Silicon Graphics International (SGI) 10-Q/A 2006 Q3 Quarterly report (amended)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q/A

Amendment No. 1

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 1, 2006

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            

Commission file number: 0-51333

RACKABLE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware	32-0047154
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1933 Milmont Drive

Milpitas, California 95035

(Address of principal executive offices including zip code)

(408) 240-8300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act).

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of May 12, 2006, there were 27,679,823 shares outstanding of the Registrant’s Common Stock, $0.001 par value per share.

INDEX

		Page
PART I FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005	3
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2006 and March 31, 2005	4
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and March 31, 2005	5
	Notes to Condensed Consolidated Financial Statements	6
Item 4.	Controls and Procedures	18
Signatures		19

2

This Amendment No. 1 on Form 10-Q/A (this “Amendment”) amends our Quarterly Report on Form 10-Q for the Quarterly Period ended April 1, 2006 to reflect the following corrections to Note 3 of the Financial Statements in Part I, Item 1 of that report:

• that the total intrinsic value of options exercised during the three months ended March 31, 2006 was $27.0 million, rather than $2.8 million as was originally reported

• that the total intrinsic value of options outstanding at March 31, 2006 was $129.9 million, rather than $114.5 million as was originally reported

• that the total intrinsic value of options vested and expected to vest at March 31, 2006 was $116.9 million rather than $103.2 million as was originally reported

This Amendment also amends Item 4 of Part I to include additional disclosure confirming the effectiveness of our disclosure controls and procedures as of March 31, 2006.

This Amendment amends only the information stated above in Note 3 of the Financial Statements in Item 1 of Part I, and the disclosure in Item 4 of Part I, of Form 10-Q as originally filed on May 15, 2006. Also attached to this Amendment is an Exhibit Index disclosing the filing of the certifications required to be filed as exhibits to this Amendment, as well as such certifications.

PART I. FINANCIAL INFORMATION

ITEM 1.Financial Statements

RACKABLE SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

(unaudited)

	December 31, 2005			March 31, 2006
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	29,099		$	136,744
Short-term investments		25,065			71,472
Accounts receivable		49,700			48,294
Inventories		40,649			60,034
Deferred income taxes		6,504			7,414
Deferred cost of sales		8,665			740
Prepaids and other current assets		4,111			8,461
Total current assets		163,793			333,159
PROPERTY AND EQUIPMENT—Net		2,588			3,490
INTANGIBLE ASSETS—Net		9,421			9,094
OTHER ASSETS		240			213
TOTAL	$	176,042		$	345,956
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	28,226		$	49,887
Accrued expenses		7,434			6,720
Sales tax payable		857			821
Income taxes payable		3,179			—
Deferred revenue		11,771			2,880
Total current liabilities		51,467			60,308
DEFERRED INCOME TAXES		304			304
DEFERRED RENT		28			22
DEFERRED REVENUE		978			1,231
Total liabilities		52,777			61,865
COMMITMENTS AND CONTINGENCIES (NOTE 13)
STOCKHOLDERS’ EQUITY:
Common stock, $0.001 par value; 120,000,000 shares authorized; 23,040,449 and 27,643,386 shares issued and outstanding at December 31, 2005 and March 31, 2006, respectively		23			28
Additional paid-in capital		231,972			385,022
Deferred stock-based compensation		(1,805	)		—
Accumulated other comprehensive income (loss)		1			(5	)
Accumulated deficit		(106,926	)		(100,954	)
Total stockholders’ equity		123,265			284,091
TOTAL	$	176,042		$	345,956

See notes to condensed consolidated financial statements.

3

RACKABLE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except for share and per share amounts)

(unaudited)

	Three Months Ended March 31, 2005			Three Months Ended March 31, 2006
REVENUE	$	30,489		$	84,392
COST OF REVENUE (a)		24,562			64,898
GROSS PROFIT		5,927			19,494
OPERATING EXPENSES:
Research and development (a)		348			1,798
Sales and marketing (a)		2,981			4,848
General and administrative (a)		1,649			3,530
Total operating expenses		4,978			10,176
INCOME FROM OPERATIONS		949			9,318
OTHER INCOME (EXPENSE)—Net:
Change in fair value of embedded derivatives in preferred stock (Note 12)		(4,192	)		—
Interest income		2			664
Interest expense		(782	)		—
Other income—net		—			244
Total other income (expense)—net		(4,972	)		908
INCOME (LOSS) BEFORE INCOME TAX PROVISION		(4,023	)		10,226
INCOME TAX PROVISION		(333	)		(4,254	)
NET INCOME (LOSS)	$	(4,356	)	$	5,972
NET INCOME (LOSS) PER SHARE
Basic	$	(0.84	)	$	0.25
Diluted	$	(0.84	)	$	0.23
SHARES USED IN NET INCOME (LOSS) PER SHARE
Basic		5,205,699			24,274,396
Diluted		5,205,699			26,234,692
__________
(a)    Includes charges for stock-based compensation:
Cost of revenue	$	25		$	706
Research and development		17			511
Sales and marketing		65			854
General and administrative		32			686
Total	$	139		$	2,757

See notes to condensed consolidated financial statements.

