UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 27, 2008

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.)

46600 Landing Parkway

Fremont, California 94538

(Address of principal executive offices including zip code)

(510) 933-8300

(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, a non-accelerated filer or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨            Accelerated filer  x            Non-accelerated filer  ¨            Smaller reporting company  ¨

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 October 31, 2008, there were 29,890,103 shares outstanding of the Registrant’s Common Stock, $0.001 par value per share.

INDEX

		Page
PART I FINANCIAL INFORMATION
Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets as of September 27, 2008 and December 29, 2007 (unaudited)	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 27, 2008 and September 29, 2007 (unaudited)	4
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 27, 2008 and September 29, 2007 (unaudited)	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	32
PART II OTHER INFORMATION
Item 1A.	Risk Factors	34
Item 6.	Exhibits	42
SIGNATURES		43

“Rackable Systems,” “Eco-Logical”, “OmniStor,” “RapidScale,” “Roamer”, “Concentro”, “ICE Cube” and the Rackable Systems logo are trademarks or registered trademarks of Rackable Systems, Inc. All other trademarks or service marks appearing in this report are trademarks or service marks of their respective owners.

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PART I—FINANCIAL INFORMATION

ITEM 1. Financial Statements

RACKABLE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

(Unaudited)

	September 27, 2008			December 29, 2007
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	173,865		$	49,897
Short-term investments		2,032			148,215
Accounts receivable, net of allowance for doubtful accounts of $492 and $434 at September 27, 2008 and December 29, 2007, respectively		44,897			49,957
Inventories		65,543			52,528
Deferred income taxes		—			499
Deferred cost of revenue		4,117			456
Prepaids and other current assets		11,063			19,000
Total current assets		301,517			320,552
PROPERTY AND EQUIPMENT, NET		6,907			8,285
LONG-TERM INVESTMENTS		8,694			—
INTANGIBLE ASSETS, NET		3,709			22,732
OTHER ASSETS		1,767			889
TOTAL	$	322,594		$	352,458
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	45,272		$	47,780
Accrued expenses		10,396			16,382
Deferred revenue		10,350			5,190
Total current liabilities		66,018			69,352
DEFERRED INCOME TAXES		785			3,031
DEFERRED RENT AND OTHER LONG-TERM LIABILITIES		1,162			868
DEFERRED REVENUE		3,085			3,089
Total liabilities		71,050			76,340
COMMITMENTS AND CONTINGENCIES (NOTE 12)
STOCKHOLDERS’ EQUITY:
Preferred stock, $0.001 par value; 12,000,000 shares authorized and none outstanding		—			—
Common stock, $0.001 par value; 120,000,000 shares authorized; 29,890,103 and 29,525,561 shares issued and outstanding at September 27, 2008 and December 29, 2007, respectively		30			29
Additional paid-in capital		451,308			440,725
Accumulated other comprehensive loss		(483	)		(11	)
Accumulated deficit		(199,311	)		(164,625	)
Total stockholders’ equity		251,544			276,118
TOTAL	$	322,594		$	352,458

See notes to these condensed consolidated financial statements.

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RACKABLE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

(Unaudited)

	Three months ended						Nine months ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
REVENUE	$	65,286		$	87,243		$	209,217		$	241,505
COST OF REVENUE		54,095			68,392			173,316			220,563
GROSS PROFIT		11,191			18,851			35,901			20,942
OPERATING EXPENSES:
Research and development		5,714			5,972			19,688			18,954
Sales and marketing		6,124			7,978			18,379			25,102
General and administrative		5,779			7,590			19,705			28,491
Impairment of long-lived assets		663			—			17,519			—
Restructuring charges		—			—			685			—
Total operating expenses		18,280			21,540			75,976			72,547
LOSS FROM OPERATIONS		(7,089	)		(2,689	)		(40,075	)		(51,605	)
Total other income, net		681			2,362			3,556			6,202
LOSS BEFORE INCOME TAX		(6,408	)		(327	)		(36,519	)		(45,403	)
INCOME TAX BENEFIT/(PROVISION)		419			332			1,833			(5,197	)
NET INCOME/(LOSS)	$	(5,989	)	$	5		$	(34,686	)	$	(50,600	)
NET INCOME/(LOSS) PER SHARE
Basic	$	(0.20	)	$	0.00		$	(1.18	)	$	(1.77	)
Diluted	$	(0.20	)	$	0.00		$	(1.18	)	$	(1.77	)
WEIGHTED SHARES USED IN NET INCOME/(LOSS) PER SHARE
Basic		29,501,614			29,124,546			29,493,743			28,636,658
Diluted		29,501,614			29,317,375			29,493,743			28,636,658

See notes to these condensed consolidated financial statements.

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RACKABLE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

	Nine months ended
	September 27, 2008			September 29, 2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(34,686	)	$	(50,600	)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
Depreciation and amortization		4,924			5,007
Loss on disposal of property and equipment		63			—
Impairment of long-lived assets		17,519			188
Provision for doubtful accounts receivable		59			264
Deferred income taxes		(1,531	)		14,740
Share-based compensation		9,891			19,132
Changes in operating assets and liabilities:
Accounts receivable		5,001			35,923
Inventories		(14,405	)		17,375
Prepaids and other assets		7,937			(11,517	)
Accounts payable		(2,830	)		1,245
Sales tax payable		(3,375	)		(1,677	)
Accrued expenses and deferred rent		(2,428	)		(3,253	)
Income taxes payable		109			436
Deferred cost of sales		(3,721	)		2,226
Deferred revenue		5,157			(1,316	)
Net cash (used in) provided by operating activities		(12,316	)		28,173
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of marketable securities		(26,253	)		(485,552	)
Proceeds from sales and maturities of marketable securities		163,286			475,001
Purchases of property and equipment		(1,057	)		(4,080	)
Terrascale acquisition, net of cash acquired		—			(350	)
Expenditures for intangible assets		(66	)		(9,122	)
Net cash provided by (used in) investing activities		135,910			(24,103	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Excess tax benefit of stock options exercised		—			(430	)
Repurchased restricted stock		—			(245	)
Restricted shares retired to cover taxes		(1,439	)		—
Proceeds from issuance of common stock upon exercise of stock options		536			2,537
Proceeds from issuance of common stock upon ESPP purchase		1,293			1,843
Net cash provided by financing activities		390			3,705
Effect of exchange rate changes on cash and cash equivalents		(16	)		(75	)
NET INCREASE IN CASH AND CASH EQUIVALENTS		123,968			7,700
CASH AND CASH EQUIVALENTS—Beginning of period		49,897			30,446
CASH AND CASH EQUIVALENTS—End of period	$	173,865		$	38,146
NON CASH INVESTING AND FINANCING ACTIVITIES:
Fixed asset expenditures in accounts payable	$	322		$	158
Unrealized loss, net on investments	$	456		$	—
SUPPLEMENTAL DISCLOSURE OF OTHER CASH FLOW INFORMATION:
Cash paid for income taxes	$	178		$	1,133

See notes to these condensed consolidated financial statements.

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RACKABLE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. BUSINESS

Rackable Systems, Inc. (“Rackable Systems”, “we” 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 Company has subsidiaries in Canada, Hong Kong , Ireland and the People’s Republic of China (“PRC”). The Company’s headquarters is located in Fremont, California. The principal business of the Company 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, biotechnology and pharmaceuticals.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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 (“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 (“US GAAP”) 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 29, 2007, which are included in the Company’s Annual Report on Form 10-K filed with the SEC on March 13, 2008.

Fiscal Year. The Company has a 52-week fiscal year ending on the Saturday nearest to December 31, with 13 week quarters ending on the last Saturday of the period. Fiscal 2008 will have a 53-week fiscal year, with 13 week quarters ending on the last Saturday of the period, except the fourth quarter which will have 14 weeks and will end on January 3, 2009. The third quarter of fiscal 2008 ended on September 27, 2008 and the third quarter of fiscal 2007 ended on September 29, 2007. The latest fiscal year ended on December 29, 2007.

Basis of Consolidation. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany balances and transactions have been eliminated.

Foreign Currency Transactions. The Company uses the U.S. dollar as its functional currency for its Ireland, Hong Kong and PRC subsidiaries and therefore re-measurement of its financial statements is not required. Currency transaction gains (losses) are recognized in current operations resulting from translating its financial statements at the reporting date. The Company uses the Canadian dollar as its functional currency for its Canada subsidiary. Assets and liabilities denominated in non-U.S. dollars are re-measured into U.S. dollars at the rates of exchange in effect at the balance sheet dates. Revenue and expenses are translated at average exchange rates in effect during each period. Translation adjustments are included in stockholders’ equity in the consolidated balance sheets as a component of accumulated other comprehensive income (loss).

Use of Estimates. The preparation of financial statements in accordance with US GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact us in the future, actual results may be different from the estimates. The Company’s critical accounting policies are those that affect the Company’s financial statements materially and involve difficult, subjective or complex judgments by management. Those policies are revenue recognition, inventory valuation, warranty, share-based compensation, intangible assets, other long-lived assets and accounting for income taxes.

Cash and Cash Equivalents. The Company classifies highly liquid investments as cash equivalents if they do not have a maturity date as of the date of purchase. Cash and cash equivalents consist of cash deposited in checking and money market accounts.

Marketable Securities. The Company accounts for short-term marketable securities in accordance with the Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Standard (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company classifies marketable securities as available-for-sale at the time of purchase and re-evaluates such designation as of each consolidated balance sheet date. Our marketable securities include commercial paper, corporate bonds, government securities and auction rate securities. Auction rate securities are securities that are structured with short-term interest rate reset dates of generally less than ninety days but with contractual maturities that can be well in excess of ten years.

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Our marketable securities are reported at fair value with the related unrealized gains and losses included in accumulated other comprehensive income (loss), a component of shareholders’ equity, net of tax. Realized gains or losses on the sale of marketable securities are determined using the specific-identification method and were not material for the nine months ended September 27, 2008 and September 29, 2007, respectively. We evaluate our investments periodically for possible other-than-temporary impairment by reviewing factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and our ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery of market value. We record an impairment charge to the extent that the carrying value of our available for sale securities exceeds the estimated fair market value of the securities and the decline in value is determined to be other-than-temporary.

Effective December 30, 2007, the Company adopted the provisions of SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. Issued in February 2008, FSP 157-1 Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, removed leasing transactions accounted for under Statement 13 and related guidance from the scope of SFAS No. 157. FSP 157-2 Partial Deferral of the Effective Date of Statement 157 (‘FSP 157-2”), deferred the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.

SFAS No. 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. SFAS No. 157 also requires that a fair value measurement reflect the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model. The adoption of SFAS No.157 did not have a significant impact on our financial statements.

SFAS No.157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under SFAS No. 157 are described below:

• Level 1- Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

• Level 2 - Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and

• Level 3 - Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

Accounts Receivable. Accounts receivable are recorded at the invoiced amount and do not bear interest. Our accounts receivable have been reduced by an allowance for doubtful accounts, which is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on customer specific experience and the aging of our receivables, among other factors.

Inventories. Inventories, consisting primarily of server chassis, hard drives, microprocessors, memory chips, cooling fans and other equipment used in the manufacture of networking servers, are stated at the lower of first-in, first-out cost or market. Cost components include materials, labor and manufacturing overhead costs.

We assess the valuation of our inventory, including demonstration inventory, on a quarterly basis based upon estimates about future demand and actual usage. To the extent that we determine that we are holding excess or obsolete inventory, we write down the value of our inventory to its net realizable value. Such write-downs are reflected in cost of revenue.

