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Executives

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

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

Nicole Noutsios - Investor Relations

Analysts

Mark Kelleher - Canaccord Adams

Analyst for Louis Miscioscia - Cowen and Company, LLC

Alex Kurtz - Merriman Curhan Ford & Co.

Douglas Reid - Thomas Weisel Partners

Rackable Systems, Inc. (RACK) F2Q08 Earnings Call August 4, 2008 5:00 PM ET

Operator

Welcome to the conference to discuss Rackable Systems second quarter fiscal 2008 earnings results. (Operator Instructions) At this time I’d like to turn the call over to Nicole Noutsios for opening remarks and introductions.

Nicole Noutsios

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

Before I turn the call over to Mark, I’d like to bring the following to your attention. The date of this call is August 4, 2008. This call is the property of Rackable Systems and any recording, production 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 webcast replay will be available on our website for approximately 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, 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. These include: Rackable Systems’ operate in a very competitive environment, and increased competition has in the past and may continue to cause pricing pressure on Rackable Systems’ products which would negatively affect Rackable Systems’ growth 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 an order or the failure of a significant customer to place additional orders could have a significant negative effect on Rackable Systems’ financial performance. Accordingly we caution you not to place undue reliance on these statements. These and other risks and uncertainties affecting Rackable Systems are set forth in our annual report on Form 10K under the caption “Risk Factors” which was filed with the Securities and Exchange Commission on March 13, 2008 as updated by Rackable Systems’ sequential 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 with corresponding GAAP measures please see our press release of today which is posted on our website at www.rackable.com.

Now I’d like to turn the call over to Rackable CEO Mark Barrenechea.

Mark J. Barrenechea

Today I’ll provide some thoughts on our business, a brief overview of our financial results, outline our customer and channel accomplishments, and spend some time on our recent product news and innovations.

Before I provide the quarterly overview, I’d like to touch briefly on five key points that demonstrate our leadership and progress. First, we have made significant progress in the transition from a single line of products x86 compute to a company providing multiple solutions for data center infrastructure, storage and x86 compute. We have done this while increasing deployment options from rack-mounted solutions to modular data center building blocks as well as offering professional services. Markets and companies evolve. What used to be called the Internet transformed into Web 2.0, then Foster Web Service, and now Cloud Computing. Our x86 series was designed to power the Cloud, which leads me to my second point.

Our renewed emphasis on R&D has produced advanced new products that extend the competitive advantage we hold over our peers at each technology shift. Our new x86 series is the most energy efficient and high density product in the history of the company. The Tolly Group recent study, which I’ll discuss later, verifies Rackable’s leadership in the increasingly important area of low energy consumption and Cloud computing.

Third, we believe that we have the best product in the modular data center market. We are the pioneer in this arena and our recent and new customers in the product have seen this through evaluation unit and working with us for customized solutions. We are now winning business. For example, we recently won an ICE Cube contract with the US federal government that can have significant revenue upside opportunities for us in the coming quarters and year. We also have additional ICE Cube products being worked in numerous other arenas across the federal government.

Fourth, our pipeline continues to diversify across many verticals even in emerging verticals where we had limited prospects a year ago. For example, in the oil and gas market we were recently awarded a large contract in a Top 10 energy company which we expect to fulfill here in Q3. Further, we had a second long-term win in the defense and security market for a radar deployment project. We believe that this book of business can have significant revenue upside in the coming quarters.

And finally, the combination of these attributes has resulted in stellar partnerships with the largest of the large: Raytheon, CTC, and IBM. In addition we will soon announce the details of a new Rackable partner that will dramatically and globally enhance our storage presence. Our approach to indirect markets is to partner selectively with large multinational organizations that extend our reach into markets and geographies that could not otherwise be served. We also have a strong management team dedicated to building the business. With each day that passes our prospects and our ability to execute strengthen.

Now I’d like to say a few words about the business environment; then summarize our results. While we recognize that there are a number of factors weighing in the economy, we are not seeing this effect short term or long term demand for our data center solutions. Pricing decisions and discussions do start earlier than usual and customers are certainly price and deal term sensitive in this economy. However, when we’re able to establish our total cost of ownership model and a sales cycle we are able to differentiate our solutions very effectively. Our business fluctuates quarter over quarter and as is our practice we discuss only annual guidance to allow us the flexibility to make the right business decisions. We are reaffirming our 2008 revenue guidance of $353 million to $374 million, non-GAAP gross margin of 18 to 21 percentage points, and non-GAAP EPS positive for the year.

