Room 4561
June 3, 2005
Mr. Thomas K. Barton
Chief Executive Officer
Rackable Systems, Inc.
1933 Milmont Drive
Milpitas, California 95035
Re: Rackable Systems, Inc.
Amendment Nos. 2, 3 and 4 to Registration Statement on Form
S-1
File No. 333-122576
Dear Mr. Barton:
We have reviewed your amended filing and have the following
comments.
Risk Factors
Our business depends on decisions by potential customers..., p. 13
1. We note your response to our prior comment no. 4 in our letter
dated April 22, 2005. Please advise us of any potential risk
posed
by customers reducing their purchases of servers from you as a
result
of the added cost of a prospective Linux license. Does the
absence
of a Linux license fee factor into a customer`s decision to
purchase
Linux servers as opposed to Windows servers or no servers at all?
Provide quantitative context for the risk you cite by disclosing
the
portion of server systems you sold in 2004 and first quarter 2005
that ran on the Linux operating system.
Capitalization
2. We note your response to our prior comment no. 8 in our letter
dated April 22, 2005 and the related revisions to your
capitalization
table. To further clarify your presentation, please adjust the
common stock section, including the par value and additional paid-
in
capital line items, under the pro forma and pro forma as adjusted
columns to reflect the issuance of approximately 9,000,000 shares
of
common stock in connection with the conversion of Series A
preferred
stock.
Selected Financial Data
3. We have considered your response to prior comment no. 9 in our
letter dated April 22, 2005 and remain unclear as to your basis
for
the adjusting pro forma net loss to reflect the accretion of the
Series A preferred shares to the Series B redemption amount. In
this
regard, it appears that the required increase at January 1, 2004
effectively represents a redemption premium. As such, the
increase
appears to represent a material non-recurring charge that results
directly from the transaction. It may be necessary to disclose
this
charge in your footnote, and to clearly indicate that it is not
included in your pro forma measure. However, it does not appear
appropriate to adjust your pro forma net loss to reflect the
impact
of this charge.
Management`s Discussion and Analysis of Financial Condition and
Results of Operations
Critical Accounting Policies, Significant Judgments and Estimates
Stock Options to Employees, pp. 39-41
4. Currently, your disclosure under this section describes two
methods used or considered to determine or assess the fair value
of
common stock underlying stock options issued at various points in
time. This disclosure appears potentially confusing to investors,
in
that it appears to create uncertainty regarding how, when and by
whom
the fair values of your common stock were determined.
In addition, the disclosures regarding the two methods appear
unclear
or incomplete in various respects. For example, disclosure in the
middle of the third paragraph on page 39 indicates that you
"estimated the increase to the fair market value per share during
the
period from December 23, 2002 to March 31, 2005." However, this
disclosure does not appear to describe the methodology used to
determine the increase in the fair market value per share over the
relevant time period. Further, the disclosure regarding the
independent valuations does not appear to explain how these
valuations were used to determine or assess the fair value of your
common stock from November 4, 2004 through March 31, 2005.
To aid investor understanding, revise your disclosure to remove
discussion of the two different methods and to provide clear,
comprehensive discussion of the method used to determine the fair
value common stock underlying stock option awards made during the
period from January 1, 2004 through March 31, 2005.
5. You disclose at the bottom of the third paragraph on page 39
that
the values of stock option awards determined through a management
valuation "did not factor in or reflect the value of liquidation
preferences." However, it appears that the May 2005 valuation
report
arrives at the fair value of your capital stock net of liquidation
preferences. Please tell us why management`s valuations did not
reflect the value of liquidation preferences. Separately, tell us
how the May 2005 valuation report can corroborate management`s
valuation reports when it appears that the liquidation preference
variable is not addressed consistently in each of the two
valuation
reports.
6. We note that the May 2005 valuation report concludes on a range
of
fair market values for your capital stock on a non-marketable
minority interest basis for each of the three valuation dates.
Please consider paragraph 167 of the AICPA publication "Valuation
of
Privately-Held-Company Equity Securities Issued as Compensation,"
or
the Practice Aid, and explain in reasonable detail the following:
* Why it was not possible or appropriate to determine specific
points
of estimated fair value;
* How you concluded that the ranges of fair market values are
sufficiently narrow; and
* How you concluded that the points of fair value you selected,
within the fair value ranges concluded by the unrelated valuation
specialist, are better estimates than the midpoints, or some other
consistently determined points, of those ranges.
7. We note that disclosure on page 39 of your amended filing
refers
to fair value as the "deemed fair market value." Deemed fair
market
value is not appropriate terminology in light of the guidance in
the
Practice Aid. Fair value should be determined without this
qualification. Please review and revise your disclosure
throughout
the document.