In our inventory valuation analysis, we also include inventory that we could be obligated to purchase from our suppliers. To the extent that our committed inventory purchases exceed our forecasted production needs, we write down the value of those inventories by taking a charge to cost of revenue and increasing our supplier liability.

Property and Equipment. Property and equipment are stated at cost and are depreciated on a straight-line basis over their estimated useful lives (generally two to seven years). Leasehold improvements and assets acquired under capital leases are amortized using the straight-line method over the shorter of the estimated useful lives of the respective assets or the lease term. When assets are retired or disposed of, the assets and related accumulated depreciation and amortization are removed from our general ledger and the resulting gain or loss is reflected in the statement of operations.

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Maintenance and repairs are charged to expense as incurred and improvements and betterments that enhance the life of the asset are capitalized.

Intangible Assets. The Company accounts for intangible assets in accordance with SFAS No. 142 Goodwill and Other Intangible Assets, (“SFAS No. 142”). The Company periodically evaluates its intangible assets. Intangible assets are carried at cost less accumulated amortization. Amortization is computed using the straight-line method over the economic lives of the respective assets, generally two to seven years.

The process of evaluating the potential impairment of intangibles is highly subjective and requires significant judgment. We estimate expected future cash flows then compare the carrying value of intangibles to the discounted future cash flows. If the total of future cash flows is less than the carrying amount of the assets, we recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets.

Impairment of Long-Lived Assets. The Company accounts for its long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”). The Company evaluates its long-lived assets for indicators of possible impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. An impairment loss would be recognized when undiscounted future cash flows expected to result from the use of an asset and its eventual disposition is less than its carrying amount.

Revenue Recognition. The Company accounts for its revenues under the provisions of Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition in Financial Statements (“SAB No. 104”), FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts (“FTB 90-1”) and Statement of Position No. 97-2, Software Revenue Recognition (“SOP 97-2”).

Under the provisions of SAB No. 104, the Company recognizes revenues from sales of products when persuasive evidence of an arrangement exists, shipment has occurred and title has transferred, the sales price is fixed and determinable, collection of the resulting receivable is reasonably assured, and all significant obligations have been met. Generally, this occurs at the time of shipment when risk of loss and title has passed to the customer.

Service revenue includes hardware maintenance and installation. Pursuant to SAB No. 104, the Company recognizes revenue from the sale of its products prior to completion of these services, as the Company’s product sales are not dependent on these services to be functional. Under FTB 90-1, revenue from hardware maintenance contracts, which are sold and invoiced separately, is recognized ratably over the contract term, generally one to three years. Installation services are typically requested by the Company’s new customers who have limited history with the products. Installation and related services are usually performed within one day after product delivery.

Where software is integrated with hardware and sold as a hardware appliance the Company provides unspecified software updates and enhancements to the software through service contracts. As a result, the Company accounts for revenue in accordance with SOP 97-2 for transactions involving the sale of software. Revenues earned on software arrangements involving multiple-elements are allocated to each element based on Vendor Specific Objective Evidence (“VSOE”) of fair value. The VSOE of fair value of the undelivered elements (maintenance and support services) is generally determined based on the price charged for the undelivered element when sold separately or renewed. If VSOE cannot be obtained to determine fair value of the undelivered elements, revenue from the entire arrangement would be deferred and recognized as these elements are delivered.

On occasion, when a customer informs the Company that a product is defective, the Company will ship a replacement product at the customer’s request prior to the customer returning the defective product for repair. This enables the customer to use the replacement product until the defective product is repaired and returned to the customer. Generally, the Company does not charge for this service unless the customer fails to return the defective product, in which case the customer is billed for the replacement product and revenue is recognized at that time.

Estimated sales returns and warranty costs, based on historical experience, changes in customer demand, and other factors, are recorded at the time product revenue is recognized in accordance with SFAS No. 48, Revenue Recognition When Right of Return Exists and SFAS No. 5, Accounting for Contingencies, respectively.

Deferred Revenue. Deferred revenue is primarily comprised of extended warranty, revenue deferred for installations yet to be completed, and advanced billing and customer deposits for service, support and maintenance agreements as well as product revenue for which performance obligations or customer acceptance is required. Deferred revenue is recorded when

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products or services provided are invoiced prior to the Company’s completion of the related performance obligations or customer acceptance. Deferred revenue is not recognized as revenue until the completion of those performance and acceptance criteria. Extended warranty and service support and VSOE deferrals are recognized ratably over the prerequisite service period.

Product Warranty. The Company’s warranty period for its products is generally one to three years. The Company accrues for estimated warranty costs concurrent with the recognition of revenue. The initial warranty accrual is based upon the Company’s historical experience and is included in accrued expenses and cost of revenue.

Share-based Compensation. The Company accounts for its employee stock purchase and stock incentive plans under the provisions of SFAS No. 123 (revised 2004), Share-Based Compensation, (“SFAS No. 123R”). SFAS No. 123R requires the recognition of the fair value of share-based compensation in net income. The fair values of the Company’s stock options and employee stock purchase plan awards are estimated using the Black-Scholes valuation model. Prior to January 1, 2006, the Company accounted for share-based employee compensation arrangements in accordance with APB No. 25, Accounting for Stock Issued to Employees, (“APB No. 25”), and related interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation, (“SFAS No. 123”.) Under APB No. 25, compensation cost was recognized based on the difference, if any, between the fair value of the Company’s common stock on the date of grant and the amount an employee must pay to acquire the stock. Compensation cost was recorded in accordance with FIN 28, using the multiple-option approach. Under SFAS No. 123R, compensation expense for those options prior to the adoption of SFAS No. 123R continue to be expensed on the same basis as they were prior to its adoption, reduced for estimated forfeitures.

Research and Development. Costs related to research, design and development of our products are charged to research and development expense as they are incurred.

Accounting for Income Taxes. The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS No. 109”), the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carry-forwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled.

The Company is required to assess the realization of deferred tax assets and the need for a valuation allowance. This assessment requires that management makes judgments and assesses the weight of positive and negative evidence in accordance with the requirements of SFAS No. 109 for purposes of concluding whether it is more likely than not that deferred tax assets will be realized. The effective tax rate varies based on a variety of factors, including overall profitability, the geographical mix of income before taxes and the related tax rates in the jurisdictions where the Company operates, restructuring and other one-time charges, as well as discrete events, such as settlements of future audits. The Company is subject to audits and examinations of tax returns by tax authorities in various jurisdictions, including the Internal Revenue Service. The Company regularly assesses the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of the provision for income taxes.

In June 2006, the FASB issued interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”). The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. FIN 48 was adopted by the Company in the first quarter of fiscal 2007. The cumulative effect of applying FIN 48 was recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The adoption of FIN 48 did not have a material impact on the Company’s consolidated results of operations, balance sheet and cash flows.

Recently Issued Accounting Pronouncements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115, (“SFAS No. 159”), which is effective for fiscal years beginning after November 15, 2007. This statement permits an entity to choose to measure certain financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The Company has elected not to adopt SFAS No. 159.

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In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141(R)”). SFAS No. 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS No. 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141(R) is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008. The Company expects to adopt SFAS No. 141(R) in the beginning of fiscal year 2009 and is currently evaluating the potential impact, if any, of the adoption of SFAS No. 141(R) on its consolidated results of operations or financial condition.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS No. 160”). SFAS No. 160 establishes requirements for ownership interests in subsidiaries held by parties other than the Company (sometimes called “minority interests”) be clearly identified, presented, and disclosed in the consolidated statement of financial position within equity, but separate from the parent’s equity. All changes in the parent’s ownership interests are required to be accounted for consistently as equity transactions and any noncontrolling equity investments in unconsolidated subsidiaries must be measured initially at fair value. SFAS No. 160 is effective, on a prospective basis, for fiscal years beginning after December 15, 2008. However, presentation and disclosure requirements must be retrospectively applied to comparative financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”). SFAS No. 161 expands quarterly disclosure requirements in SFAS No. 133 about an entity’s derivative instruments and hedging activities. SFAS No. 161 is effective for fiscal years beginning after November 15, 2008. The implementation of this standard will not have a material impact on our consolidated financial position or results of operations.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles”. The implementation of this standard will not have a material impact on our consolidated financial position or results of operations.

In October 2008, the FASB issued FASB Staff Position (FSP) FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (“FSP 157-3”). The FSP clarifies the application of FASB Statement No. 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The FSP is effective October 10, 2008, and for prior periods for which financial statements have not been issued. Therefore, the Company has adopted the provisions of FSP 157-3 in its financial statements for the three and nine months ended September 27, 2008. The adoption did not have a material impact on the Company’s consolidated results of operations or financial condition.

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3. BALANCE SHEET

Short-and Long-Term Investments

At September 27, 2008 and December 29, 2007, all of the Company’s marketable debt securities were classified as available-for-sale and were carried at fair market value. Auction rate securities are securities that are structured with short-term interest rate reset dates of generally less than ninety days but with contractual maturities that can be well in excess of ten years. At the end of each reset period, which occurs every seven to thirty-five days, investors can sell or continue to hold the securities at par subject to a successful interest rate reset. In the first and subsequent quarters of fiscal year 2008, certain auction rate securities failed auction due to sell orders exceeding buy orders. Our auction rate securities consist of investments that are backed by pools of student loans ultimately guaranteed by the U.S. Department of Education. We believe that the credit quality of these securities is high based on these guarantees. Based on an analysis of other-than-temporary impairment factors, we recorded a temporary impairment within accumulated other comprehensive loss of approximately $0.4 million at September 27, 2008 related to these auction rate securities. The Company intends and has the ability to hold these securities until the value of such securities recovers. The funds associated with failed auctions will not be accessible until a successful auction occurs, a buyer is found outside of the auction process, the underlying securities have matured or the securities are recalled by the issuer. Given the recent disruptions in the credit markets and the fact that the liquidity for these types of securities remains uncertain, the Company has classified all of its auction rate securities ($8.7 million, net of unrealized loss), as long-term assets in our condensed consolidated balance sheet, as our ability to liquidate such securities in the next 12 months is uncertain. The Company utilized the guidance and procedures as provided by SFAS No. 157 in determining the current fair value. The unrealized gains (losses) on available-for-sale securities are recorded in accumulated other comprehensive income (loss). Short- and long-term investments consisted of the following (in thousands):

	Purchase/ Amortized Cost		Gross Unrealized Gain		Gross Unrealized Loss			Aggregate Fair Value
September 27, 2008
Short-term investments-U.S. notes and bonds	$	2,032	$	—	$	—		$	2,032
Long-term investments-auction rate securities		9,100		—		(406	)		8,694
Total investments	$	11,132	$	—	$	(406	)	$	10,726
December 29, 2007
U.S. notes and bonds	$	10,206	$	25	$	—		$	10,231
Federal agency notes		50,437		37		—			50,474
Commercial paper		22,969		—		(13	)		22,956
Auction rate securities		64,554		—		—			64,554
Total short-term investments	$	148,166	$	62	$	(13	)	$	148,215

Accounts Receivable, net

Accounts receivable from Amazon, Microsoft and Conoco Phillips accounted for 54%, 15% and 13%, respectively, of total accounts receivable at September 27, 2008. Accounts receivable from Microsoft and Facebook accounted for 49% and 18%, respectively, of total accounts receivable at December 29, 2007.

