9 million, up $36.8 million or 22% compared to the end of Q1 FY 2007, and up $8.8 million compared to December 2007. Note that March cash balances included option-based securities of $8.7 million. We applied a $400,000 charge to other comprehensive loss in our shareholders' equity, which reflects a reduction in the fair value. The charge did not have an impact to our net income during Q1. Net of the valuation charge, we have reclassified $8.7 million to long-term investments.

Cash flow from operations for the quarter was $9.5 million. DSOs during the first quarter was 47 days. As reflected in our record cash balances as well as cash flow from operations, we continued to show strong progress on cash generation and working capital management.

And with that, I will turn the call over to Mark.

Mark Barrenechea

Thank you, Madhu. Let's turn to our annual guidance. We've examined a number of factors relating to our business, and we think it is prudent to tighten our annual revenue guidance from 0 to 10% growth to 0 to 6% growth. Some of these factors include current uncertainty in the economy, the continued transition of unfavorable revenues and visibility into customer demand and timing of decisions over the next nine months.

We continue to tune our model and certain '08 operating improvements are ahead of schedule. We expect better annual non-GAAP gross margin performance of 18 to 21 points, a 100 basis point improvement over previous annual projections. Additionally, we intend to be non-GAAP EPS positive and accrete cash on an annual basis. Any given quarter could fluctuate in, above or below these ranges, which is the nature of our business in the markets we serve. We also expect to see seasonal patterns similar to 2007, with growth accelerating in the second half of the year.

Next week, will mark my one-year anniversary as CEO at Rackable, and I am pleased with many of our accomplishments. We have assembled a superb management team and a world class Board of Directors, a Board, I would note, that would be the envy of any billion dollar company. We have increased our cash and investment balances by 22% from a year ago, while holding no debt, a claim many of our peers or competitors will be hard pressed to make. We are operating profitably on a non-GAAP basis. We have fine-tuned our business model and have delivered non-GAAP gross margin improvements four quarters in a row. Our innovation engine is firing again.

In these past 12 months, we have created long-term staying power for the company, while continuing to build an engine for growth. Further, customers want a model to purchasing and deploying servers and storage, and that model is build-to-order. Why should customers purchase from a catalog when they can create a tailored, engineered to workload solution? Rackable is unique and there are high barriers to entry in this model.

In summary, it is easy to see why I'm enthusiastic about 2008. With operations tuned, the leadership team assembled, the healthy balance sheet, new products and new markets, a relevant value proposition and a unique business model, we can now focus a disproportional amount of time to the next phase of Rackable, and that phase is growth and scale.

And with that, operator, we'd like to open it up to Q&A.

Questions-and-Answers Session

Operator

(Operator Instructions) We will go first to Louis Miscioscia with Cowen & Company. Louis, your line is up and go ahead.

Louis Miscioscia - Cowen & Company

Okay. Just found the mute button. So, on the gross margin line, how much help did you get from just DRAM pricing still staying very soft?

Mark Barrenechea

I mean, 24 points of gross margin is a very strong quarter for us, and I would say the number one contributor to those 24 points was market diversification and product mix. Secondly, our value proposition as energy prices soar, is very compelling and we're a discreet manufacturer and we operate it very well. We certainly did get some benefit, but where sometimes you would rank a component price improvement 1 or 2, I'd have to put DRAM prices down 4 or 5, in what contributed to a stellar Q1 in gross margin.

Louis Miscioscia - Cowen & Company

Okay. And when you mentioned a mix shift, was it just more highly configured high-end kind of boxes? Maybe if you could just give us a little more detail there?

Mark Barrenechea

Sure. The contributors to gross margin, are typically a level of performance in operations and supply chain, pricing and customers and product mix. So, where close to 60% of our mix was base markets, 19% of our business was storage in Q1. And we saw a fair amount of business building high end tailored solutions for database environments as well as a fair amount of growing our database class.

Louis Miscioscia - Cowen & Company

And was that in a NAS or SAN environment?

Mark Barrenechea

I would characterize it more as a network attached environment.

Louis Miscioscia - Cowen & Company

Okay, I've got a couple more. Let me just let somebody else go and I'll just circle back in.

Operator

We will go next to Mark Kelleher with Canaccord Adams.

Mark Kelleher - Canaccord Adams

Good afternoon, thanks for taking my call. On the revenue side, you talked about some transition of unprofitable revenue. Is there a way to size how much that affected the revenue number and could you give us an example of what an unprofitable revenue is?

Mark Barrenechea

Sure. Well, I'd spoken in the last call that I wasn't going to get into the specific revenue numbers, customers or product lines and still not going to get to that level of specificity. What I would say is, strategy is about making choices and the choice we've made is profitable growth. And Q1 is a very good example where we've had strong gross margin, EPS, cash, versus trading off slightly higher revenues at poor gross margins. We're going to compete for every piece of business out there. We're going to hold to our value proposition, and the strategy choice we have made is profitable growth.