4

RACKABLE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

	Three Months Ended March 31, 2005			Three Months Ended March 31, 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income	$	(4,356	)	$	5,972
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:
Depreciation and amortization		854			607
Provision for doubtful accounts receivable		6			20
Provision for inventory		787			—
Deferred income taxes		(495	)		(910	)
Accretion for preferred stock dividends recorded as interest expense		597			—
Stock-based compensation		139			2,757
Changes in fair value of embedded derivatives in preferred stock		4,192			—
Changes in operating assets and liabilities:
Accounts receivable		(14,499	)		1,386
Inventories		(5,164	)		(19,385	)
Prepaids and other assets (exclusive of excess tax benefits of stock option exercises)		(485	)		2,798
Prepaid asset relating to excess tax benefit of stock option exercises (Note 15)		—			(7,121	)
Accounts payable		5,104			21,661
Sales tax payable		221			(36	)
Accrued expenses		(281	)		(719	)
Income taxes payable		(931	)		(3,179	)
Deferred cost of sales		—			7,925
Deferred revenue		427			(8,638	)
Net cash provided by (used in) operating activities		(13,884	)		3,138
CASH FLOWS FROM INVESTING ACTIVITIES:
Expenditures for intangibles		—			(51	)
Purchases of marketable securities		—			(62,961	)
Proceeds from sales and maturities of marketable securities		—			16,548
Purchases of property and equipment		(186	)		(1,131	)
Net cash used in investing activities		(186	)		(47,595	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under line of credit, net		5,462			—
Repurchase of common stock from Founders		(6,000	)		—
Costs incurred in connection of initial public offering		(710	)		—
Excess tax benefit of stock options exercised (Notes 2 and 15)		—			11,375
Proceeds from issuance of common stock upon ESPP purchase		—			829
Proceeds from issuance of common stock upon exercise of stock options		—			1,427
Proceeds from issuance of common stock upon follow on offering—net of issuance costs		—			138,471
Net cash provided by (used in) financing activities		(1,248	)		152,102
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(15,318	)		107,645
CASH AND CASH EQUIVALENTS—Beginning of period		17,111			29,099
CASH AND CASH EQUIVALENTS—End of period	$	1,793		$	136,744
NON CASH INVESTING AND FINANCING ACTIVITIES:
Deferred compensation related to stock option grants, net of cancellations	$	400		$	—
Increase to additional-paid in capital resulting from excess tax benefit of stock options exercised (Notes 2 and 15)	$	—		$	11,375
Reclassification of embedded derivatives in preferred stock to additional paid-in capital	$	107,831		$	—
Issuance of Common Stock as payment for accrued liabilities	$	50		$	—
SUPPLEMENTAL DISCLOSURE OF OTHER CASH FLOW INFORMATION:
Cash paid for income taxes	$	1,760		$	2,860
Cash paid for interest	$	167		$	—

See notes to condensed consolidated financial statements.

5

RACKABLE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. BUSINESS AND BASIS OF PRESENTATION

Rackable Systems, Inc. (“Rackable Systems” or the “Company”) was incorporated in the state of Delaware in December 2002 in connection with the acquisition of substantially all the assets and liabilities of Rackable Systems’ predecessor company referred to herein as Old Rackable. The principal business of Rackable Systems is the design, manufacture and implementation of highly scalable compute servers and high-capacity storage systems, which are sold to customers such as large Internet businesses, and companies in vertical markets such as semiconductor design, enterprise software, federal government, entertainment, financial services, oil and gas, and biotechnology and pharmaceuticals.

The accompanying unaudited condensed consolidated financial statements included herein have been prepared by the Company in accordance with the published rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) applicable to interim financial information. Certain information and footnote disclosures included in financial statements prepared in accordance with the generally accepted accounting principles in the United States of America have been omitted in these interim statements as allowed by such SEC rules and regulations. However, management believes that the disclosures herein are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the fiscal year ended December 31, 2005, which are included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 22, 2006.

If the last day of the calendar quarter does not end on a Saturday, Rackable Systems’ fiscal quarter ends on the first Saturday following the last day of the calendar quarter. To simplify the presentation, the interim periods are shown as ending on March 31, 2005 and 2006 although the interim periods actually ended on April 2, 2005 and April 1, 2006, respectively.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates include the allowance for doubtful accounts and sales returns, allowance for obsolete inventory, depreciation, amortization and certain accruals. Actual results could differ from those estimates.

Unaudited Interim Financial Information—The interim financial information for the three months ended March 31, 2005 and 2006 is unaudited and has been prepared on the same basis as the audited financial statements. In the opinion of management, such unaudited information includes all adjustments (consisting only of normal recurring adjustments) necessary for fair presentation of the interim financial information. Operating results for the three months ended March 31, 2006 are not necessarily indicative of results for any subsequent periods.