Regarding the June quarter our revenue was $76 million with a $0.12 non-GAAP EPS loss. Our EPS result was principally driven by a non-GAAP gross margin of 9.7%. Cash and investments remained strong at $206 million. Our gross margin profile was impacted by two independent causes. First, we accepted a sizable deal with unfavorable pricing. The decision was made to support an important property for an important customer which we believe will put us in an advantageous position for more profitable long-term opportunities. This was a tactical move to support a customer and does not alter our long-term view on not taking unfavorable business. Second, supply shortages contributed to increased cost of goods sold further decreasing gross margins. Given that we are a built-to-order business, shortages can result in higher costs. We have worked through these shortages with our suppliers and they do not appear to be an issue for Q3. These two factors do not represent a short or long-term challenge to our business. Excluding these two factors our base market gross margin performance was very strong.

Our year is shaping up with positive revenue mixed attributes. International market expansion is a key driver of growth for us and year-to-date our international sales are up 8% from last year, our storage sales are up 13%, media is up 44%, financial services up over 50%, we added over 20 new customers in Q2, our base Internet and Cloud computing business is strong, federal and energy sectors will be core contributors to the second half of 2008. Our strategy of providing solutions for high-value high-growth markets, Internet, Cloud computing, media, financial services, oil and gas, federal, HPC, is starting to show signs of success.

On the partnership front, as previously announced, we have signed a significant agreement with IBM that enables us to offer the IBM BladeCenter servers and software and our ICE Cube. This partnership and its implications are important as IBM chose to work with Rackable and our ICE Cube over other containers in the market representing strong validation for our product superiority. In addition this partnership should enable Rackable to reach new markets. With the IBM products the joint solution is ideal for harsh environments and demanding conditions like those seen in telecommunications and fault tolerant enterprise applications, desirable verticals and workloads that expand our reach.

Our year-to-date partner program is shaping up nicely with Raytheon, IBM and CTC. Speaking of CTC we recently booked our first Japan originated business with this partnership announced just last quarter. This is worth noting because we competed head-to-head with entrenched and country competitors and the customer chose Rackable.

Let me spend a few moments on storage. Year-to-date our storage revenues represent 13% of our business. The largest contributors being our integrative storage compute servers and high density expandable JBOD solutions. The key to accelerating storage growth and meeting customer demand is expanding our portfolio. To that end we will soon be announcing the details of a large global partnership. With this partner the go-to-market aspects will include fault tolerant enterprise workload and virtualization. Watch this space. We expect our customers to begin benefitting from this new combined offering as soon as the end of Q3. We are pleased with our core storage strategy and our progress year to date. Having said that at this juncture we believe that RapidScale is no longer core to our strategy and Jim will discuss our decision to seek strategic alternatives for the asset.

Let me turn to some independent validation we are proud of. During the last quarter we were pleased to announce the findings of the Colly Group, one of the industry’s most respected testing organizations. They recently tested a Rackable compute configuration and the equivalent versions from Dell, HP, IBM and Sun. This is the first independent comparison of power consumption for major server vendors. The results: In every test they ran the Rackable server was most efficient. Our average power savings was on the order of 20%. As many of our customers struggle with rising energy costs and a limited electricity supply, these findings help support our TCO model and provide clear and independent viewpoints of the Rackable advantage.

I’d like to conclude by providing a few additional comments on our new x86 series. Simply stated, these products double the compute density of our existing servers while significantly increasing efficiency. The new rack-mount designs combine multiple server boards for enclosure with Rackable Systems’ high efficiency power technology to create the company’s most ecological systems to date while nearly eliminating the cost of management. We have created five new server versions optimized for HPC and Cloud computing workloads. As an example, one XE populated ICE Cube can run over 20,000 CPU cores in a single 40 foot data center module. Just a few quarters ago it would have taken over 60 cabinets to provide equal CPU core density. What a difference a year makes.

Before I hand the call off I’d like to share with you that we have successfully concluded our proxy content putting all proposals at our annual meeting. We’d like to express our appreciation for the support we received from our shareholders.

Now I’d like to turn the call over to Jim Wheat, our CFO, to review our financial results.

James D. Wheat

Before I begin, please let me add to what Nicole 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.