Mark Kelleher - Canaccord Adams

Okay. Can you talk a little bit about the progress of the ICE Cube in the quarter, how's that going?

Mark Barrenechea

Yes, sure thing. So, the pipeline certainly remains very healthy for the Cube, and I still firmly believe that this will be a year for the Cube. I've spoken about $20 million to $50 million in revenues deployed within containers this year. Our pipeline is pretty broad across a handful of industries right now; the Internet, financial services, opportunity in oil and gas, defense and intelligence. And when I look out over the year, our expectations will be in the range of $20 million to $50 million in revenues deployed within the Cube. The Cube is a deployment option, right, whether you're deploying in a cabinet, a row of cabinets in a data center or deploying storage or servers in a container. So, I'd expect 20 to 50 million of our revenues this year deployed within a container.

Mark Kelleher - Canaccord Adams

Did you sell any containers this quarter?

Mark Barrenechea

We did not. We did not recognize any revenue in Q1 on the Cube. We have delivered additional prototypes within the quarter and believe we'll hit that revenue range I've set out there for the year.

Mark Kelleher - Canaccord Adams

And one quick numbers question for Madhu, maybe. Is the stock comp the only difference between GAAP and non-GAAP?

Madhu Ranganathan

There are actually two categories, stock compensation expense, of course, and we have some Terrascale acquisition related charges.

Mark Kelleher - Canaccord Adams

Okay, great, thanks.

Operator

Our next question comes from Tom Curlin with RBC Capital Markets.

Tom Curlin - RBC Capital Markets

Hi, good afternoon.

Madhu Ranganathan

Hi, Tom.

Mark Barrenechea

Tom, good afternoon.

Tom Curlin - RBC Capital Markets

Let's talk large customers, you mentioned Amazon, FaceBook and MS, and I think those were 10% customers last quarter as well, is that correct?

Madhu Ranganathan

Those three were over 10% last quarter as well and this quarter we named a fourth over 10%, Tom, and that's YouTube.

Tom Curlin - RBC Capital Markets

YouTube. And then, do you expect those four to be 10% customers for the year? Or could there be some moving in and out, if you will, in that list?

Mark Barrenechea

We're expecting to continue to compete, Tom, in each of these accounts. I don't know if they'll be above or below 10%, but I do expect to have a good healthy book of business, given the trends we see.

Tom Curlin - RBC Capital Markets

Okay. And then you talked about accelerating revenue through the year, but just to clarify that, we can get to your guide, I believe, or get pretty close with decelerating year-over-year growth, or at least flat. So, are we talking sequential as in accelerating would mean up sequentially and therefore, maybe June is flat and then we go from there?

Madhu Ranganathan

Tom, this is Madhu. We did outline in the call, in terms of annual guidance and we're maintaining the annual guidance.

Tom Curlin - RBC Capital Markets

Okay. Well, I guess you said similar to last year, right? So, that would imply a sequential trend through the quarters?

Madhu Ranganathan

A sequential trend through the course of 2008, yes, correct. But definitely accelerated growth towards the second half of the year, was Mark's comment.

Tom Curlin - RBC Capital Markets

Okay. The storage business was up nicely, sequentially and year-over-year. Is that part of the gross margin contribution?

Mark Barrenechea

Certainly. Product mix and customer mix.

Tom Curlin - RBC Capital Markets

And how much of that is related to RapidScale -- we'll, call it systems that have RapidScale as part of the content versus, I'll call it raw, or just gross storage hardware sales?

Mark Barrenechea

There's certainly -- I wouldn't put RapidScale as the main contributor there. I think of new RAID technologies, new higher capacity drives, the demand for more storage capabilities, growing our ability now to address a broader database market, not just a MySQL sort of environment, but more enterprise class databases, as well as database clouds. So, I'd say we saw sort of a nice confluence of new componentry that we've integrated and tested, some new chassis designs from us, and understanding a good sweet spot for a database market and [compute class]. So, storage yields a greater margin, given its complexity and its relevance to the business, so it was certainly a good favorable trend for us in Q1.

Tom Curlin - RBC Capital Markets

And then just finally, with respect to RapidScale, it sounds like maybe that wasn't the primary driver, so what is the status, if you will, on that product? It was an executive departure you filed, so I'm just curious on the level of commitment and where you are with that product?