8. You disclose on the top of the second paragraph on page 40 that
"[t]he projections used for each valuation date were based on the
expected outlook on [y]our operating performance and market
environment through the forecast periods," which was the same for
each of the three valuation dates. Please explain to us, in
reasonable detail, why you believe that use of the same set of
projections is appropriate for estimating enterprise value at each
valuation. As part of your response, explain how you considered
the
following:
* The significant time lapse of approximately 10 months between
January 27, 2004, the first valuation date, and November 4, 2004,
the
third valuation date; and
* The substantial revenue growth between the first and third
valuation dates.
9. You disclose in the middle of the second paragraph on page 40
that
the unrelated valuation specialist then determined future debt-
free
cash flows based on these projections, which incorporated
estimated
annual growth rates ranging from 35% to 70%, EBIT growth rates
ranging from 29% to 60%, "future capital depreciation, capital
spending and changes in working capital." Please revise your
disclosure to clarify the following:
* Whether the estimated annual growth rates of 35% to 70% refer to
revenue or some other metric; and
* The meaning of the quoted portion of your disclosure above. In
this regard, clarify how these factors were incorporated into the
determination of debt-free cash flow.
10. You disclose at the bottom of the second paragraph on page 40
that you used discount rates of 24% and 23% for the January 27,
2004
and April 21, 2004 valuation dates, respectively. You further
disclose that such discount rates were based on the weighted
average
cost of capital, or WACC, of comparable companies. However,
according to the May 2005 valuation report, the mean WACC for such
comparable companies is approximately 16% and 15% for the January
27,
2004 and April 21, 2004 valuation periods. Explain to us the
reason
for this apparent inconsistency. As part of your response,
describe
for us, in reasonable detail, the factors you considered in
concluding that the discount rates used are more appropriate than
the
mean discount rates of comparable companies.
11. You disclose in the last paragraph on page 40 that
marketability
discounts of 20%, 10% and 5% were used for each of the valuation
dates. Please identify and explain in reasonable detail all
relevant
factors and their applicability in objectively substantiating a
50%
reduction in the marketability discount between January 27, 2004
and
April 21, 2004. For examples of such factors, please see
paragraph
57 of the Practice Aid. Additionally, revise your disclosure
under
the same paragraph to read "marketability discount" instead of
"market discount."
12. Your disclosure on page 39 includes references to two
valuations
performed by unrelated valuation specialists. If you choose to
refer
to the independent valuation firms, please identify the firms and
include their written consents as exhibits to your registration
statement. Please see Rule 436 under the Securities Act and
footnote
60 to the Practice Aid.
13. After reviewing the May 2005 valuation report it is not
evident
to us how you concluded on the appropriateness of certain input
variables. Please explain in reasonable detail the factors
considered in determining that the value of the following
variables
was more appropriate than a different value for such variables:
* the terminal multiple of 9x; and
* numerous multiple ranges (see third column of page 19 of the May
2005 valuation report) under the market multiple methodology for
each
valuation date.
Consider providing relevant calculations to support your response.
Business
Industry Background
The High-Capacity Storage Market, p. 61
14. Please note that our prior comment no. 14 in our letter dated
April 22, 2005 intended to generally refer to your petabyte
statistical data rather than the particularly 2003 petabyte number
which has been subsequently revised.
Principal and Selling Stockholders
15. Please update your information in this section to a more
recent
date. Please see Items 403 and 507 of Regulation S-K. For
additional guidance, please also see note (7) of Schedule A of the
Securities Act which states that such information should be as of
a
date within 20 days from the filing date of your registration
statement.
Financial Statements
Note 17. Stock Based Compensation, pp. F-28 to F-30
16. We note that you include in your management`s discussion and
analysis a table showing the stock option award activity for the
period between January 31, 2003 and March 31, 2005. Please tell
us
how you have considered the disclosure of such information under
this
note. See paragraph 179(a) of the Practice Aid.
* * * *
As appropriate, please amend your registration statement in
response to these comments. You may wish to provide us with
marked
copies of the amendment to expedite our review. Please furnish a
cover letter with your amendment that keys your responses to our
comments and provides any requested supplemental information.
Detailed cover letters greatly facilitate our review. Please
understand that we may have additional comments after reviewing
your
amendment and responses to our comments.
You may contact Stathis Kouninis at (202) 551-3476, or Brad
Skinner, Branch Chief - Accounting, at (202) 551-3489, if you have
questions or comments on the financial statements and related
matters. Please contact Daniel Lee at (202) 551-3477 with any
other
questions. If you need further assistance, you may contact or me
at
(202) 551-3462 or Barbara Jacobs, Assistant Director, at (202)
551-
3730.
Sincerely,
Mark P. Shuman
Branch Chief - Legal
cc: Via Facsimile
Timothy J. Moore, Esq.
Brett D. White, Esq.
Cooley Godward LLP
Five Palo Alto Square
3000 El Camino Real
Palo Alto, California 94306
Telephone: (650) 843-5000
Facsimile: (650) 843-5191