Short-term Investments—Short term investments consist of investments in marketable debt securities, primarily U.S. Agency Notes, and Municipal Bonds. At March 31, 2006, all of Rackable Systems’ marketable debt securities were classified as available-for-sale and were carried at fair market value. The unrealized gains (losses) on available-for-sale securities are recorded in accumulated other comprehensive income (loss). Short-term investments consist of the following at December 31, 2005 and March 31, 2006 (in thousands):

As of December 31, 2005:	Purchased/ Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss		Aggregate Fair Value
Municipal bonds	$	12,096	$	—	$	—	$	12,096
Federal Agency Notes		12,968		1		—		12,969
Total	$	25,064	$	1	$	—	$	25,065

6

As of March 31, 2006:	Purchased/ Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Aggregate Fair Value
Municipal bonds	$	58,686	$	—	$	—		$	58,686
Federal Agency Notes		12,791		—		(5	)		12,786
Total	$	71,477	$	—	$	(5	)	$	71,472

Product Warranty—Rackable Systems’ warranty period for its products is generally one to three years. Rackable Systems accrues for estimated warranty costs concurrent with the recognition of revenue. The initial warranty accrual is based upon Rackable Systems’ historical experience and is included in accrued expenses and cost of revenue. The amounts charged and accrued against the warranty reserve for three months ended March 31, 2005 and 2006 are as follows (in thousands):

	Three Months Ended March 31,
	2005			2006
Balance—beginning of period	$	550		$	726
Current period accrual		302			372
Warranty expenditures charged to accrual		(151	)		(218	)
Balance—end of period	$	701		$	880

Concentration of Credit Risk—Financial instruments that potentially subject Rackable Systems to concentrations of credit risk consist principally of trade accounts receivable. Accounts receivable from three customers accounted for 46%, 23% and 14% of total accounts receivable at December 31, 2005 and accounts receivable from two customers accounted for 51% and 25% of total accounts receivable at March 31, 2006.

Revenue from customers representing 10% or more of total revenue was as follows:

	Three Months Ended March 31,
	2005		2006
Customer A	27	%	31	%
Customer B	—	%	30	%
Customer C	—	%	19	%

Fair Value of Financial Instruments—The fair values of cash and cash equivalents reported in the accompanying balance sheets approximate their carrying value. Rackable Systems accounts for derivative instruments in accordance with the provisions of SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and its related interpretations, and complies with SFAS No. 138,Accounting for Certain Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (“SFAS 138”). SFAS 133 and SFAS 138 establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and hedging activities. These standards require that Rackable Systems record derivatives at their fair values on the balance sheet. Rackable Systems had two non-hedged derivatives embedded in its Series A mandatorily redeemable preferred stock at March 31, 2005 and none at March 31, 2006 (see Note 12). Changes in the fair value of these embedded derivatives are recognized in the Statements of Operations.

Statement of Cash Flows- Prior to the adoption of SFAS No. 123(R),Shared-Based Payment(“SFAS 123R”), the Company presented tax benefits related to the excess of tax deductions from employee’s exercises of stock options over the stock-based compensation cost recognized for those options as operating cash flows in the statement of cash flows. In accordance with SFAS 123R, such excess tax benefits are now classified as financing cash flows. During the three months ended March 31, 2006, the Company recorded $11.4 million of excess tax benefit from stock option exercises as financing cash flows.

7

Net Income (Loss) Per Share—Basic net income (loss) per share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding for the period (excluding shares subject to repurchase). Diluted net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders for the period by the weighted average number of common and common equivalent shares outstanding during the period, determined using the treasury stock method. Potentially dilutive securities, composed of incremental common shares issuable upon the exercise of stock options and the redemption or conversion of preferred stock, are included in diluted net income per share to the extent such shares are dilutive. Diluted net loss per share was the same as basic net loss per share for the three months ended March 31, 2005.

For the three months ended March 31, 2005, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, but the incremental shares from the assumed exercise of these securities were excluded in the computation of diluted net loss per share, as their effect would have been anti-dilutive.

Recently Issued Accounting Standards—In May of 2003, the FASB issued SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity(“SFAS 150”). SFAS 150 requires issuers to classify as liabilities (or assets in some circumstances) certain financial instruments that embody obligations. Financial instruments within the scope of SFAS 150 shall be initially measured at fair value and subsequently revalued with changes in value being reflected in interest cost. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Restatement is not permitted. Upon the adoption of SFAS 150 on July 1, 2003, the Company reclassified the carrying amount of the Series A mandatorily redeemable preferred stock, including cumulative accretion to redemption value, from mezzanine debt to long-term liabilities. Accretion to redemption value subsequent to the adoption of SFAS 150 has been recorded to interest expense in the accompany Statements of Operations.

In November 2004, SFAS No. 151,Inventory Costs, was issued. This statement amends the guidance in Accounting Research Bulletin (“ARB”) No. 43, Chapter 4,Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of this interpretation had no impact on the Company’s financial position, cash flows and results of operations.