Mark Barrenechea

We remain committed to RapidScale. The orientation of RapidScale is more towards high-performance compute environments and certainly as we look to diversify our book of business, HPC is an area we need to grow into. We need to get additional skills on the software stack in HPC environments. We do extremely well in HPC opportunities, where universities or research or military installations are looking for commodity compute with high-speed interconnectivity, but we need to expand our skills at the software stack layer. So, we're committed to RapidScale and we're certainly pointing it more towards HPC environments.

Tom Curlin - RBC Capital Markets

Okay, thank you very much.

Operator

We will go next to Doug Reid from Thomas Weisel Partners.

Alfredo - Thomas Weisel Partners

This is [Alfredo], attending for Doug Reid. I had a question about your international expansion. I wanted to find out when you think the Japanese new VARs and partnerships will significantly contribute to the revenue of Rackable?

Mark Barrenechea

We've spoken about a range of channel business in '08, between 10% and 20% of our revenues for '08, and 2 to 3 large-scale system implementers. CTC certainly is in that category of 2 to 3 large-scale system implementers. The requirements in Japan for increased energy efficiency, reducing facilities cost, customized solution, it's just a fantastic fit, and CTC is a premier provider of those data center solutions. We're certainly factoring our channel business in that range of 10% to 20%, and we'd expect some contribution from the channel this year. Growth, as we look into '09, will absolutely be part, accelerated growth will absolutely be part of the channel business we're building this year. So, I'd say we have modest expectations this year. We want to selectively find a handful of partners in the top half-dozen countries, and look for real premier providers like CTC in other countries.

Alfredo - Thomas Weisel Partners

Thanks. And just one last one. Does the channel and international expansion change anything in terms of OpEx for the rest of the year?

Madhu Ranganathan

I can take that. This is Madhu. So, when we talked about OpEx for the remainder of the year, directive to where Q1 is, we definitely see growth in OpEx and this has been factored into, when you look at the overall framework of the positive non-GAAP EPS. The investments in OpEx -- to answer your question a little bit more broadly, will be focused towards sales and engineering, and obviously within sales, certainly focused with channels and international expansion as well.

Alfredo - Thomas Weisel Partners

Thank you.

Operator

(Operator Instructions) We will go next to Alex Kurtz with Merriman Curhan Ford & Company.

Alex Kurtz - Merriman Curhan Ford & Co.

Thanks, can you guys hear me.

Mark Barrenechea

Yes, very well.

Alex Kurtz - Merriman Curhan Ford & Co.

So, could you first talk about linearity in the quarter, excluding your top-four customers, then including your top-four customers, and help me understand how that works?

Madhu Ranganathan

Alex, this is Madhu. So, in terms of linearity, we would say that linearity was sort of average, mediocre, it was not a heavily back-end loaded quarter. At the same time, we didn't have perfect linearity. But, I would say the linearity is not very different between our top three and the base market, so this pattern I described applies consistently to both groups.

Alex Kurtz - Merriman Curhan Ford & Co.

Okay. So, no real difference between the top-four and the rest of the customer base?

Madhu Ranganathan

No.

Alex Kurtz - Merriman Curhan Ford & Co.

Okay. And then just following on the channel development question, so you have this big plan this year to grow your channel community, but the comment I just heard was that you're really looking for a couple of very large, national integrators to lead that charge. Am I hearing that right and you're not as interested in sort of the mid-market VAR as a core channel partner?

Mark Barrenechea

A couple of things in there. We've spoken in the past and are holding to, because we think it's the right strategy for us, in '08, bringing onboard two to three additional large system implementers, those who have reach into unique geography or unique verticals and can bring deployment and service capabilities; Raytheon in that category, CTC in that category.

In '08, we're looking between a dozen to two dozen -- let's call them high-end specialty VARs, those who may have a data center team dedicated to them, who understand an engineered to workload environment, and that's the priority. We're not going after mid-market resellers at this point in time.

Having said that, there are a variety of regional or more boutique oriented specialty VARs who may understand -- the San Francisco community, the Las Vegas community, etc. I'd also note, Tony Carrozza, who's recently joined us, who built an $800 million business at Quantum, who had a nice mix of direct and indirect, is bringing an incredible perspective and sense of execution to how to build that out for '08, as we're marching towards greater growth in '09.

Alex Kurtz - Merriman Curhan Ford & Co.

And just on that point, would you expect to be investing OpEx dollars in building a partner support center and additional partner marketing activities throughout the year?

Mark Barrenechea

Absolutely. Everything from helping either with MDFs, to deal registration, to appropriate materials, training, as well as a channel sales force, that instead of interacting directly with the customer, interacts with the partner.

Alex Kurtz - Merriman Curhan Ford & Co.

Okay, great. And one last question and I'll jump off here. Yahoo and Microsoft, obviously there is activity there with Microsoft looking at Yahoo. Has that impacted your discussions with them on a quarterly basis as far as spending activity? Has there been any change or any tone there that we should be aware of?