Before beginning my financial review, I would like to touch on several details. Rackable was able to successfully bring to a close a number of issues during the most recent quarter. These items had consumed a reasonable amount of management time and focus and we are happy to have them completed. First, we finished the restatement of our first quarter financial statement and filed a 10QA with the SEC on July 18. In this filing and consistent with what was previously disclosed we reported our GAAP gross margin to be 26.1% up from the previously reported 23.5%. Second, we reviewed the progress on our RapidScale business and concluded that this business is not likely to meet our future expectations. Accordingly we are considering strategic alternatives to enable us to exit the business. For these reasons we have taken an impairment charge of $16.9 million in our Q2 income statement. And finally, we exited our [Nomont] Road facility and negotiated a settlement to end this lease. With the termination of our obligation on this lease, we have taken a charge of $1 million in Q2. By exiting this building and moving our engineering team into our headquarters buildings with our operations team, we expect to gain additional synergies by co-locating these groups.

Now on to our financial results. Q2 revenue was $76 million down 8% compared to $82.2 million in the second quarter of last year. We continued to see strong bookings during the quarter from our customer base. Amazon, Yahoo and Microsoft were each greater than 10% of revenue during the quarter. We were disappointed with our gross margin performance during the second quarter especially given the positive trend we demonstrated over the past four quarters. Q2 non-GAAP gross margin was 9.7% or 780 basis points lower than the year ago quarter and Mark has already covered the reasons the results came in as such.

Turning to expenses for the second quarter, non-GAAP operating expenses were $14 million representing a decrease of $1.4 million compared to the second quarter of fiscal 2007. While our investment in R&D increased year-over-year, our spending in sales and marketing and G&A each decreased. Many of these decreases in expenses were due to continued efficiency gains in our operations. We expect our spending in sales and marketing to pick up through the year however as we continue to invest in strategic marketing and sales efforts.

Q2 non-GAAP loss from operations was $6.7 million compared to non-GAAP operating loss of $1 million during the year ago second quarter. The weaker gross margins and lower spending resulted in a -8.8% operating margin compared to -1.2% in the year ago quarter. After recording interest and other income of $845,000 and using a non-GAAP tax rate of 40.9% we reported non-GAAP net loss of $3.5 million or a $0.12 per share loss compared to a non-GAAP net income of $613,000 or $0.02 per share during the year ago second fiscal quarter.

At the end of the second fiscal quarter total employee headcount was 328 down from 378 employees at the end of 2007. We have outsourced our internal production line and thus consolidated from three manufacturing lines to two, which accounts for the vast majority of the decrease in headcount.

Now on to the balance sheet. Total cash, cash equivalents and investments decreased slightly during the second quarter to $206.2 million down $800,000 compared to the end of Q1 but still up $8 million from the end of fiscal 2007. Most of our cash accretion in the first six months of 2008 has come from cash flows from operations which were $8.8 million for the first half of 2008. Our metrics for working capital during the second quarter were strong. Day sales outstanding was 62 days and days payables outstanding was 66 days resulting in a cash conversion cycle of 53 days. Inventories and accounts payable have increased to accommodate an expected stronger second half of fiscal 2008.

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

Mark J. Barrenechea

In summary, comparing fiscal year 08 year-to-date performance over the same fiscal year 07 period our non-GAAP gross margin performance is 200 basis points improved, non-GAAP EPS is $0.09 improved, and we are approximately $10 million behind in revenue. As previously stated, given our performance year to date and our prospects for the second half of fiscal year 08 we are reaffirming our annual projections. Our team is working smart and creating a business capable of growth and scale. We are building the infrastructure that will allow us to expand our reach into new geographies and verticals; we have released a new product line that furthers our advantage in the compute server and storage markets; the modular data center business that we pioneered has begun showing tangible business results; we are partnering at new levels. It’s a great time to be at Rackable.

I’d now like to open the call for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Kelleher - Canaccord Adams.

Mark Kelleher - Canaccord Adams

Mark, that gross margin is a little surprising. Could you maybe size the amount of the order that was at low margin? You said there were two effects on it. Can you maybe size those two effects?

Mark J. Barrenechea

We’re not going to get into the specifics of which customer or which property in terms of the sizable deal, but let’s put it in the context obviously of gross margin. As Jim said, we were disappointed with the economic result but not the business decision and it doesn’t change our outlook for the year and we’re again reaffirming our annual projections. The two contributors were the one deal at lower margins which we believe we can grow this opportunity over time. It would have been the wrong decision to walk away from this Rackable customer. Secondly, in quarter costs associated with component shortages and the ability to find alternative components, adding CM charges, freight rework, increased overhead contributed to the lower gross margin. Our base market business was particularly strong in the quarter. So as we’re disappointed for sure, it doesn’t affect our outlook for the entire year.

Mark Kelleher - Canaccord Adams

On the revenue from RapidScale, could you size that and maybe tell us how you figured that into the full-year guidance? Is that included in there or do you assume that’s out of there?