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

	Three months ended				Nine months ended
	September 27, 2008		September 29, 2007		September 27, 2008		September 29, 2007
Amazon	59	%	21	%	36	%	15	%
Microsoft	11	%	29	%	14	%	31	%
Yahoo		*		*		*	14	%
Facebook		*	11	%		*		*

* indicates less than 10% for the period.

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A summary of the activity in the reserves relating to doubtful accounts receivable and sales returns is as follows (in thousands):

	December 29, 2007		Additions		Reductions			September 27, 2008
Allowance for Doubtful Accounts	$	434	$	58	$	—		$	492
Sales Return Reserve	$	330	$	162	$	(246	)	$	246

Inventories

Inventories consist of the following (in thousands):

	September 27, 2008		December 29, 2007
Finished goods	$	3,935	$	5,820
Work in process		17,246		16,385
Raw materials		44,362		30,323
Total inventories	$	65,543	$	52,528

Prepaid and other current assets

Prepaid and other current assets consist of the following (in thousands):

	September 27, 2008		December 29, 2007
Prepaid taxes	$	9,140	$	8,845
Other prepaid expenses		1,923		10,155
Total prepaid and other current assets	$	11,063	$	19,000

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Property and Equipment, net

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

	September 27, 2008			December 29, 2007
Leasehold improvements	$	1,345		$	1,484
Manufacturing equipment		4,526			3,303
Furniture and fixtures		873			1,127
Computer equipment		7,386			6,858
Construction in progress		754			362
Vehicles		104			118
		14,988			13,252
Less accumulated depreciation and amortization		(8,081	)		(4,967	)
Total property and equipment, net	$	6,907		$	8,285

Depreciation and amortization expense of property and equipment for the three months ended September 27, 2008 and September 29, 2007 was $0.8 million and $0.8 million, respectively. Depreciation and amortization expense of property and equipment totaled $2.5 million and $2.0 million for the nine months ended September 27, 2008 and September 29, 2007, respectively.

In conjunction with the impairment of long-lived assets discussed in Note 4, the Company recorded an impairment charge on certain property and equipment of $0.8 million assets during the nine months ended September 27, 2008.

In conjunction with the restructuring activity discussed in Note 5, the Company accelerated depreciation on certain property and equipment of $0.2 million assets during the nine months ended September 27, 2008.

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Intangible Assets, net

Intangible assets are recorded at cost, less accumulated amortization. The following tables present details of the Company’s intangible assets, as of September 27, 2008 (dollars in thousands):

	Gross		Amortization through June 28, 2008		Amortization for quarter ended September 27, 2008		Accumulated Amortization		Net
Rackable Systems
Patents	$	608	$	362	$	26	$	388	$	220
Other intangibles		25		21		2		23		2
		633		383		28		411		222
Tradename		3,487		—		—		—		3,487
Terrascale Acquisition
Existing technology		8,256		7,808		448		8,256		—
Distributed Parity Engine “DPE”		13,097		12,317		780		13,097		—
Customer relationships		633		605		28		633		—
Maintenance contracts		35		33		2		35		—
Non-compete agreements		313		311		2		313		—
		22,334		21,074		1,260		22,334		—
Total	$	26,454	$	21,457	$	1,288	$	22,745	$	3,709

In December 2002, as a part of the acquisition of Old Rackable, the Company recorded an intangible asset allocated to tradename in the amount of $3.5 million. This intangible asset is not amortizable.

Long-lived assets with a determinable economic life are tested for recoverability whenever events or circumstances indicate that their carrying amounts may not be recoverable. As discussed in Note 4, during the nine months ended September 27, 2008, the Company recorded an impairment charge in the amount of $16.7 million related to intangible assets acquired through the Terrascale acquisition. These intangible assets are used exclusively for our RapidScale products. The Company determined that long-lived intangible assets were not impaired at December 29, 2007.

In the three months ended September 27, 2008 and September 29, 2007, amortization of intangible assets was $0.7 million and $1.1 million, respectively. In the nine months ended September 27, 2008 and September 29, 2007, amortization of intangible assets was $2.4 million and $3.0 million, respectively.

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Amortization is computed using the straight-line method over the estimated useful life of the intangible asset. The Company expects that the future amortization of acquired intangible assets will be as follows (in thousands):

2008 (remainder)	$	47
2009		131
2010 and beyond		44
Total amortization	$	222

Accrued Expenses

Accrued expenses consist of the following (in thousands):

	September 27, 2008		December 29, 2007
Accrued payroll and related expenses	$	3,139	$	5,754
Accrued warranty		3,454		2,038
Accrued sales and use tax		712		3,828
Accrued commission		958		2,137
Other accrued expenses		2,133		2,625
Total accrued expenses	$	10,396	$	16,382

Accumulated Other Comprehensive Loss

Comprehensive loss consists of the following (in thousands):

	Accumulated Other Comprehensive Loss
December 29, 2007	$	(11	)
Change in unrealized loss on investments		(456	)
Change in cumulative translation adjustment		(16	)
September 27, 2008	$	(483	)

4. IMPAIRMENT OF LONG-LIVED ASSETS

During the three months ended June 28, 2008, the Company evaluated the recoverability of its long-lived assets which were used in connection with the Company’s RapidScale product line. During the quarter ended June 28, 2008, the Company significantly lowered its projected revenue and cash flow from the RapidScale product line. The decrease in projections was due to a change in strategic direction, as well as an inability to license certain third party software on reasonable commercial terms. The analysis on a discounted cash flow basis indicated that an impairment of the long-lived assets existed and the Company recorded an impairment charge of approximately $16.9 million. The Company updated its analysis during the three months ended September 27, 2008 and recorded an additional impairment charge of approximately $0.7 million.

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The impairment charge in the nine months ended September 27, 2008 consists of the following (in thousands):

	Impairment Charge
Existing technology	$	5,902
DPE		10,401
Customer relationships		333
Maintenance contracts		24
Non-compete agreements		24
Total intangibles	$	16,684
Fixed assets		835
Total	$	17,519

The fair value was estimated based on discounted cash flows. At September 27, 2008 all of the long-lived assets related to RapidScale were fully impaired.

5. RESTRUCTURING CHARGES

The Company incurred restructuring charges of $0.7 million for the nine months ended September 27, 2008 related to future lease commitments for excess facilities vacated during the quarter ended June 28, 2008. There were no such charges in any other periods.

6. EARNINGS PER SHARE

In accordance with SFAS No.128, Earnings Per Share, basic net loss per common share has been computed by using the weighted average number of shares of common stock outstanding during the period, less the shares subject to repurchase. The following table sets forth the computation of basic and diluted net loss per share (in thousands, except share and per share data):

	Three months ended					Nine months ended
	September 27, 2008			September 29, 2007		September 27, 2008			September 29, 2007
Numerators:
Net income (loss)	$	(5,989	)	$	5	$	(34,686	)	$	(50,600	)
Denominators:
Weighted-average shares - Basic		29,501,614			29,124,546		29,493,743			28,636,658
Weighted-average shares - Diluted		29,501,614			29,317,375		29,493,743			28,636,658
Net income (loss) per common share - Basic	$	(0.20	)	$	0.00	$	(1.18	)	$	(1.77	)
Net income (loss) per common share - Diluted	$	(0.20	)	$	0.00	$	(1.18	)	$	(1.77	)

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For the three and nine months ended September 27, 2008 and September 29, 2007 the Company had stock options outstanding which could potentially dilute basic earnings per share in the future, but the incremental shares from the assumed exercise of these stock options were excluded in the computation of diluted net loss per share, as their effect would have been anti-dilutive. The number of such outstanding stock options were as follows:

	Nine months ended
	September 27, 2008	September 29, 2007
Stock options	3,218,785	2,788,143

7. SHARE-BASED COMPENSATION

Share-Based Benefit Plans

In 2005, the Company’s Board of Directors adopted and its stockholders approved the Company’s 2005 Equity Incentive Plan (the “2005 Plan”), 2005 Non-Employee Directors’ Stock Option Plan and 2005 Employee Stock Purchase Plan (the “2005 ESPP”).

The Company’s Board of Directors adopted the 2006 New Recruit Equity Incentive Plan (the “New Recruit Plan”) in January 2006 which allows the Company to grant non-statutory stock awards to employees newly hired by the Company as an inducement to join the Company. No grants may be made under the New Recruit Plan to persons who are continuing employees of the Company, or to directors. The New Recruit Plan provides for the grant of the following stock awards: (i) non-statutory stock options, (ii) stock purchase awards, (iii) stock bonus awards, (iv) stock appreciation rights, (v) stock unit awards, and (vi) other stock awards.

Adoption of SFAS 123R

On January 1, 2006, the Company adopted the provisions of SFAS 123R requiring the Company to recognize expenses related to the fair value of the Company’s share-based compensation awards. The Company elected to use 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 is 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 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 over the requisite service period for each separately vesting portion of the award as if the awards were, in-substance, multiple awards. 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.

Tender Offer

On June 11, 2007, in order to address the lack of retention and incentive effect that the Company’s “out-of-the-money” stock options were having on the Company’s employees, the Company filed a tender offer on Schedule TO (“Tender Offer”) with the SEC under which holders of options with exercise prices greater than $16.00 per share could tender their options in exchange for restricted stock unit awards granted under the 2005 Equity Incentive Plan. On June 11, 2007, the closing price per share was $13.23. The tender offer was based upon the following exchange ratios:

Exercise Price Range	Stock Options Shares per Restricted Stock Unit
$16.00—$24.99	2 to 1
$25.00—$34.99	3 to 1
$35.00 and above	3.5 to 1

The restricted stock unit awards are subject to vesting in equal quarterly installments through August 15, 2009 (if the grant date of the option being tendered was prior to October 1, 2006) or August 15, 2010 (if the grant date of the option being tendered was after October 1, 2006). The Company completed the Tender Offer on July 10, 2007. As a result, the Company accepted for exchange options to purchase an aggregate of 2,238,883 shares of the Company’s common stock from 187 eligible participants, representing 87% of the shares subject to options that were eligible to be exchanged in the Offer to Exchange as of May 31, 2007. Upon the terms and subject to the conditions set forth in the Tender Offer to Exchange, the Company issued restricted stock unit awards covering an aggregate of 893,828 shares of the Company’s common stock in exchange for the options surrendered pursuant to the Tender Offer to Exchange.

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The fair value of the restricted stock unit awards was measured as the total of the unrecognized compensation cost of the original options tendered and the incremental compensation cost of the restricted stock unit awards on July 10, 2007, the date of cancellation. The incremental compensation cost was measured as the excess of the fair value of the restricted stock unit awards over the fair value of the options immediately before cancellation based on the share price and other pertinent factors at that date. The unrecognized compensation cost of the 2,238,883 options cancelled was $17.1 million. The incremental cost of exchange for the 893,828 restricted stock unit awards was approximately $145,000. The total fair value of the restricted stock unit awards on July 10, 2007 was $17.2 million and the cost will be amortized over the service period of the restricted stock unit awards. The service period of the restricted stock unit awards is longer than the service period of the options tendered.