Mark Barrenechea

I'll go back to sort of my previous response. This has obviously been the news for a handful of months. My response is the same. It's sort of unhealthy for me to speculate whether it will happen or not. Should it happen, what would the post merger company look like, would spending be up, down, flat? What I do know is I'm a strategic supplier to both, and should it happen, we're in a great position to compete. So I can't and won't speculate on it.

Alex Kurtz - Merriman Curhan Ford & Co.

Okay, thank you very much.

Madhu Ranganathan

Thank you, Alex.

Operator

And we do have a follow-up from Louis Miscioscia from Cowen & Company.

Louis Miscioscia - Cowen & Company

Could you maybe go into a little bit more, comments about just the demand environment? You mentioned there seems to be some indecision on some customers, just why they're actually doing that and do you think it's going to persist for a while?

Mark Barrenechea

Sure. I'll start with maybe why customers are buying. We certainly see facility consolidation, the need for energy efficiency, movement to quad-core, new workloads, and these are favorable trends for us in an up economy or a down economy. There's certainly uncertainty in the market, and some decisions were delayed, but none were canceled. And I think that's a very important point, whereas I think the general IT market is a bit cautious and some decisions have been delayed, at least for Rackable, we haven't seen anything canceled. And if I see things cancel, then your worry grows a bit.

And what's important to us is to have a good industry diversification, geography diversification that allows us to be more immune to a quarter or two spending habit. So where some decisions may have been delayed or certain customers took smaller bites, we've seen nothing canceled at this point.

Louis Miscioscia - Cowen & Company

Okay. When you look at the comments that you made about ICE Cube and also the channels, would you say that these are incremental revenue streams or are they cannibalistic? Because if you're going to get 20 to 50 million from ICE Cube and another 10% to 20% -- let's say 10% from the channel, and if they weren't cannibalistic that would be about $60 million. So then, your sort of year-on-year guidance sort of goes from $350 million last year to about 300. And, maybe that is the dislocation of revenues or something else. I don't know. Maybe if you could just give us some thoughts on that?

Mark Barrenechea

I sort of chose my words carefully here on the [condition]. I'm not trying to slice any verbiage. The container, from our view, one view and a strong view, is it's a deployment option. Okay? So a customer may be out of facility space, but they need to add 2,000 servers. How do you add those 2,000 servers? Do you go build a new facility or do you bring a Cube to the back of the data center and run water, power and network?

So, we see it as a deployment option, if you will. Overtime, it will grow into new markets. Federal is a new market for mobility, which is a market we haven't traditionally served. But I look at '08, I see it really as an additional deployment choice, so I don't see it as cannibalization, but as a deployment choice.

Louis Miscioscia - Cowen & Company

Okay. And then just sort of on that same topic, if you could just maybe follow-up on comments about competition, what you're seeing out there? IBM had an announcement about a very dense server system for the Internet space that seemed to theoretically be aimed right at you. I don't know if you had a chance to look at it yet.

Mark Barrenechea

Sure. So, in terms of competition, I would say Sun continues to be lost. HP is the very expensive provider. Dell's behavior is they will continue to bundle, but be the low cost spoiler. And IBM is very expensive and inflexible. IBM, the name of the product is iDataPlex and my one word response is, I am perplexed. If these customers -- these competitors at this point are beginning to -- almost every one at this point has validated our value proposition and business model, which has very high barriers to entry in build-to-order.

And if they start drumming up demand for energy efficiency, build-to-order, engineered to workload, we have a set of products, we have systems, we have a supply chain and a manufacturing capability all built around build-to-order. And all that I see is that they're going to drum up demand for us, if they make this a core issue in their customers.

Louis Miscioscia - Cowen & Company

Okay. Madhu, a question for you. I think you had given that you thought your interest income was going to be $1.1 million to $1.2 million, and obviously it was higher than that in the first quarter. Was there something else that lifted it in the first quarter that's not repeating?

Madhu Ranganathan

It's a good question. So, I said 1.1 to 1.2, yes, that's correct. When we took the approach to sort of move to the conservative side in terms of the securities and investment, it happened towards the end of the quarter, so the impact of that you're really going to see for the remainder of the year and hence, the Q1 needle is higher.

Louis Miscioscia - Cowen & Company

Okay, thank you.

Operator

And there appear to be no further questions at this time. I'd like to turn the call back to Management for any additional or closing comments.

Mark Barrenechea

Very good. We'd like to thank everyone for joining us today and we'll speak with you soon.

Operator

Again, that does conclude today's conference call. Thank you for your participation. You may disconnect at this time.

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Source: Rackable Systems Inc. Q1 2008 Earnings Call Transcript
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