Mark J. Barrenechea

When we look at the annual project, it’s one of the reasons we provided a range. We had projected modest RapidScale revenue and it doesn’t affect our view at this point on the annual revenue projection.

Mark Kelleher - Canaccord Adams

So you’re assuming it’s in there?

Mark J. Barrenechea

The projection certainly had some RapidScale revenue in it and with RapidScale out we still feel we can make the revenue range.

Operator

Our next question comes from Analyst for Louis Miscioscia - Cowen and Company, LLC.

Analyst for Louis Miscioscia - Cowen and Company, LLC

Mark, last quarter you had spoken about a healthy pipeline for ICE Cube and a difference to $20 million to $50 million in revenues for containers. Has that target range changed at all?

Mark J. Barrenechea

No, the range remains the same. So $20 million to $50 million in revenues related to deployments inside the ICE Cube this year. We have lots of customers evaluating the technology, the pipeline remains impressive, we’ve secured our first win in the US federal market which we believe over time could allow us to ship many containers for this one particular project, so we remain just as enthusiastic and we continue to see $20 million to $50 million in revenues related to the Cube this year.

Analyst for Louis Miscioscia - Cowen and Company, LLC

On the federal contract you’d mentioned in the upcoming quarters. Is it a Q3 event or is it a Q4 event?

Mark J. Barrenechea

We’ll certainly have federal revenues here in Q3 and equal or more in Q4. So some of the revenues are for Q3; some are for Q4. I kind of think of it as soon as we can fulfill the orders.

Analyst for Louis Miscioscia - Cowen and Company, LLC

The margin profile for containers, how does that compare with the overall corporate average?

Mark J. Barrenechea

Should be higher as we’ve discussed on previous calls. If you kind of think of the value proposition with the ICE Cube where we can reduce facilities costs, reduce the burden rate in data centers, the cooling costs up by 8%, and our new XE series, we hope to sell more on a value based equation versus a cost plus model. So it should yield a higher gross margin profile than what we would otherwise deploy in traditional cabinets.

Operator

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

Alex Kurtz - Merriman Curhan Ford & Co.

The sales cycle for the non-Top 10 percent customers, do you see any lengthening in the sales cycle this quarter and any impact to your business?

Mark J. Barrenechea

No, we’re not seeing it right now. If we look at our base market business, it’s about 60% of our business in Q1, it was about 35% here in Q2, our goal for the year is sort of a 50/50 split if you will from historical top customers to the base market growth. And I like to put in perspective growth in scale where we need three core elements. One is three core product lines in the market and we’re making good progress there. The second is more revenue on ramps by competing in larger-scale more profitable industries like oil and gas and federal. We had a very nice win in oil and gas that we’re looking to deliver here in Q3. And bringing new partners on board to extend our reach like CPC, Raytheon, IBM and a soon-to-announce large scale storage partner. So I don’t see the sales cycles extending in the base line.

Alex Kurtz - Merriman Curhan Ford & Co.

Just on that point, looking at your guidance for the year, apparently the back half no longer includes RapidScale. It seems somewhat aggressive growing $10 million to $15 million a quarter or so. Do you have a book of business right now that gives you that confidence in hitting those in the back half of the year target that you put out?

Mark J. Barrenechea

Short answer is yes. We sort of look at our guidance based on year-to-date performance, our current view of our pipeline and backlog, partnerships, RP activity, and a conservative but stable economic environment. So when you factor all those things in, Jim and I feel comfortable looking at the year and reaffirming guidance.

Alex Kurtz - Merriman Curhan Ford & Co.

Jim, just thinking about the sales and marketing line for the next couple of quarters, do you see the increase is more weighted toward your Q4 or do you see that evenly distributed growing a couple hundred thousand per quarter through Q3 and Q4? How do you see that playing out?

James D. Wheat

I think you’ll see Q3 and Q4 both higher than Q2 and I would say that Q4 expenses would probably ramp up a little bit higher than in Q3.

Operator

Our next question comes from Douglas Reid - Thomas Weisel Partners.

Douglas Reid - Thomas Weisel Partners

Mark, I’m hoping to get your updated thoughts on any changes you might be seeing in the competitive landscape in the container business. And if you could comment on who you were up against in winning that large opportunity and what impact you might see in gross margin then as the competitive landscape intensifies?

Mark J. Barrenechea

There’s no doubt that all our competitors now have an offering in the market but I would note that we are two years ahead of every competitor in the market and it’s very difficult technology. It’s not just an [ISO] cargo container at 40 feet. We’ve taken the decision to make our container water-based versus air which is complex plumbing and thermals; it’s a DC based container; we also have a new UPS strategy that goes inside the container for distributed [PECO] based application tuned uptime. So I feel pretty good that we have a nice competitive advantage on the technology and secondly, we’re a couple years ahead.