Determining Fair Value

The fair value of share-based awards was estimated using the Black-Scholes model with the following weighted-average assumptions for the following periods:

	Three months ended						Nine months ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
Option Plan Shares
Dividend yield		—			—			—			—
Risk-free interest rate		3.2	%		4.6	%		3.2	%		4.7	%
Volatility		56.9	%		58.0	%		58.5	%		60.0	%
Weighted average expected life (in years)		5.2			5.7			5.2			5.4
Estimated annual forfeitures		11.6	%		10.5	%		11.6	%		10.5	%
Weighted average fair value	$	6.33		$	7.42		$	5.61		$	9.33
ESPP shares
Dividend yield		—			—			—			—
Risk-free interest rate		2.21	%		4.4	%		2.21	%		4.5	%
Volatility		50.0	%		49.0	%		50.0	%		50.0	%
Weighted average expected life (in years)		1.25			1.25			1.25			1.25
Weighted average fair value	$	9.35		$	4.63		$	9.35		$	4.95

The computation of expected life is based on an analysis of the relevant industry sector post-vest termination rates and the exercise factors. The expected volatility is based on a combination of the implied and historical volatility for both the Company and its peer group. The interest rate is based 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 share-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. The estimated forfeiture rate was based on an analysis of the Company’s pre-vest termination rate, as the Company believes that its historical forfeiture rates are representative of future expectations.

Share-Based Compensation Expense

The following table shows total share-based compensation expense included in the condensed consolidated statement of operations (in thousands):

	Three months ended				Nine months ended
	September 27, 2008		September 29, 2007		September 27, 2008		September 29, 2007
Cost of revenue	$	307	$	455	$	977	$	1,867
Research and development		683		892		2,428		3,789
Selling and marketing		362		1,036		1,689		4,671
General and administrative		1,324		2,543		4,797		8,805
Total	$	2,676	$	4,926	$	9,891	$	19,132

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.

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Stock Options and Restricted Stock Awards Activity

A summary of stock option activity for the nine months ended September 27, 2008 is as follows:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual term in years	Aggregate Intrinsic Value
Balance at December 29, 2007	2,892,480		$	13.13
Options granted	966,873			10.83
Options exercised	(75,884	)		7.06
Options cancelled	(564,684	)		12.54
Balance at September 27, 2008	3,218,785		$	12.55	8.32	$	1,342,713
Vested and expected to vest at September 27, 2008	2,860,371		$	12.60	8.25	$	1,241,705
Exercisable at September 27, 2008	939,831		$	13.10	7.40	$	667,760

The total intrinsic value of options exercised for the nine months ended September 27, 2008 and September 29, 2007 was $0.4 million and $10.1 million, respectively.

As of September 27, 2008 there was $14.8 million of total unrecognized compensation cost related to non-vested stock options. That cost is expected to be recognized over a weighted average period of 1.4 years.

The following table summarizes the Company’s restricted stock awards (“RSA”) activity for the nine months ended September 27, 2008.

	Number of Shares		Weighted Average Grant Date Fair Value
Balance at December 29, 2007	239,534		$	16.03
Released	(45,936	)		15.38
Forfeited	(51,877	)		20.03
Balance at September 27, 2008	141,721		$	14.77

As of September 27, 2008 there was $3.5 million of total unrecognized compensation cost related to RSA. That cost is expected to be recognized over a weighted average period of 2.5 years.

The following table summarizes the Company’s restricted stock units (“RSU”) activity for the nine months ended September 27, 2008.

	Shares		Aggregate Intrinsic Value
Balance at December 29, 2007	800,249		$	7,787,314
Awarded	1,117,600
Released	(323,163	)
Forfeited	(361,881	)
Balance at September 27, 2008	1,232,805		$	12,574,611
Vested and expected to vest at September 27, 2008	1,024,753

As of September 27, 2008 there was $13.5 million of total unrecognized compensation cost related to RSU. That cost is expected to be recognized over a weighted average period of 3.0 years.

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During the nine months ended September 27, 2008, 132,759 shares of common stock were delivered to the Company in payment of $1.4 million of withholding tax obligations arising from the release of RSA and RSU. The withholding tax obligations were based upon the fair market value of the Company’s common stock on the vesting date.

At September 27, 2008, the total compensation cost related to options to purchase the Company’s common stock under the 2005 ESPP not yet recognized was approximately $0.6 million. This cost will be amortized on a straight-line basis over periods of up to 2 years.

The following table shows the shares issued, and their respective weighted-average purchase price per share, pursuant to the 2005 ESPP during the nine months ended September 27, 2008 and September 29, 2007.

	September 27, 2008		September 29, 2007
Shares issued		162,823		166,834
Weighted-average purchase price per share	$	7.94	$	11.05

8. EMPLOYEE BENEFIT PLANS

Defined Contribution Plans—Effective September 1, 2003, Rackable Systems established a 401(k) retirement plan covering substantially all employees. The plan provides for voluntary salary reduction contributions up to the maximum allowed under Internal Revenue Service rules. The Company can make annual contributions to the plan at the discretion of the Board of Directors. The Company contributed $163,753 and $106,520 for the nine months ended September 27, 2008 and September 29, 2007, respectively.

9. DEFERRED REVENUE AND DEFERRED COST OF GOODS SOLD

At September 27, 2008, the Company had total deferred revenue of $13.4 million; this deferred revenue includes product revenue of $5.8 million. These product deferrals are related to shipments to customers pending acceptance or deferrals related to sales which did not qualify for immediate revenue recognition. The remaining deferred revenue of $7.6 million pertains to revenue from maintenance and extended warranty arrangements that are recognized ratably over the contract period and professional support services which had not been completed as of the balance sheet date. Deferred product costs associated with deferred revenue were $4.3 million at September 27, 2008.

At December 29, 2007, the Company had total deferred revenue of $8.3 million, this deferred revenue was composed of product revenue of $1.1 million. These product deferrals are related to shipments to customers pending acceptance or deferrals related to sales which did not qualify for immediate revenue recognition. The remaining deferred revenue of $7.2 million pertains to revenue from maintenance and extended warranty arrangements that are recognized ratably over the contract period and professional support services which had not been completed as of the balance sheet date. Deferred product costs associated with deferred revenue were $0.5 million at December 29, 2007.

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10. ENTERPRISE AND RELATED GEOGRAPHIC INFORMATION

The Company is managed by its executive officers in Fremont, California. The Company’s chief operating decision maker is the Chief Executive Officer (“CEO”). Based on the financial information reviewed by the CEO, the Company has determined that it operates in a single reportable segment. 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 (in thousands, except percentage amounts):

	Three months ended						Nine months ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
Domestic revenue	$	54,406		$	75,999		$	192,259		$	224,644
International revenue		10,880			11,244			16,958			16,861
Total revenue	$	65,286		$	87,243		$	209,217		$	241,505
Revenue by country:
United States		83	%		87	%		92	%		93	%
Ireland		11			6			5			2
Other		6			7			3			5
Total		100	%		100	%		100	%		100	%
Sales revenue for the high-density compute server and high-capacity storage system were as follows (in thousands):
	Three months ended						Nine months ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
Compute servers	$	51,275		$	81,359		$	176,180		$	218,713
Storage systems		14,011			5,884			33,037			22,792
Total revenue	$	65,286		$	87,243		$	209,217		$	241,505

Over 90% of the Company’s property, plant and equipment was located in the United States for the periods ended September 27, 2008 and September 29, 2007.

11. INCOME TAXES

The Company recorded a tax benefit of $0.4 million and $1.8 million for the three and nine months ended September 27, 2008, respectively, including a $0.2 million and $2.6 million discrete foreign tax benefit associated with $0.6 million and $17.5 million of impairment charges recorded for the three and nine months ended September 27, 2008, respectively. The effective tax rate used to record the tax benefit (exclusive of the discrete foreign tax benefit) differed from the combined federal and net state statutory income tax rate for the three months and nine months ended September 27, 2008 due primarily to increases in the valuation allowance for deferred tax assets.

The income tax (benefit)/provision for the three and nine months ended September 29, 2007 was ($0.3) million and $5.2 million, respectively. The income tax provision for the three months ended September 29, 2007 included a $13.2 million charge for an increase in the valuation allowance for deferred tax assets in excess of amounts recoverable through loss carry-back. The $13.2 million discrete charge for the increase in valuation allowance was partially offset by a $0.2 million tax benefit resulting from a reversal of a liability previously recorded for an uncertain tax position and related accrued interest as a result of a tax audit settled in the three months ended September 29, 2007.

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12. COMMITMENTS AND CONTINGENCIES

Future minimum lease payments under operating leases are as follows (in thousands):

Three Months ending January 3, 2009	$	423
Year ending January 2, 2010		2,058
Year ending January 1, 2011		2,066
Year ending December 31, 2011		1,850
Year ending December 30, 2012		1,886
Year ending December 29, 2013		1,927
Total	$	10,210

Total rent expense for the nine months ended September 27, 2008 and September 29, 2007 was approximately $3.9 million and $3.8 million, respectively.

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 nine months were as follows (in thousands):

	September 27, 2008			September 29, 2007			December 29, 2007
Balance—beginning of period	$	2,038		$	868		$	868
Current period accrual		2,420			2,149			3,117
Warranty expenditures charged to accrual		(1,004	)		(1,403	)		(1,947	)
Balance—end of period	$	3,454		$	1,614		$	2,038

Purchase Commitments—In connection with supplier agreements, the Company agreed to purchase certain units of inventory and non-inventory items through 2008. As of September 27, 2008, these remaining commitments were approximately $26.8 million and $4.1 million respectively.

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 were outstanding as of September 27, 2008. 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 September 27, 2008.

13. FAIR VALUE MEASUREMENTS

The financial assets of the Company measured at fair value on a recurring basis are cash equivalents, short-term and long-term investments. The Company’s cash equivalents and short-term investments are generally classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The Company’s long-term investments are classified within Level 3 of the fair value hierarchy because they are valued using unobservable inputs, due to the fact that observable inputs are not available, or situations in which there is little, if any, market activity for the asset or liability at the measurement date.

• Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

• Level 2: Quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability; or

• Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and are unobservable.

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The following table sets forth the Company’s short- and long-term investments as of September 27, 2008 which are measured at fair value on a recurring basis by level within the fair value hierarchy. As required by SFAS No. 157, these are classified based on the lowest level of input that is significant to the fair value measurement, (in thousands):

	Level 1		Level 2		Level 3		Assets at fair value
Corporate notes/bonds		2,032		—		—		2,032
Auction rate securities		—		—		8,694		8,694
Total	$	2,032	$	—	$	8,694	$	10,726

The above table excludes $23.8 million of cash held by us.

The Company’s Level 3 assets consist of long-term auction rate securities for which the Company used a discounted cash flow model to value these investments.

The following table provides a summary of changes in the fair value of the Company’s Level 3 financial assets as of September 27, 2008, (in thousands):

December 29, 2007	$	—
Unrealized loss included in other comprehensive income		(396	)
Transfers in to Level 3		9,125
March 29, 2008		8,729
June 28, 2008		8,729
Unrealized loss included in other comprehensive income		(10	)
Redemption at par value		(25	)
September 27, 2008	$	8,694

14. SUBSEQUENT EVENTS

In October 2008, a formal plan to abandon the RapidScale product line was reviewed and approved by management with appropriate authority, and was communicated to the affected employees. The RapidScale product line will be treated and reported as a discontinued operation as required by SFAS No. 144 in the Company’s annual report on Form 10K for the year ended January 3, 2009.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements included or incorporated by reference in this Form 10-Q other than statements of historical fact, are forward-looking statements. Investors can identify these and other forward-looking statements by the use of words such as “estimate,” “may,” “will,” “could,” “anticipate,” “expect,” “intend,” “believe,” “continue” or the negative of such terms, or other similar expressions. Forward-looking statements also include the assumptions underlying or relating to such statements.