In December 2004, the FASB issued SFAS No. 153 (“SFAS 153”),Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 29 (“APB 29”),Accounting for Non-monetary Transactions. The guidance in APB 29 is based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. SFAS 153 amends APB 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005, and should be applied prospectively. The adoption of SFAS 153 had no material effect on the Company’s financial position, results of operations, or cash flows.

In May 2005, SFAS No. 154,Accounting Changes and Error Corrections, was issued. This statement applies to all voluntary changes in accounting principle and requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless this would be impracticable. This statement also makes a distinction between “retrospective application” of an accounting principle and the “restatement” of financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of this interpretation had no impact on the Company’s financial position, cash flows and results of operations.

In June 2005, the FASB ratified the Emerging Issues Task Force Issue No. 05-06 “Determining the Amortization Period for Leasehold Improvements” (“EITF 05-06”). EITF 05-06 provides that the amortization period used for leasehold improvements acquired in a business combination or purchased after the inception of a lease be the shorter of (a) the useful life of the assets or (b) a term that includes required lease periods and renewals that are reasonably assured upon the acquisition or the purchase. The Company does not believe the adoption of EITF 05-06 will have a material effect on its consolidated financial position, results of operations or cash flows.

8

3. STOCK-BASED COMPENSATION

Stock-Based Benefit Plans

Rackable Systems adopted the 2005 Equity Incentive Plan (the “2005 Plan”) in April 2005. The 2005 Plan is the successor equity incentive program to the 2002 Stock Option Plan (the “2002 Plan”). The 2005 Plan became effective on June 9, 2005 and the aggregate number of shares of common stock that may be issued pursuant to stock awards under the 2005 Plan is 1,533,333 shares. The number of shares reserved for issuance under the 2005 Plan is subject to an annual increase on the first anniversary of the Company’s initial public offering and annually on each January 1^st thereafter as defined in the 2005 Plan. In the three months ended March 31, 2006, Rackable Systems granted 227,000 options under the 2005 Plan.

Rackable Systems adopted the 2006 New Recruit Equity Incentive Plan (the “2006 Plan”) in January 2006 which allows the Company to grant nonstatutory stock awards for up to 1,000,000 shares of common stock. The 2006 Plan provides for the grant of the following Stock Awards: (i) nonstatutory stock options, (ii) stock purchase awards, (iii) stock bonus awards, (iv) stock appreciation rights, (v) stock unit awards, and (vi) other stock awards. The exercise price of each nonstatutory stock option shall be not less than one hundred percent (100%) of the fair market value of the common stock subject to the option on the date the option is granted. Stock awards expire ten years from the date of grant, or such shorter period specified in the option agreement. In the three months ended March 31, 2006, Rackable Systems granted 418,000 options under the 2006 Plan.

Rackable Systems adopted the 2005 Employee Stock Purchase Plan (“2005 ESPP”) in April 2005. The 2005 ESPP became effective in June 2005 and the aggregate number of shares of common stock that may be initially issued pursuant to the 2005 ESPP is 400,000 shares. The number of shares of common stock reserved for the 2005 ESPP is subject to an annual increase on January 1^st of each year as defined by the plan. On January 1, 2006 the total shares of common stock reserved for the 2005 ESPP was increased by 230,404 shares. There were 80,907 shares issued under the 2005 ESPP on February 14, 2006.

In connection with the stock options granted to employees under the 2002 Plan, Rackable Systems recorded cumulative deferred stock-based compensation, net of cancellations, of $2.7 million, which represents the difference between the option exercise price and the deemed fair market value of the common stock determined for financial reporting purposes on the grant date. Compensation costs for the portion of awards for which the required service period has not been rendered (such as unvested options) that were outstanding as of December 31, 2005 shall be recognized as the remaining required services are rendered. The compensation costs relating to unvested awards is based on the grant date fair value of those awards as calculated under SFAS No. 123, “Accounting for Stock-Based Compensation”(“SFAS 123”), adjusted for forfeitures as required by SFAS No. 123(R),Share-Based Payment.

Adoption of SFAS No. 123(R)

Prior to January 1, 2006, the Company’s stock-based employee compensation plans were accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related Interpretations, as permitted by SFAS 123. The Company recognized stock-based compensation cost in its statement of operations for periods prior to January 1, 2006 for certain options granted prior to the Company’s initial public offering of its common stock in June 2005 based upon the intrinsic value, the difference between the deemed fair value of the Company’s common stock and the exercise price at the date of the grant.

On December 16, 2004, the FASB issued SFAS 123R which eliminates the alternative of applying the intrinsic value measurement provisions of APB 25 to stock compensation awards issued to employees. The new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period).

SFAS 123R was effective for the Company’s fiscal quarter beginning January 1, 2006, and requires the use of the Modified Prospective Application Method. Under this method, SFAS 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that was outstanding as of the date of adoption shall be

9

recognized as the remaining requisite services are rendered. The compensation cost relating to unvested awards at the date of adoption is based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. Additionally, under SFAS 123R, the 2005 ESPP is considered a compensatory plan, which requires the recognition of compensation cost for grants made under the ESPP. The Company recognizes compensation expense for all share-based payment awards on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards.