In terms of our first wins here, I think it’s an indication of our technology being stronger. I think the indication of IBM partnering with us with their BladeCenter and our container is another proof point. So we feel pretty good on the competitive side right now.

Operator

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

Alex Kurtz - Merriman Curhan Ford & Co.

Just a little more detail about partner activity. Could you break out what percentage partners drove this quarter versus last quarter? Have you seen what that uptick was?

Mark J. Barrenechea

I think our partner number was less than 10% here in the quarter.

Alex Kurtz - Merriman Curhan Ford & Co.

On an absolute dollar value would you say it went up quarter-over-quarter?

Mark J. Barrenechea

Yes, slightly up quarter-over-quarter and we’re still looking at our business goals for 08 to have our partner revenue in the 10% to 20% range.

Alex Kurtz - Merriman Curhan Ford & Co.

Can you talk about the decision to get out of the RapidScale business and why now and how you came to this decision? Was there just a certain lack of interest from customers or is it just draining too many resources from your core business?

Mark J. Barrenechea

I would say it’s a fine product. It’s a good market. But we’ve concluded it’s not a good fit for Rackable and thus the strategical alternative. The most attractive alternative would be a sale of the asset to a partner who can invest in the technology because it’s going to take investment, a partner who has an expert sales and service force to deploy complex software, and hopefully we’ll be able to maintain a strong relationship with any prospective buyer. So at the end of the day we think it’s a fine product, a good team, a good market, but it’s going to take a significant amount of investment that I think can be better applied internally and it’s going to require a company that is expert in complex software and services.

Alex Kurtz - Merriman Curhan Ford & Co.

Looking at the sizable customer you had in the quarter and the impact that had to your gross margins, looking forward to securing additional business with new customers, how do you feel about that impacting future gross margin and was this just a really extraordinary situation where you felt like you had to be on the floor there and decide to take a hit? I think some investors would come back and say “If you guys are going to secure new additional customers going forward, potentially this could happen again.”

Mark J. Barrenechea

It can always happen again but it was an extraordinary event. There were two contributing factors, the second one being component shortages, and these two elements combined created the gross margin profile you saw. I don’t think this represents a challenge to our business short or long term. It was an extraordinary event. We felt it was a must-win property that we can grow over time and volume and profitability, and I think it’s an isolated Q2 event.

Alex Kurtz - Merriman Curhan Ford & Co.

And just to follow up to the product shortages, specifically what components did you have a problem procuring in the quarter?

Mark J. Barrenechea

I’ve wrestled with how much detail we want to get into and I sort of concluded that not a lot of good can come from it. We’ve worked through it. It was certainly my first quarter here at Rackable where I experienced this. There was a fair amount of choreographing we had to go through in our master planning and scheduling, finding and certifying alternative components, expediting materials, additional labor and overtime charges, higher standard product costs, but we got through it. But we’re not going to get down into the specific components.

Alex Kurtz - Merriman Curhan Ford & Co.

On Amazon, Yahoo and Microsoft, in the aggregate what was their total percentage in the quarter?

James D. Wheat

They were 65% of our revenues in Q2.

Operator

Our next question comes from Analyst for Louis Miscioscia - Cowen and Company, LLC.

Analyst for Louis Miscioscia - Cowen and Company, LLC

On RapidScale, you obviously mentioned that your projection includes revenues for it. Can you give us some color on the gross margins RapidScale? I mean, versus the range you’ve given, what delta is it to the 18% low end and 21% high end?

Mark J. Barrenechea

I think in a macro point with RapidScale factored out we continue to affirm our annual projection. Jim and I won’t get into the quantity of revenue and gross margin or profit dollar contribution that was in the model, but it’s now out of the model and we’re still reaffirming our guidance.

Operator

We are at the end of our question and answer session.

Mark J. Barrenechea

Thank you. As a reminder, Jim Wheat and I will be on the road at investor conferences over the next week and a half. Tomorrow we’ll be presenting at the Pacific Crest conference in Vail, Colorado at 3:00 PM Pacific time and on Wednesday we’ll be presenting at the RBC conference in San Francisco at 3:00 PM Pacific time. In addition we’ll be presenting next Wednesday, August 13, at the Canaccord Adams conference at 1:30 PM Pacific time. You’ll be able to listen to these presentations live via webcast at www.rackable.com. Thank you for joining us today.

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