Our actual results could differ materially from those projected in the forward-looking statements included herein as a result of a number of factors, risks and uncertainties, including, among others, the risk factors set forth in,” Part I, Item 2—”Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in “Part II, Item 1A—Risk Factors” in this Form 10-Q and elsewhere in this Form 10-Q and the risks detailed from time to time in Rackable Systems, Inc.’s future U.S. Securities and Exchange Commission reports. The information included in this Form 10-Q is as of the filing date with the Securities and Exchange Commission and future events or circumstances could differ materially from the forward-looking statements included herein. We assume no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results except as required by law. Accordingly, we caution readers not to place undue reliance on such statements. We expressly disclaim any obligation to update or alter our forward-looking statements, whether, as a result of new information, future events or otherwise.

“Rackable Systems,” “Eco-Logical”, “OmniStor,” “RapidScale,” “Roamer”, “Concentro”, “ICE Cube” and the Rackable Systems logo are trademarks or registered trademarks of Rackable Systems, Inc. All other trademarks or service marks appearing in this report are trademarks or service marks of their respective owners.

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The following discussion and analysis should be read in conjunction with the condensed financial statements and notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended December 29, 2007, contained our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 13, 2008.

Company Overview

We develop, market and sell compute server, storage systems and data center infrastructure purpose-built for large-scale data center deployments. Recently, enterprises have begun to deploy large-scale computing and storage farms by aggregating large numbers of relatively inexpensive, open-standard modular computing and storage systems. These systems typically run low-cost operating systems such as Linux and Windows and, we believe, enable enterprises to meet their computing and storage requirements at a lower total cost of ownership and provide enterprises with greater flexibility and scalability.

We have developed innovative technologies in the areas of chassis and cabinet design, power distribution techniques and hardware-based remote management technology. We offer compute servers using our half-depth design, enabling back-to-back mounting for higher server density and improved thermal management. In August 2004, we expanded our product line of compute servers, which we designed to further increase density levels, improve thermal management, and enhance cable management and system serviceability. In September of 2007, we released the newest generation of our modular data center products, known as “ICE Cube,” designed to augment or replace traditional brick-and-mortar data centers of any size and is ideal for data centers facing power and space limitations. We also sell low-cost, high-capacity storage servers, which leverage many of our core compute server technologies, to help enterprises cost-effectively meet their increasing data storage requirements. Our storage servers represented approximately 15.8% and 9.4 % of our revenue in the nine months ended September 27, 2008 and September 29, 2007 respectively. In addition, we selectively use reseller and OEM relationships to provide additional compute server and storage offerings that our customers may request. Service revenues were approximately 3% and 2% of total revenues in the nine months ended September 27, 2008 and September 29, 2007, respectively.

We market our systems primarily through our direct sales force predominantly to enterprises within the United States. In the nine months ended September 27, 2008 and September 29, 2007, international sales were approximately 8% and 7% of our revenues respectively. In fiscal 2007, international sales represented 7% of our total sales. We are in the early stages of developing an international sales and operational presence, focusing initially on Europe and China. We focus our sales and marketing activities on enterprises that typically purchase hundreds of servers and tens or hundreds of terabytes of storage per year. To date, we have sold our products to over 500 customers. In the three months ended September 27, 2008 we added 25 new customers. We have concentrated our marketing efforts on leading Internet companies, as well as customers with high-performance computing requirements in vertical markets such as semiconductor design, enterprise software, federal government, media, financial services, oil and gas exploration, biotechnology and pharmaceuticals.

In the second quarter of 2008 we had several significant events impacting the results for the nine months ended September 27, 2008; primary among those were changes in our expectations for the RapidScale product line, which required us to perform an impairment analysis of our intangible and other long-lived assets, as required by SFAS No. 144. This analysis resulted in an impairment of approximately $16.9 million to our intangibles and long-lived assets. In the three months ended September 27, 2008, we recorded an additional impairment of approximately $0.7 million of the remaining RapidScale related intangibles and other long-lived assets. As part of our ongoing consolidation of production facilities, we early terminated leases on two properties and recorded a restructuring charge of approximately $0.7 million in the nine months ended September 27, 2008. For additional information on these events please see our consolidated financial statements in this Form 10-Q, as well as the discussion of our results of operation below.

Share-based Compensation

In July 2007, we completed a tender offer to exchange 2,238,883 employee stock options for 893,828 restricted stock unit awards. See Note 7 of the condensed consolidated financial statements. More than 87% of the eligible employees representing more than 92% of the eligible stock options participated. The incremental accounting charge for the restricted stock unit awards was approximately $145,000, which reflects the difference between the unrecognized compensation costs of the options cancelled of $17.1 million and the total value of the restricted stock unit awards on July 10, 2007 of $17.2 million. The total value of the restricted stock unit awards is amortized over the vesting period of the restricted stock unit awards which is longer than the remaining vesting period of the options tendered.

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Beginning with the tender offer discussed above and continuing into 2008, we have increased the mix of restricted stock awards (“RSA”) and restricted stock units (RSU”) as compared to stock option awards for our equity compensation. The following table represents the grants outstanding by type and percent of possible dilution as of the dates set forth below:

	September 27, 2008	As a percent of common outstanding		September 29, 2007	As a percent of common outstanding
Common stock outstanding	29,890,103	100.0	%	29,462,022	100.0	%
Stock option awards	3,218,785	10.8		2,788,143	9.5
Restricted stock units	1,232,805	4.1		912,410	3.1
Total grants oustanding	4,451,590	14.9		3,700,553	12.6
Fully diluted	34,341,693	114.9	%	33,162,575	112.6	%

The following table represents the share-based compensation expenses for the respective periods (in thousands, except percentage):

	Three months ended				Change %		Nine months ended				Change %
	September 27, 2008		September 29, 2007				September 27, 2008		September 29, 2007
Cost of revenue	$	307	$	455	(33	)%	$	977	$	1,867	(48	)%
Research and development		683		892	(23	)%		2,428		3,789	(36	)%
Selling and marketing		362		1,036	(65	)%		1,689		4,671	(64	)%
General and administrative		1,324		2,543	(48	)%		4,797		8,805	(46	)%
Total	$	2,676	$	4,926	(46	)%	$	9,891	$	19,132	(48	)%

The significant reduction in share-base compensation in the three and nine months ended September 27, 2008 is the result of several factors, among them fewer awards outstanding due to reorganizing the management team and its responsibilities, which included the departure of several senior executives, lower fair value at grant date and changes in assumptions in 2008. Changes in the assumptions that are used to calculate expense were the volatility percentage, which was reduced to 58.5% in the third quarter of 2008 from 60% during 2007 and the estimated forfeiture rate for unvested awards, which increased to 11.6% in the third quarter of 2008 from 10.5% during 2007. In the three months ended September 27, 2008, share-based compensation was reduced by approximately $0.8 million due to a change in the estimated forfeiture rate. Also contributing to the reduced expense was the declining grant date fair value over the past year, which results in lower future expense.

Fiscal Periods

We have a 52-week fiscal year ending on the Saturday nearest to December 31, with 13 week quarters ending on the last Saturday of the period. The third quarter of our fiscal year 2008 ended on September 27, 2008. The third quarter of our fiscal year 2007 ended on September 29, 2007. Fiscal year 2007 ended on December 29, 2007.

Critical Accounting Policies

Our critical accounting policies are discussed in our Annual Report on Form 10-K for our fiscal year ended December 29, 2007, and there have been no significant changes.

Significant Judgments and Estimates

The preparation of financial statements in conformity with US GAAP requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses. These estimates and judgments are based on historical experience and on various other assumptions that we believe are reasonable under the circumstances, as well as management’s knowledge about current events and expectation about actions that we may undertake in the future. Actual results could differ materially from those estimates. Our significant judgments and estimates are discussed in our Annual Report on Form 10K for our fiscal year ended December 29, 2007.

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Results of Operations

The following table sets forth our financial results for the three and six months ended September 27, 2008 and September 29, 2007, as a percentage of revenue.

	Three months ended				Nine months ended
	September 27, 2008		September 29, 2007		September 27, 2008		September 29, 2007
REVENUE	100.0	%	100.0	%	100.0	%	100.0	%
COST OF REVENUE	82.9		78.4		82.8		91.3
GROSS PROFIT	17.1		21.6		17.2		8.7
OPERATING EXPENSES:
Research and development	8.8		6.9		9.4		7.9
Sales and marketing	9.4		9.1		8.8		10.4
General and administrative	8.9		8.7		9.4		11.8
Impairment of long lived assets	1.0		—		8.4		—
Restructuring charges	—		—		0.3		—
Total operating expenses	28.1		24.7		36.3		30.1
LOSS FROM OPERATIONS	(11.0	)	(3.1	)	(19.1	)	(21.4	)
Total other income, net	1.0		2.7		1.7		2.6
LOSS BEFORE INCOME TAX	(10.0	)	(0.4	)	(17.4	)	(18.8	)
INCOME TAX BENEFIT/(PROVISION)	0.6		0.4		0.9		(2.2	)
NET INCOME/(LOSS)	(9.4	)%	0.0	%	(16.5	)%	(21.0	)%

Comparison of the three and nine months ended September 27, 2008 and September 29, 2007

Revenue.

	Three months ended										Nine months ended
	September 27, 2008			September 29, 2007			Change				September 27, 2008			September 29, 2007			Change
							$		%								$			%
	(in thousands, except percentages)										(in thousands, except percentages)
Revenue	$	65,286		$	87,243		$(21,957)		(25	)%	$	209,217		$	241,505		$	(32,288	)	(13	)%
Top Three Historic Customers		70	%		57	%	—		—			59	%		60	%		—		—
Units Shipped		17,426			24,904		(7,478	)	(30	)%		59,613			67,880			(8,267	)	(12	)%

The decline in revenue for the three months ended September 27, 2008, compared to the three months ended September 29, 2007, reflected the recent economic downturn which has greatly impacted the timing of our customers’ buying decisions. This downturn has led to financial and economic deterioration, and has resulted in a demonstrable slowdown in corporate purchasing, particularly among customers outside of our historical top three customers. In the three months ended September 27, 2008, revenue from our top three historical customers fell by 7% to $45.9 million, but represented 70% of revenue as compared with $49.3 million or 57% of revenue in the three months ended September 29, 2007. While the number of units shipped decreased 30% from the year ago quarter, the average selling price increased 7% reflecting customer and product configuration mix changes. In addition, deferred revenue increased by $5.1 million for product shipped in the three months ended September 27, 2008 that was not recognized as revenue until the subsequent quarter because customer acceptance was not received prior to the end of the quarter.

The decline in revenue for the nine months ended September 27, 2008 as compared to the nine months ended September 29, 2007, resulted from lower product revenue from two of our historical top three customers. In the nine months ended September 29, 2007, revenue from our top three historical customers decreased by 15% to $123.4 million, or 59% of revenue as compared with $145.3 million, or 60% of revenue, in the nine months ended September 29, 2007. While the number of units shipped decreased 12% from the nine-month period one year ago, the average selling price was essentially unchanged. In addition, deferred revenue increased by $4.7 million for product shipped in the nine months ended September 27, 2008 that was not recognized as revenue until the subsequent quarter because customer acceptance was not received prior to the end of the period.