The pro forma effects on net loss and net loss per share for the quarter ended March 31, 2005, if the Company had applied the fair value recognition provisions of original SFAS 123 on stock compensation awards (rather than applying the intrinsic value measurement provisions of APB 25) are as follows (in thousands):

	2005
Net loss	$	(4,356	)
Employee stock-based compensation as reported		139
Stock-based compensation determined under the fair value based method for all awards—net of tax		(527	)
Pro forma net loss	$	(4,744	)
Basic and diluted net loss per share – as reported	$	(0.84	)
Basic and diluted net loss per share – pro forma	$	(0.91	)

As a result of adopting SFAS 123R on January 1, 2006, the Company’s income before income taxes and net income for the three months ended March 31, 2006 are $2.6 million and $1.5 million, respectively, lower than if it had continued to account for share-based compensation under APB 25. Basic and diluted net income per share for the three months ended March 31, 2006 would have been $0.06 and $0.06 higher, respectively, if the Company had not adopted SFAS 123R. In addition, for the quarter ended March 31, 2006, cash flows from operating activities would have been $11.4 million higher and cash flows from financing activities would have been $11.4 million lower had the Company not adopted SFAS 123R.

Determining Fair Value

Valuation and amortization method—The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a multiple option award approach. This fair value is then amortized ratably over the requisite service periods of the awards, which is generally the vesting period.

Expected Term—The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on an analysis of the relevant industry sector post-vest termination rates and the exercise factors.

Expected Volatility—Expected volatility for purposes of pro forma disclosures under SFAS No. 123 for the quarter ended March 31, 2005, were based on the stock volatilities of the Company’s peer group because the Company’s stock was not publicly-traded during that quarter. Upon the adoption of SFAS 123R, the Company reevaluated the assumptions used to estimate volatility, and determined that it would use a combination of the implied and historical volatility for both the Company and its peer group.

Expected Dividend—The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input which is not applicable to the Company.

Risk-Free Interest Rate—The Company bases the risk-free interest rate used in the Black-Scholes-Merton valuation method on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of the Company’s stock-based awards do not correspond with the terms for which interest rates are quoted, the Company performed a straight-line interpolation to determine the rate from the available term maturities.

Estimated Forfeitures—The estimated forfeiture rate was based on an analysis of the relevant industry sector pre-vest termination rate due to the fact that the Company’s historical forfeiture rates were unusually low, approximately 2%, given that a substantial portion of the Company’s stock options were granted subsequent to its initial public offering in June 2005.

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Fair Value—The fair value of the Company’s stock options granted to employees for the three months ended March 31, 2006 was estimated using the following weighted-average assumptions:

	March 31, 2006
Option Plan Shares
Expected term (in years)		5.55
Volatility		0.56
Expected dividend		—
Risk-free interest rate		4.7	%
Estimated annual forfeitures		8.3	%
Weighted-average fair value	$	19.65
ESPP Shares
Expected term (in years)		0.5 –1.0
Volatility		0.49
Expected dividend		—
Risk-free interest rate		4.7	%
Weighted-average fair value	$	14.25

Stock Compensation Expense

Stock Compensation Expense— The following table shows total stock-based compensation expense included in the condensed consolidated statement of operations, and the recognized tax benefit related thereto, for the three months ended March 31, 2006.

Cost of revenue	$	706
Research and development		511
Selling and marketing		854
General and administrative		686
Income tax benefit		(1,147	)
Total	$	1,610

As required by SFAS 123R, management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

Stock Options and Awards Activities

The following is a summary of option activity for our stock option plans (in thousand, except per share amounts):

	Number of Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term in Years
Outstanding at December 31, 2005	3,506,778		$	7.30
Granted	645,000		$	36.31
Exercised	(786,180	)	$	2.80	n/a
Forfeitures and cancellations	(27,332	)	$	11.67	n/a
Outstanding at March 31, 2006	3,338,266		$	13.93	8.64
Vested and expected to vest at March 31, 2006	2,969,295		$	13.48	8.64
Exercisable at March 31, 2006	392,878		$	5.16	7.54

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The weighted-average grant-date fair value of options granted during the three months ended March 31, 2006 was $19.65. The total intrinsic value of options exercised during the three months ended March 31, 2006 was $27.0 million. The total intrinsic value of options outstanding at March 31, 2006 was $129.9 million. The total intrinsic value of options vested and expected to vest at March 31, 2006 was $116.9 million.

As of March 31, 2006, there was $18.4 million of total unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 1.59 years.

At March 31, 2006, the total compensation cost related to options to purchase the Company’s common stock under the 2005 ESPP but not yet recognized was approximately $886,000. This cost will be amortized on a straight-line basis over a period of approximately 1.9 years.

The following table shows the shares issued, and their respective weighted-average purchase price per share, pursuant to the 2005 ESPP during the three months ended March 31, 2006.

Purchase date		February 14, 2006
Shares issued		80,907
Weighted-average purchase price per share	$	10.24

4. COMPREHENSIVE INCOME

Rackable Systems’ comprehensive income is comprised of net income and unrealized losses on marketable securities classified as available-for-sale. The net unrealized gains/(losses) on marketable securities was $1,000 and ($5,000) for the year ended December 31, 2005 and for the three months ended March 31, 2006, respectively.

