Analyst Conference Summary

RACK
Rackable Systems, Inc.

conference date: February 1, 2007
for quarter ending: December 30, 2006 (4th quarter)

Overview: Record revenues, but little profit due to pricing competition. Weak Q1 2007 followed by strong 2007 overall revenue predicted, but at lower margin levels.

Basic data:

Revenues of $106.9 million were up 33% sequentially from $80.5 million and up 28.6% from Q4 2005.

Net income was $563,000 or $0.02 per share, down sequentially and down from 7.3 million in Q4 2005.

Claimed non-GAAP EPS of $.19 with non-GAAP net income of $5.6 million. Stock-based compensation was $7.8 million, down from $7.6 million and $0.33 per share in Q4 2005.

$160.5 million cash and short-term investments (down from $190 million).

Guidance:

2007 full year guidance to $450 to $525 million (from $475 to $525 million). Non-GAAP gross margin 18 to 22%. Earmarked $3 million for patent litigation. 20% reduction in G&A expense compared to 2006. Non-GAAP EPS $0.75 to $1.05.

Q1 revenues between $70 and $75 million due to seasonality and lumpiness in largest accounts. Expect gross margins at low end of range.

Conference Highlights:

Pleased with revenue generation over $100 million for first time. Beat guidance for full 2006.

68% revenue from top 3 customers 82% from top 10. 38 new customers. Added Internet and Oil and Gas customers. YouTube continues to be a strong buyer. Only 2 over 10% customers.

Processor mix AMD 80%, Intel 20%.

19.8% non-GAAP gross margin after projecting 23 to 24%.

$1.8 million was due to DDR memory unanticipated price increases when they expected it to be flat or down. Were not able to pass on to customers. Also stocked up on DDR1 for future, but if customers shift too quickly to DDR2 could have to write off later.

$.6 million was due to missed opportunity in RapidScale, but should close that deal in Q1 2007.

$.3 million was from back-end loading of revenue and resulting transportation and handling costs.

$2.2 million was to keep market share amid intense competitive conditions. Had factored a 200 basis point reduction to account for this. Believes competitors have taken deals at a loss to retain customers. Likely to see continued intense pressures. But does not require a strategy shift. Will maintain share position in installed base, trying to keep up gross margins. RapidScale will be ramped up as quickly as possible. Higher-gross opportunities like data centers and HPC and backoffice IT. Will control expenses tightly.

December alone had $79 million in revenue. One big customer that had an order with low gross margin in Q4 has re-ordered at close to normal margins.

Op ex were $21.5 million: R&D $5, Sales $8.7 million, general and admin $7.3 million. Tax rate was 39.7%. Interest income was $2 million.

286 employees.

DSO's 89 days. Inventory balances $68.1 million, up over $27 million from Q4 2005.

Only has 2.5% of global market, so plenty of room to grow. Can balance margin losses on x86 with higher margins in RapidScale.

Several account situations could lead to revenues on the upside of given guidance.

Q&A:

DRAM pricing? Inventory policy is not to purchase commodity items until deals are in hand. Prices spiked 20% to 30%.

Who were the competitors? Much more competition from Dell and HP than in past. IBM and Sun not so much.

Large cash decrease? For memory inventory.

Our customers value platform longevity, so not all AMD customers have shifted to Socket F.

Memory suppliers are switching productuction to DDR2, so shortage of legacy DDR1 on spot market.

Pricing going forward, versus value? Customers do value TCO and operating advantages, that is why competition uses pure price to compete. It is hard to know what is going on systemically. They had overlooked Internet market somewhat until now. Don't know where x86 gross margins are heading.

Pipeline confidence? Very high. Tempted to not change revenue guidance, but given Q1 softness, decided to be conservative.

Storage mix? 6% of Q4 versus 10% of full year.

RapidScale eval units? Typically 3 to 4 months for evals to convert to sales. About a dozen significant evaluations going on, some with very large accounts. Universally postive feedback from customers.

DDR1 inventory risk? Significantly lower inventory than total used in Q4.

Predatory pricing? Mostly attributable to a single customer. But risk is it will be for multiple accounts going forward.

March quarter weak guidance? Mostly due to large orders moving out of quarter.

Amazon, Microsoft and Yahoo are the biggest customers. Stronger position because competitors have not executed well when tried.

Long term model: 23 to 25% gross margin, 11 to 13% operating margins, with 2009 time frame.

Is DRAM down? Q1 may be flat to down, but stayed high during Q4. The inventory they got and brought forward was at high market price.

Intel % going forward? Intel's more recent CPUs more competitive, so likely to see increased percent, but possible change when AMD quad cores arrive. Price competition was on both AMD and Intel servers.

New 10% customers in 2007? Hard because revenues are so much higher. Expect 5 to 7 over $30 million in 2007.

Internet vertical was in high 80% range.

Growth driven by unit or ASP? Primarily by units.

Foreign based vendors? Have not seen them active in the US markets. SuperMicro has not been seen much lately.

Encroachment by blades? Competition from HP and IBM it is with rack-level offerings. Believes there are two separate markets. Blades are oriented towards back-office IT functions.

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Disclaimer: Our analyst summaries may include both our condensations of statements made by company representatives and our own analysis. They are not covered by any warranty. We cannot guarantee anything said by company representatives is true. We try not to make errors, but its possible. Before making or terminating an investment you should always verify any factual basis of your decision.

Copyright 2007 William P. Meyers