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Given the downturn in the US and international economies that is underway, we expect revenue to decline in the fourth quarter of this year. The company has forecasted that full year revenue will decline by approximately 22%.

Cost of revenue and gross profit.

	Three months ended									Nine months ended
	September 27, 2008			September 29, 2007			$ Change			September 27, 2008			September 29, 2007			$ Change
	(in thousands, except percentages)									(in thousands, except percentages)
Cost of revenue	$	54,095		$	68,392		$	(14,297	)	$	173,316		$	220,563		$(47,247)
Gross profit	$	11,191		$	18,851		$	(7,660	)	$	35,901		$	20,942		$14,959
Gross margin		17.1	%		21.6	%		n/a			17.2	%		8.7	%		n/a

The decrease in gross profit for the three months ended September 27, 2008 as compared to the same period in 2007 consisted of approximately $5.7 million due to shipping fewer systems and approximately $2.0 million due to the lower gross margin on those shipments. The primary causes for the decrease in gross margin for the three months ended September 27, 2008 as compared to the same period in 2007, were:

• Expense for the write-down of excess and obsolete inventory for the three months ended September 27, 2008 was $1.6 million as compared to $0.7 million in the same period in 2007,

• A decrease in usage of previously written down inventory from $0.8 million in the three months ended September 27, 2008 as compared to $2.6 million in the three months ended September 29, 2007.

The increase in the gross profit for the nine months ended September 27, 2008 as compared to the same period in 2007 consisted of approximately $17.5 million due to higher gross margin on systems shipped partially offset by approximately $2.5 million due to shipping fewer systems. The primary cause for the increase in gross margin for the nine months ended September 27, 2008 as compared to the same period in 2007, was:

• Charges for the write-down of excess and obsolete inventory for the three months ended September 27, 2008 were $8.1 million as compared to $21.5 million in the same period in 2007.

Changes in customer and product mix, pricing actions by our competitors and commodity prices, that comprise a significant portion of cost of revenue, significantly impact our gross margin from period to period. In addition, significant shifts in technology, declining shipments and revenues will depress gross profits and gross margin because certain manufacturing are fixed or semi-variable in nature and all may not be able to reduce them in proportion to the reductions in our revenues.

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Operating expenses.

	Three months ended									Nine months ended
	September 27, 2008		September 29, 2007		Change					September 27, 2008		September 29, 2007		Change
					$			%						$			%
	(in thousands, except percentages)									(in thousands, except percentages)
OPERATING EXPENSES:
Research and development	$	5,714	$	5,972	$	(258	)	(4	)%	$	19,688	$	18,954	$	734		4	%
Sales and marketing		6,124		7,978		(1,854	)	(23	)%		18,379		25,102		(6,723	)	(27	)%
General and administrative		5,779		7,590		(1,811	)	(24	)%		19,705		28,491		(8,786	)	(31	)%
Impairment of long lived-assets		663		—		663		N/A			17,519		—		17,519		N/A
Restructuring Charges		—		—		—		N/A			685		—		685		N/A
	$	18,280	$	21,540	$	(3,260	)			$	75,976	$	72,547	$	3,429

Research and development expense.

	Three months ended							Nine months ended
	September 27, 2008		September 29, 2007		Change			September 27, 2008		September 29, 2007		Change
Compensation and related	$	2,150	$	1,960	$	190		$	7,260	$	5,638	$	1,622
Terrascale employment retention expense		—		1,270		(1,270	)		2,532		3,797		(1,265	)
Consulting fees		496		228		268			1,061		883		178
Material and supplies		890		171		719			1,398		983		415
Amortization of intangibles		631		701		(70	)		2,295		1,799		496
Share-based compensation		683		892		(209	)		2,428		3,789		(1,361	)
Other		864		750		114			2,714		2,065		649
	$	5,714	$	5,972	$	(258	)	$	19,688	$	18,954	$	734

The change in research and development expenses in the three and nine months ended September 27, 2008, compared to the same periods in 2007, was due to:

• Increased compensation and compensation related expenses due to the addition of 11 new employees during the year

• Higher amortization expense in the nine month period due to the acquisition of the DPE technology in April 2007

• Increased consulting fees as well as material usage which related to the development of future product lines

• Increased depreciation expense as a result of the addition of test systems to support engineering activities.

These increases were offset by the following decreases:

• Reduced share-based compensation in the nine month period in 2008 due to the changes described in the Company overview under share-based compensation above and

• Decreased continued employment expense related to the Terrascale acquisition which ended in the three months ended June 28, 2008.

We expect research and development expense will increase, in absolute dollars, in future periods because we intend to increase our investment in engineering activities in the areas of storage, remote management and power systems. We also plan to launch our next generation Cloud Computing and HPC product line in the next quarter. Further, we opened our new Shanghai Technology Center during the quarter to expand our research and development activities and anticipate adding headcount in the next quarter.

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Sales and marketing expense.

	Three months ended							Nine months ended
	September 27, 2008		September 29, 2007		Change			September 27, 2008		September 29, 2007		Change
Compensation and related	$	2,311	$	2,501	$	(190	)	$	7,161	$	7,434	$	(273	)
Commission and sales bonus		1,338		2,099		(761	)		3,748		5,612		(1,864	)
Share-based compensation		362		1,036		(674	)		1,689		4,671		(2,982	)
Evaluation systems depreciation		599		637		(38	)		1,731		2,693		(962	)
Other		1,514		1,705		(191	)		4,050		4,692		(642	)
	$	6,124	$	7,978	$	(1,854	)	$	18,379	$	25,102	$	(6,723	)

The decrease in sales and marketing expenses in the three and nine months ended September 27, 2008 compared to the same periods in 2007, was due to:

• Decrease in compensation and related expenses due to a decrease in headcount of 4 people

• Decreased commission and sales expense due to lower revenue

• Reduced share-based compensation due to the changes described in the Company overview under share-based compensation, above, and

• Decreased evaluation system charges as a result of the implementation of a new evaluations program

We expect sales and marketing expense to increase, in absolute dollars, in future periods as we expect to expand our sales presence in the United States and internationally. In execution of this strategy, we have hired a new EMEA Vice President of Sales and APAC/Japan Vice President of Sales and will be expanding our sales organization in Europe. In addition we have expanded our sales and sales support organizations to cover key new verticals such as federal, oil and gas, media and entertainment and financial services.

General and administrative expense.

	Three months ended							Nine months ended
	September 27, 2008		September 29, 2007		Change			September 27, 2008		September 29, 2007		Change
Compensation and related	$	1,778	$	1,340	$	438		$	5,405	$	3,921	$	1,484
Severance		—		119		(119	)		—		917		(917	)
Sales tax settlement expense		53		996		(943	)		237		3,241		(3,004	)
Amortization of intangibles		27		390		(363	)		82		1,182		(1,100	)
Share-based compensation		1,307		2,529		(1,222	)		4,748		8,752		(4,004	)
Other		2,614		2,216		398			9,233		10,478		(1,245	)
	$	5,779	$	7,590	$	(1,811	)	$	19,705	$	28,491	$	(8,786	)

The reduction of general and administrative expense in the three and nine months ended September 27, 2008 compared to the same periods in 2007 consisted of the following:

• Reduced expense associated with sales and use tax filings resolved in fiscal 2007 period

• Reduced expense related to the amortization of intangibles related to the “Old Rackable” acquisition that became fully amortized by the end of fiscal year 2007

• Reduced share-based compensation due to the changes described in the Company overview under share-based compensation, above.

These decreases were offset by the following increase:

• Increased compensation related expenses due to the addition of 12 new employees during the year

29

We expect our general and administrative expenses may increase slightly in our fiscal fourth quarter as we make selective strategic investments in certain areas, including our China facility.

Impairment of long-lived assets.

We evaluated our long-lived assets with determinable economic life for recoverability due to events that indicated their carrying amounts might not be recoverable as of June 28, 2008. During the quarter ended June 28, 2008, the Company significantly lowered its projected revenue and cash flow from the RapidScale product line. The decrease in projections was due to a change in strategic direction, as well as an inability to license certain third party software on reasonable commercial terms. We determined that certain property and equipment and intangible assets related to our RapidScale product were impaired. The total impairment was $16.9 million. During the three months ended September 27, 2008, we recognized an additional impairment charge $0.7 million for the remaining RapidScale related long-lived assets.

Restructuring charges.

In the three months ended June 30, 2008, we relocated certain engineering activities that were being performed in our Milmont, California facility, which was under lease through June 30, 2009. We completed the relocation and returned the facility to the lessor prior to June 28, 2008. In addition, we negotiated and completed a lease termination agreement with the lessor, releasing us from any further responsibilities in exchange for a payment by us of $0.7 million.

Other income, net.

	Three months ended									Nine months ended
	September 27, 2008		September 29, 2007		Change					September 27, 2008		September 29, 2007			Change
					$			%							$			%
Other income, net:	$	681	$	2,362	$	(1,681	)	(71	)%	$	3,556	$	6,202		$	(2,646	)	(43	)%
Other income in the three and nine month periods ended September 27, 2008 as compared to the same periods in fiscal 2007 decreased due to a decrease in interest rates in the US markets and re-balancing of our investment portfolio to a more conservative position in response to the auction rate securities market collapse in late 2007 and early 2008. Provision for income taxes.
	Three months ended									Nine months ended
	September 27, 2008		September 29, 2007		Change					September 27, 2008		September 29, 2007			Change
					$			%							$			%
	(in thousands, except percentages)									(in thousands, except percentages)
Tax (provision)/benefit	$	419	$	332	$	87		26	%	$	1,833	$	(5,197	)	$	7,030		(135	)%

We recorded a tax benefit of $0.4 million and $1.8 million for the three and nine months ended September 27, 2008, respectively, including a $0.2 million and $2.6 million discrete foreign tax benefit associated with $0.6 million and $17.5 million of impairment charges recorded for the three and nine months ended September 27, 2008, respectively. The effective tax rate used to record the tax benefit (exclusive of the discrete foreign tax benefit) differed from the combined federal and net state statutory income tax rate for the three months and nine months ended September 27, 2008 due primarily to increases in the valuation allowance for deferred tax assets.

The income tax (benefit)/provision for the three and nine months ended September 29, 2007 was ($0.3) million and $5.2 million, respectively. The income tax provision for the three months ended September 29, 2007 included a $13.2 million charge for an increase in the valuation allowance for deferred tax assets in excess of amounts recoverable through loss carry-back. The $13.2 million discrete charge for the increase in valuation allowance was partially offset by a $0.2 million tax benefit resulting from a reversal of a liability previously recorded for an uncertain tax position and related accrued interest as a result of a tax audit settled in the three months ended September 29, 2007.

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Liquidity and Capital Resources

Liquidity

Cash, cash equivalents and investments totaled $184.6 million at September 27, 2008, a decrease of $13.5 million compared to $198.1 million at December 29, 2007. We expect to finance our operations for the next twelve months primarily through cash, cash equivalents and short term investment balances and cash flow from operations. A large portion of our available cash is invested in highly liquid, short-term investment grade government and agency debt securities and commercial paper with maturities of less than three months.