5. DEFERRED REVENUE AND DEFERRED COST OF GOODS SOLD

Rackable Systems accounts for its revenue under the provisions of SAB No. 104,Revenue Recognition in Financial Statements. Under the provisions of SAB No. 104, revenue is recorded at the later of the time of shipment when title and risk of loss passes to the customer or when customer acceptance periods expire, generally within 15 days of receipt by the customer. At March 31, 2006, Rackable Systems had deferred revenue and related deferred product costs of $1.0 million and $740,000, respectively, related to shipments to customers pending acceptances. In addition, at March 31, 2006, Rackable Systems had deferred revenue of approximately $0.5 million associated with customer orders and payments that were received but for which the products had not yet been shipped. At December 31, 2005, Rackable Systems had deferred revenue and related deferred product costs of $5.3 million and $4.5 million, respectively, related to shipments to customers pending acceptances. Rackable Systems also deferred $5.4 million relating to a sale to a customer for systems shipped uncompleted, at the request of the customer, as of December 31, 2005. Deferred cost of sales for the uncompleted shipments was approximately $4.2 million as of December 31, 2005 and are included in current assets. The remaining deferred revenue of $2.6 million at March 31, 2006 and $2.1 million at December 31, 2005, pertains to revenue from extended warranty arrangements that are recognized ratably over the warranty period and professional support services which had not been completed as of the balance sheet dates.

6. INVENTORIES

Inventories consist of the following (in thousands):

	December 31, 2005			March 31, 2006
Finished goods	$	3,980		$	4,217
Evaluation units, net		828			1,364
Work in process		8,111			23,216
Raw materials		31,635			35,138
Reserves		(3,905	)		(3,901	)
Total inventories	$	40,649		$	60,034

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7. PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):

	December 31, 2005			March 31, 2006
Leasehold improvements	$	415		$	524
Manufacturing equipment		506			720
Furniture and fixtures		310			326
Computer equipment		1,754			2,143
Construction in progress		572			955
Vehicles		98			118
		3,655			4,786
Less accumulated depreciation and amortization		(1,067	)		(1,296	)
Property and equipment, net	$	2,588		$	3,490

Depreciation and amortization of property and equipment totaled $131,000 and $229,000 for the three months ended March 31, 2005 and 2006, respectively.

8. INTANGIBLE ASSETS

Intangible assets consist of the following (in thousands):

	December 31, 2005			March 31, 2006
Intangible assets subject to amortization:
Patents	$	4,738		$	4,789
Customer list		2,791			2,791
Customer backlog		156			156
Other		25			25
		7,710			7,761
Accumulated amortization		(4,597	)		(4,975	)
Amortized intangible assets, net		3,113			2,786
Intangible assets not subject to amortization:
Goodwill		2,821			2,821
Tradename		3,487			3,487
		6,308			6,308
Total intangible assets, net	$	9,421		$	9,094

Amortization expense for customer list, patents and other intangibles was as follows (in thousands):

	Three Months Ended March 31,
	2005		2006
Customer list	$	140	$	140
Patents		230		236
Other		—		2
Total	$	370	$	378

The Company considers all goodwill to be related to the high density compute server segment.

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9. ACCRUED EXPENSES

Accrued expenses consist of the following (in thousands):

	December 31, 2005		March 31, 2006
Accrued commission	$	1,204	$	1,001
Accrued payroll and related expenses		2,802		2,020
Accrued warranty		726		880
Accrued estimated sales and use tax payable		1,150		1,150
Other accrued expenses		1,552		1,669
Total accrued expenses	$	7,434	$	6,720

10. BORROWINGS UNDER LINE OF CREDIT

Rackable Systems has a line of credit agreement with a bank that provides for borrowings not to exceed the lesser of $20,000,000 or the sum of 80% of eligible accounts receivable and loans from the bank in the aggregate principal amount of $10,000,000, provided that such loans shall only be available as long as Rackable Systems maintains profitability in each of the two preceding fiscal quarters, less the amount of all outstanding letters of credit, foreign exchange reserves and all amounts utilized for cash management services. The line of credit agreement matures on August 30, 2006 and provides an aggregate sub-limit of $5,000,000 for letters of credit, cash management services and reserves, as defined, and foreign exchange contracts. Borrowings under the line of credit bear interest at prime. The line of credit agreement contains financial covenants that specify minimum profitability and tangible net worth requirements. There were no borrowings under the line of credit at December 31, 2005 and at March 31, 2006. There was $20,000,000 available for borrowings under the line of credit at March 31, 2006.

11. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK

In connection with Rackable Systems’ initial public offering of its common stock, the sole holder of Rackable Systems’ Series A redeemable preferred stock elected, pursuant to the terms thereof, to convert each share of Series A preferred stock into conversion units, each conversion unit consisting of one share of Series B redeemable preferred stock and 0.467 shares of common stock (a “Conversion Unit”), and then immediately distribute the shares of Series B preferred stock and common stock to its members. Upon the closing of Rackable Systems’ initial public offering of its common stock in June 2005, each share of Series B preferred stock was redeemed for cash. Consequently, Rackable Systems issued 9,016,000 shares of common stock and paid $24,738,000 to the Series B preferred stockholders. As of December 31, 2005 and March 31, 2006, there were no outstanding shares of preferred stock.

Effective July 1, 2003, upon the adoption of SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, Rackable Systems reclassified the aggregate carrying value of Series A preferred stock at that date, totaling approximately $21,400,000, net of deferred compensation of $1,839,000 associated with 800,000 shares of Series A preferred stock issued to two company executives, to long-term liabilities. Subsequent to the adoption of SFAS No. 150, Rackable Systems recorded accretion for preferred stock dividends of approximately $597,000 and $0, for the three months ended March 31, 2005 and 2006, respectively, which is included as a component of interest expense in the condensed consolidated statements of operations.

12. EMBEDDED DERIVATIVES IN PREFERRED STOCK

The Series A preferred stock redemption feature that provides for settlement of the common stock portion of the Conversion Unit in cash at the option of the holder effectively provides the holder of Series A preferred stock with a call option that is considered an embedded call option derivative under SFAS No. 133. Consequently, the common stock portion of the Conversion Unit must be bifurcated and accounted for separately. On December 23, 2002 (first issuance date), the fair value of the embedded call option was approximately $3,763,000, recorded as a liability at the date of issuance, reducing the recorded value of Series A preferred stock. On February 13, 2003 (second issuance date), the fair value of the embedded call option was approximately $412,000, recorded as a liability at the second issuance date, reducing the recorded value of the second issuance of Series A preferred stock. In accordance with the provisions of SFAS No. 133, Rackable Systems is required to adjust the carrying value of such embedded call option to fair value at each reporting date and recognize the change in fair value in the Statement of Operations. As a result Rackable Systems recognized expense of approximately

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$4,204,000 and $0 for the three months ended March 31, 2005 and 2006, respectively, recorded as a component of changes in fair value of embedded derivatives in preferred stock in the Statements of Operations. At December 31, 2005 and March 31, 2006, the estimated fair value of the embedded call option was $0. In February 2005, Rackable Investment LLC, the sole holder of all outstanding shares Series A preferred stock, relinquished its option to receive cash in lieu of common stock upon redemption of the Series A preferred stock held by it. As a result, because the common stock portion of the conversion unit can only be settled in common stock, the carrying amount of the embedded call option as of the date of the rescission of the right to take cash ($107,831,000) was reclassified from liabilities to additional paid-in capital.

The Series A preferred stock redemption feature that provided for redemption at the greater of (i) the face value (plus any accumulated or accrued but unpaid dividends thereon) or (ii) product of the face value multiplied by 1.25 effectively provided the holders of the Series A preferred stock with a put option that was considered an embedded derivative under SFAS No. 133. Consequently the embedded put option was bifurcated and accounted for separately. On December 23, 2002 (first issuance date), the fair value of the embedded put option was $128,000, recorded as a liability at the date of issuance, reducing the recorded value of the Series A preferred stock. On February 13, 2003 (second issuance date), the fair value of the embedded derivative was insignificant. In accordance with the provisions of SFAS No. 133, Rackable Systems was required to adjust the carrying value of the embedded put option to fair value at each reporting date and recognize the change in fair value in the Statement of Operations. At December 31, 2005 and March 31, 2006, the estimated fair value of the put option in the Series A preferred stock was $0. As a result, during the three months ended March 31, 2005 and 2006, Rackable Systems recognized income of approximately $12,000 and $0, respectively, recorded as a component of changes in fair value of embedded derivatives in preferred stock in the Consolidated Statements of Operations.

13. COMMITMENTS AND CONTINGENCIES

Indemnification Agreements—The Company enters into standard indemnification agreements with its customers and certain other business partners in the ordinary course of business. These agreements include provisions for indemnifying the customer against any claim brought by a third party to the extent any such claim alleges that the Company’s product infringes a patent, copyright or trademark, or misappropriates a trade secret, of that third party. The agreements generally limit the scope of the available remedies in a variety of industry- standard methods, including but not limited to product usage and geography-based limitations, a right to control the defense or settlement of any claim, and a right to replace or modify the infringing products to make them non-infringing. The Company has not incurred significant expenses related to these indemnification agreements and no material claims for such indemnifications are outstanding as of March 31, 2006. As a result, the Company believes the estimated fair value of these indemnification agreements, if any, to be de minimus; accordingly, no liability has been recorded with respect to such indemnifications as of March 31, 2006.

General—From time to time, the Company is party to certain other claims and legal proceedings that arise in the course of business. There are no such matters at March 31, 2006 which, in the opinion of management, will have a material adverse effect on the Company’s financial position or results of operations.