The following table summarizes our statement of cash flows for the following periods (in thousands):

	Nine months ended
	September 27, 2008			September 29, 2007
Consolidated Statements of Cash Flows Data:
Net cash provided by (used in) operating activities	$	(12,316	)	$	28,173
Net cash provided by (used in) investing activities		135,910			(24,103	)
Net cash provided by financing activities		390			3,705
Effect of exchange rate changes on cash and cash equivalents		(16	)		(75	)
Net increase in cash and cash equivalents		123,968			7,700
Cash and cash equivalents - beginning of period		49,897			30,446
Cash and cash equivalents - end of period	$	173,865		$	38,146

Operating Activities

Net cash used by operating activities for the nine months ended September 27, 2008 was $12.3 million, resulting from net loss of $34.7 million, adjusted for $31.0 million in non-cash charges and $8.6 million net change in assets and liabilities. The non-cash charges included impairment of long-lived assets, depreciation and amortization and share-based compensation offset by a deferred income tax liability. The change in assets and liabilities included an increase in inventory due to the new Ice Cube product line, and decreases in accounts payable, sales tax payable, accrued liabilities and deferred cost of sales, offset by increases in accounts receivable, prepaid assets and deferred revenue.

Even though we had a $50.6 million net loss in the nine months ended September 29, 2007, net cash provided by operating activities was $28.2 million. The net cash from operating activities resulted from the fact that the net loss for the period included significant non-cash changes related to stock-based compensation, impairment charges, write-downs of excess and obsolete inventory and depreciation and amortization; and better collections of accounts receivable.

Investing Activities

Cash provided by investing activities was $135.9 million for the nine months ended September 27, 2008. Cash provided by investing activities consisted primarily of sales and maturities of our short-term marketable securities of $163.3 million, partially offset by purchases of short-term marketable securities of $26.3 million and purchases of long-term assets of $1.1 million

During the nine months ended September 29, 2007, cash used by investing activities consisted of $4.1 million related primarily to the build-out of our new Fremont facility, $9.1 million for the acquisition of the DPE technology in April 2007, and other intangible assets and net purchases of short-term marketable securities of $10.6 million.

In general, we are not a capital intensive company. However, we do expect capital investments to increase moderately in future periods.

Financing Activities

Net cash provided from financing activities during the nine months ended September 27, 2008 was $0.4 million. The primary source of the cash provided was proceeds from the employee stock purchase plan and the exercise of employee stock options. Net cash provided from financing activities during the nine months ended September 29, 2007 was $3.7 million. The primary source of the cash provided was proceeds from the employee stock purchase plan and the exercise of employee stock options.

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In order to execute our business strategy, we expect to experience growth in our operating expenses for the foreseeable future. This increase in operating expenses may not result in an increase in our revenue and our anticipated revenue may not be sufficient to support these increased expenditures. Our operating expenses and working capital could constitute a material use of our cash resources. However, we believe our current cash and short-term investments are adequate to support our funding of our operating expenses and working capital requirements for at least the next twelve months.

Contractual Obligations and Contingent Liabilities and Commitments

The following are contractual commitments at September 27, 2008, associated with debt obligations, lease obligations, and contractual commitments (in thousands):

	Payments due by period
	Total		Less than 1 year		1 - 3 years		3 - 5 years		More than 5 years
Operating leases	$	10,210	$	1,976	$	3,972	$	3,819	$	443
Purchase obligations		30,934		30,934		—		—		—
Total	$	41,144	$	32,910	$	3,972	$	3,819	$	443

In connection with agreements with our suppliers, we agreed to purchase certain units of inventory through 2008. As of September 27, 2008, there was a remaining commitment of $26.8 million through the end of 2008.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Interest rate risk represents the risk of changes in value of a financial instrument caused by fluctuations in interest rates. If and when we do enter into future borrowing arrangements or borrow under a new revolving credit facility, we may seek to manage exposure to interest rate changes by using a mix of debt maturities and variable- and fixed-rate debt, together with interest rate swaps where appropriate, to fix or lower our borrowing costs. We do not make material sales or have material purchase obligations outside of the United States denominated in foreign currencies and therefore do not generally have exposure to foreign currency exchange risks.

Our exposure to market risks for changes in interest rates relates primarily to our investment portfolio. As of September 27, 2008, our cash equivalents consisted of money market funds in the amount of $150.0 million, and our short-term investments consisted of $2.0 million of debt securities with effective maturities of six months or less. We do not hold short-term investments for trading purposes. Our exposure to interest rate changes has not changed materially since December 29, 2007. We do not believe that an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio at September 27, 2008. Since we believe we have the ability to liquidate this portfolio, we do not expect our operating results or cash flows to be materially affected to any significant degree by a sudden change in market interest rates on our investment portfolio.

At December 29, 2007, we held $64.6 million of short-term investments consisting of various auction rate municipal bonds and variable rate municipal demand notes (“ARS”), compared to $8.7 million, net of unrealized loss of $0.4 million, which are classified as long-term investments as of September 27, 2008. Substantially all of these securities consisted of guaranteed student loans, insured or reinsured by the federal government.

ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, including our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures that are designed to ensure that the information included in reports we file under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is processed and reported within the appropriate time periods. As discussed in more detail below, our management, including our chief executive officer and chief financial officer, has concluded that these disclosure controls and procedures were ineffective as of September 27, 2008 due to material weaknesses that we identified in our internal control over financial reporting, specifically related to inventory valuation and accounting for income taxes. We do not expect that we will assess and conclude that either of these material weaknesses has been satisfactorily mitigated before the end of fiscal 2008.

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As reported in our Annual Report on Form 10-K for our fiscal year ended December 29, 2007, our management identified two material weaknesses in internal control over financial reporting as of December 29, 2007, which continue to be material weaknesses as of September 27, 2008, as follows:

Inventory Valuation

Our management concluded that the controls over our accounting for inventory valuation did not operate effectively as of December 29, 2007 and continued to be a material weakness as of September 27, 2008. In particular, errors were detected in the inventory valuation for the annual and interim financial statements resulting from: (i) items relating to the calculation of purchase price variances and excess and obsolete inventory reserve adjustments and; (ii) reviews of inventory valuations not being performed with sufficient precision. Due to the number and magnitude of the errors identified resulting from these internal control deficiencies and the absence of mitigating controls, management concluded that these internal control deficiencies constitute a material weakness in our internal control over financial reporting because there is a reasonable possibility that a material misstatement of the annual and interim financial statements would not have been prevented or detected on a timely basis.

Accounting for Income Taxes

Our management concluded that the controls over our accounting for income taxes did not operate effectively as of December 29, 2007. In particular, errors were detected in the tax calculations for the annual financial statements resulting from: (i) current period tax calculations not being accurately prepared, and (ii) reviews of tax calculations not being performed with sufficient precision. Due to the magnitude of the error identified resulting from these internal control deficiencies and the absence of mitigating controls, management concluded that these internal control deficiencies constitute a material weakness in our internal control over financial reporting because there is a reasonable possibility that a material misstatement of the annual financial statements would not have been prevented or detected on a timely basis.

Changes in Internal Control over Financial Reporting

We commenced a number of efforts to remediate the two material weaknesses noted above. These efforts will continue throughout 2008 and include the following:

Inventory Valuation

During the three months ended September 27, 2008, we continued the remediation process commenced during the first quarter of fiscal 2008, for the material weakness in accounting for inventory valuation, as reported in Item 9A of our Annual Report on Form 10-K filed March 13, 2008.

We will continue to make changes as necessary through automation, recruiting and enhancing the training of high quality personnel, in order to provide us with the infrastructure and processes necessary to remediate the inventory valuation material weakness, and to ensure operating effectiveness and improved internal controls over financial reporting.

Accounting for Income Taxes

During the three months ended September 27, 2008, we continued the remediation process commenced during the first quarter of fiscal 2008, for the material weakness in accounting for income taxes, as reported in Item 9A of our Annual Report on Form 10-K filed March 13, 2008. For example, during the period we recruited a senior tax manager to lead tax accounting and review.

We will continue to make changes as necessary through automation, recruiting and enhancing the training of high quality personnel, and improving the quality and timing of our accounting close process to allow for increased review time, in order to provide us with the infrastructure and processes necessary to remediate the income tax accounting material weakness, and to ensure operating effectiveness and improved internal controls over financial reporting.

Management expects to complete our remediation efforts during fiscal 2008; however, the ultimate remediation of these material weaknesses is contingent upon our ability to test the internal controls related to the material weaknesses once the remediation efforts described above are complete.

Inherent Limitation on the Effectiveness of Internal Controls

The effectiveness of any system of internal control over financial reporting, including ours, is subject to inherent limitations, including the exercise of judgment in designing, implementing, operating, and evaluating the controls and procedures, and the inability to eliminate misconduct completely. Accordingly, any system of internal control over financial

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reporting, including ours, no matter how well designed and operated, can only provide reasonable, not absolute assurances. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We intend to continue to monitor and upgrade our internal controls as necessary or appropriate for our business, but cannot assure you that such improvements will be sufficient to provide us with effective internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1A. Risk Factors

We have updated the risk factors appearing under the caption “Risks Relating to our Business and Industry” set forth in our Annual Report on Form 10-K for the year ended December 29, 2007. These updated risk factors are set forth below. We have designated with an asterisk (*) those risk factors that have changed substantively from those set forth in our Annual Report on Form 10-K. However, there have not been any substantive changes from the risks under the caption “Risks Relating to Owning Our Stock” in our Annual Report on Form 10-K for the year ended December 29, 2007, and these risks are not repeated here.

Risks Related To Our Business and Industry

* Our quarterly operating results have fluctuated significantly in the past and will continue to fluctuate in the future, which could cause our stock price to decline.

Our quarterly operating results have fluctuated significantly in the past, and we believe that they will continue to fluctuate in the future, due to a number of factors, many of which are beyond our control. For example, our revenues were $72.0 million for the quarter ended March 31, 2007, increased to $111.7 million for the quarter ended December 29, 2007 and decreased to $68.0 million for the quarter ended March 29, 2008 and then increased to $76.0 million for the quarter ended June 28, 2008 and then decreased to $65.3 million for the quarter ended September 27, 2008. The decrease in revenue in the third quarter of fiscal 2008 is attributed to a variety of reasons including a slowing of the global economy. Further, our gross margin decreased dramatically in the second quarter of 2008 as a result of competition for the business derived from a principal customer. We expect that our revenues, gross margin and earnings per share will fluctuate on a quarterly basis in future periods. If in future periods our operating results do not meet the expectations of investors or analysts who choose to follow our company, our stock price may fall. Factors that may affect our quarterly operating results include the following:

• fluctuations in the buying patterns and sizes of customer orders from one quarter to the next;

• increased competition causing us to sell our products or services at decreasing margins;

• location and timing requirements for the delivery of our products and services;

• addition of new customers or loss of existing customers, especially involving our largest customers;

• gross margin obtained on the sales of products and services, especially to our largest customers;

• modifications or cancelations of anticipated customer orders, which in some cases have been pre-built or for which we have already purchased component inventory which is rendered unusable by the cancellation or modification;

• write-off of excess and obsolete inventory;

• impairment and shortening of the useful life of components from our suppliers;

• unexpected changes in the price for, and the availability of, components from our suppliers;

• our ability to enhance our products with new and better designs and functionality;

• costs associated with obtaining components to satisfy customer demand;

• productivity and growth of our sales force;

• actions taken by our competitors, such as new product announcements or introductions or changes in pricing;

• revenues and gross margin disparity among our lines of server product and storage product lines;

• market acceptance of our newer products, such as ICE Cube;

• technology regulatory compliance, certification and intellectual property issues associated with our products;

• the payment of unexpected legal fees and potential damages or settlements resulting from protecting or defending our intellectual property or other matters;

• the payment of significant damages or settlements resulting from faulty or malfunctioning products or the provision of services unsatisfactory to our customers;

• the departure and acquisition of key management and other personnel; and

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• general economic trends, including changes in information technology spending or geopolitical events such as war or incidents of terrorism.