14. STOCKHOLDERS’ EQUITY

The Company has reserved the following shares of authorized but unissued common stock as of March 31, 2006:

Options available for grant under stock option plans	714,743
Employee stock purchase plan	549,497
Options issued and outstanding under stock option plans	3,338,266
Total	4,602,506

In March 2006, Rackable Systems completed a second follow-on public offering. Aggregate net proceeds from the offering, after deducting underwriting discounts and commissions and issuance costs, were approximately $138.5 million.

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15. INCOME TAXES

Provisions for income taxes were $333,000 and $4.3 million for the three months ended March 31, 2005 and 2006, respectively. The effective tax rate for the three months ended March 31, 2005 differs from the statutory income tax rate mainly due to permanent tax differences associated with the accounting for embedded derivatives and preferred stock dividends recorded as interest expense. The effective tax rate approximates the statutory income tax rate for the three months ended March 31, 2006.

In the first quarter of 2006, the Company recorded a tax benefit of approximately $11.4 million as an addition to additional paid in capital related to a tax benefit resulting from excess option deductions of approximately $27.9 million which are taxed at a statutory tax rate of 40.75%.

During the three months ended March 31, 2006, the Company recorded $11.4 million of excess tax benefits related to stock option exercises as a financing cash inflow and a change to prepaids and other assets of approximately $7.1 million associated with the benefit from the excess tax deductions as an operating cash outflow. In addition, the tax provision of approximately $4.3 million for the quarter ended March 31, 2006 was recorded through the increase in additional paid-in capital associated with the excess tax benefits associated with stock option exercises.

16. ENTERPRISE AND RELATED GEOGRAPHIC INFORMATION

Rackable Systems is managed by its executive officers in Milpitas, California and has no long-lived assets outside of the United States. Rackable Systems operates in two reportable business segments: the design, developing and marketing of customized high-density compute servers and high-capacity storage systems. Rackable Systems’ chief operating decision maker is the CEO. Sales revenue from both domestic and international customers, and on a percentage basis by country, (based on the address of the customer on the invoice) was as follows:

	Three Months Ended March 31,
	2005			2006
Domestic revenue	$	30,236		$	67,702
International revenue		253			16,690
Total revenue	$	30,489		$	84,392
Revenue by country:
United States		99	%		80	%
Ireland		—			18	%
Luxembourg		—			1	%
Others		1	%		1	%
Total		100	%		100	%

Sales revenue for the high-density compute server and high-capacity storage system segments for the three months ended March 31, 2005 and 2006 (in thousands):

	Three Months Ended March 31,
	2005		2006
Compute servers	$	28,709	$	78,794
Storage systems		1,780		5,598
Total revenue	$	30,489	$	84,392

Revenue for the compute servers segment includes two product lines (Foundation Series and Scale Out Series). The storage segment includes only one product line (Foundation Series Storage Server). Revenue by product line for the three months ended March 31, 2005 and 2006 were as follows (in thousands):

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	Three Months Ended March 31,
	2005		2006
Foundation Series Compute Server	$	24,077	$	74,026
Scale Out Series Compute Server		4,632		4,768
Foundation Series Storage Server		1,780		5,598
Total gross revenue	$	30,489	$	84,392

Cost of revenue information by segment and product line is not available. Accordingly, only revenue by segment is reported.

17. RELATED PARTY TRANSACTIONS

In February 2005, the Company entered into an agreement with Rackable Investment LLC, the Company’s controlling stockholder, in which Rackable Investment LLC gave up its right to take cash in lieu of common stock upon redemption of the Series A preferred stock held by it. In consideration for this, the Company agreed (1) not to take a number of corporate actions without Rackable Investment LLC’s consent, including pricing or consummating a contemplated initial public offering, (2) to amend the registration rights agreement between the Company and Rackable Investment LLC and the Company’s founders that provides Rackable Investment LLC with additional registration rights in the event of another offering, and (3) to amend the voting agreement with Rackable Investment LLC to clarify the provisions of that agreement. As a result, the carrying amount of the embedded derivative related to the common stock conversion unit of the Series A preferred stock was reclassified to additional paid-in capital in February 2005 (Note 12).

In February 2005, the Company repurchased a total of 816,083 shares of its common stock from the three founders of Old Rackable for approximately $6,000,000 in cash. Such shares had been issued to the three founders in connection with the purchase of Old Rackable in December 2002 and represented approximately 18% of the common stock in the Company held by the founders.

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ITEM 4.Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Based on our management’s evaluation (with the participation of our chief executive officer and chief financial officer), as of the end of the period covered by this report, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) are effective as of March 31, 2006 to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting during the quarter ended March 31, 2006, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

RACKABLE SYSTEMS, INC.
By:	/s/ Madhu Ranganathan
By:	Madhu Ranganathan
	Chief Financial Officer
	(Duly authorized and principal financial officer)

Dated: August 25, 2006

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Exhibit Index

Number	Exhibit
31.1	Certification required by Rule 13a-14(a) or Rule 15d-14(a).
31.2	Certification required by Rule 13a-14(a) or Rule 15d-14(a).
32.1*	Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).

 * The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by Rackable Systems for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

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