* We are substantially dependent on a concentrated number of customers, specifically Internet companies that purchase in large quantities. If we are unable to maintain or replace our relationships with these customers and/or diversify our customer base, our revenues may fluctuate and our growth may be limited.

Historically, a significant portion of our revenues has come from a limited number of customers. There can be no guarantee that we will be able to sustain our revenue levels from these customers because our revenues have largely been generated in connection with these customers’ decisions to deploy large-scale server and storage farms and their capacity requirements may become fulfilled. In 2007, our three largest customers accounted for 64% of our revenues. In the third quarter of 2008, our three historical largest customers accounted for 70% of our revenue. Moreover, the proportion of our revenues derived from a limited number of customers may be even higher in any future quarter. If we cannot maintain or replace the customers that purchase large amounts of our products, or if they do not purchase products at the levels or at the times that we anticipate, our ability to maintain or grow our revenues will be adversely affected. To maintain our relationships with our largest customers, and to continue to win their business, we may from time to time sell products to them at less than optimal gross margins. For example, in the second quarter of 2008 our gross margin was negatively impacted by an order shipped in the quarter to a significant customer priced at unfavorable gross margins with the intent of preserving an existing and significant customer relationship. In addition, customer concentration may expose us to credit risk, as a large portion of our accounts receivable may be from a small number of customers. For example, as of September 27, 2008, 82% of our accounts receivable were owed to us from our three largest customers.

In 2007 and through the third quarter of 2008, a substantial majority of our revenues were generated from companies that compete in the Internet market. A significant part of our growth has been due to the fact that these companies are doing well and, in many cases, expanding and, as a result, have been purchasing large quantities of products from us. If economic factors change for these Internet companies, as they have before, our ability to maintain or grow our revenues will be adversely affected.

We face intense competition from the leading enterprise computing companies in the world as well as from emerging companies. If we are unable to compete effectively, we might not be able to achieve sufficient market penetration, revenue growth or profitability.

The markets for compute server products and storage products are highly competitive. In addition to intensely competitive smaller companies, we face challenges from some of the most established companies in the computer industry, such as Dell, Inc, Hewlett-Packard Company (“H-P”), International Business Machines Corporation and Sun Microsystems, Inc in the computer server market. In the storage market, we compete primarily with EMC Corporation, H-P, Hitachi Data Systems, Inc, Super Micro Computer, Inc and Network Appliance, Inc. These larger competitors have at least the following advantages over us:

• substantially greater market presence and greater name recognition;

• substantially greater financial, technical, research and development, sales and marketing, manufacturing, distribution and other resources;

• longer operating histories;

• a broader offering of products and services;

• more established relationships with customers, suppliers and other technology companies; and

• the ability to acquire technologies or consolidate with other companies in the industry to compete more effectively.

Because these competitors may have greater financial strength than we do and are able to offer a more diversified bundle of products and services, they may have the ability to severely undercut the pricing of our products or provide additional products or servicing at little or no cost, which would make us less competitive or force us to reduce our average selling prices, negatively impacting our margins. In the past, we have had transactions where one or more competitors undercut our prices causing us to reduce our price, which negatively impacted our gross margin on that transaction and our overall gross margin. In addition, we have on occasion lost sales opportunities due to a competitor undercutting the pricing of our products or maintaining superior brand recognition. These competitors may be able to develop products that are superior to the commercially available components that we incorporate into our products, or may be able to offer products that provide significant price advantages over those we offer. For instance, a competitor could use its resources to develop proprietary motherboards with specifications and performance that are superior in comparison with the platforms that are currently available to the marketplace, which could give that competitor a distinct technological advantage. In addition, if our competitors’ products become more accepted than our products, our competitive position will be impaired.

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As the enterprise computing industry evolves, we expect to encounter additional competitors, including companies in adjacent technology businesses such as storage and networking infrastructure and management, companies providing technology that is complementary to ours in functionality, such as datacenter management software, contract manufacturers, and other emerging companies that may announce server product offerings. Moreover, our current and potential competitors, including companies with whom we currently have strategic alliances, may establish cooperative relationships among themselves or with other third parties. If this occurs, new competitors or alliances may emerge that could negatively impact our competitive position.

Our products incorporate open standard, commoditized components and materials that we obtain in spot markets, and, as a result, our cost structure and our ability to respond in a timely manner to customer demand are sensitive to volatility of the market prices for these components and materials.

A significant portion of our cost of goods sold is directly related to the pricing of commoditized materials and components utilized in the manufacture of our products, such as memory, hard drives, central processing units (“CPUs”), or power supplies. As part of our procurement model, we generally do not enter into long-term supply contracts for these materials and components, but instead, purchase these materials and components in a competitive bid purchase order environment with suppliers or on the open market at spot prices. As a result, our cost structure is affected by the availability and price volatility in the marketplace for these components and materials, especially for Dynamic Random Access Memory (“DRAM”), and new versions of hard drives and CPUs that are introduced by our suppliers. In the fourth quarter of 2006, we experienced volatility in DRAM prices that caused us to procure DRAM at prices higher than anticipated, which negatively impacted our overall gross margin for the quarter. In 2007, prices of DRAM decreased. This volatility makes it difficult to predict expense levels and operating results and may cause them to fluctuate significantly. In addition, if we are successful in growing our business, we may not be able to continue to procure components solely on the spot market, which would require us to enter into contracts with component suppliers to obtain these components. This could increase our costs and decrease our gross margins. Also, if we try to take advantage of favorable pricing of a particular component by purchasing a large quantity, there is the risk that a shift in our customers’ preferred components may render any stockpiled components of little value to us. For example, we recorded a $16.6 million expense related to the write down for excess and obsolete inventory during fiscal year 2007, contributed in part by customer driven technology platform shift from AMD to Intel, affecting demand for memory, motherboards, CPUs and chassis that we had previously purchased.

In addition, because our procurement model involves our ability to maintain a low inventory and to acquire materials and components as needed, and because we do not enter into long-term supply contracts for these materials and components, our ability to effectively and efficiently respond to customer orders may be constrained by the then-current availability or the terms and pricing of these materials and components. Our industry has experienced component shortages and delivery delays in the past, and in the future we may experience shortages or delays of critical components as a result of strong demand in the industry or other factors. As one example, DRAM can represent a significant portion of our cost of revenues, and both the price and availability of various kinds of DRAM are subject to substantial volatility in the spot market. In the fourth quarter of 2006 we encountered situations where we were forced to pay higher prices than we anticipated for DRAM and we have encountered situations where DRAM was in tight supply and we were unable to deliver customer orders on their anticipated delivery dates. As another example, the industry in the past has experienced a shortage of selected Intel chips, which caused some of our motherboard suppliers to reduce or suspend shipments of motherboards using these chips. This impacted our ability to ship selected configurations to some of our customers, and in some cases accelerated a transition to other platforms. If shortages or delays arise, the prices of these components may increase or the components may not be available at all. We may not be able to secure enough components at reasonable prices or of acceptable quality to build new products to meet customer demand, which could adversely affect our business and financial results. In addition, if any of our suppliers, such as Intel or AMD, were to increase the costs to Rackable for components we use, we would either pass these price increases on to our customers, which could cause us to lose business from these customers, or we would need to absorb these price increases, which would cause our margins to decrease, either of which could adversely affect our business and financial results.

We intend to expand our operations and increase our expenditures in an effort to grow our business. If we are not able to manage this growth and expansion, or if our business does not grow as we expect, our operating results may suffer.

We intend to continue to grow our business by entering new markets, developing new product and service offerings and pursuing new customers. In connection with this growth, we expect that our annual operating expenses may increase over the next several years to the extent we expand our sales and marketing, research and development, manufacturing and production infrastructure, and our customer service and support efforts. Our failure to timely or efficiently expand operational

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and financial systems and to implement or maintain effective internal controls and procedures could result in additional operating inefficiencies that could increase our costs and expenses more than we had planned and might cause us to lose the ability to take advantage of market opportunities, enhance existing products, develop new products, satisfy customer requirements, respond to competitive pressures or otherwise execute our business plan. Additionally, if we do increase our operating expenses in anticipation of the growth of our business and this growth does not meet our expectations, our financial results could be negatively impacted.

* If we acquire or invest in other companies, assets or technologies and we are not able to integrate them with our business, or we do not realize the anticipated financial and strategic goals for any of these existing or future transactions, our financial performance may be impaired.

If appropriate opportunities present themselves, as they have in the past, we may consider acquiring or making investments in companies, assets or technologies that we believe are strategic. We only have limited experience in doing so, and for any such company, asset or technology which we successfully acquire or invest in, we will be exposed to a number of risks, including:

• we may find that the acquired company, asset or technology does not further our business strategy, that we overpaid for the company, asset or technology or that the economic conditions underlying our acquisition decision have changed;

• we may have difficulty integrating the assets, technologies, operations or personnel of an acquired company, or retaining the key personnel of the acquired company;

• our ongoing business and management’s attention may be disrupted or diverted by transition or integration issues and the complexity of managing geographically or culturally diverse enterprises;

• we may encounter difficulty entering and competing in new product or geographic markets or increased competition, including price competition or intellectual property litigation; and

• we may experience significant problems or liabilities associated with product quality, technology and legal contingencies relating to the acquired business or technology, such as intellectual property or employment matters.

For example, in connection with our acquisition of Terrascale Technologies, Inc., we have expended a great deal of effort and resources, but have been unable to generate revenue, increase gross profit or contribute positive cash flow into our business, sufficient to realize our investment, causing us to exit this product line. This resulted in an impairment charge of $17.5 million in the nine months ended September 27, 2008.

If we were to proceed with one or more significant acquisitions or investments in which the consideration included cash, we could be required to use a substantial portion of our available cash. To the extent we issue shares of capital stock or other rights to purchase capital stock, including options and warrants, existing stockholders might be diluted and earnings per share might decrease. In addition, acquisitions and investments may result in the incurrence of debt, large one-time write-offs, such as of acquired in-process research and development costs, and restructuring charges.

We intend to further expand our sales into additional international markets, which may be more difficult than we expect, and if we are unable to do so successfully, our revenues and operating results may be adversely impacted.

One component of our growth strategy is to continue to expand into international markets. However, we have limited experience in selling our systems overseas, and we may encounter unexpected difficulties in doing so. To date, our sales to these geographies have been primarily originated from our U.S. based multi-national customers. If we are not able to successfully expand into international markets, our ability to grow our business will be adversely affected. Some of the factors that may impact our ability to initiate and maintain sales in foreign markets include:

• our ability to establish international manufacturing, support and service, which could be costly and time consuming;

• our ability to establish channel relationships with resellers in international markets;

• adoption of new laws or changes to existing international laws;

• our ability to service international installations;

• compliance with local laws, regulations and requirements for doing business in such jurisdictions;

• tax liabilities and currency fluctuations; and

• political and economic instability.

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Our business depends on decisions by potential customers to adopt our modular, open standard-based products and to replace their legacy server systems with our products, and they may be reluctant to do so, which would limit our growth.

Our business depends on companies moving away from large proprietary RISC/UNIX servers to standardized servers that utilize commercially available x86 processor architectures and can deploy a variety of operating systems, including Linux and Microsoft Windows. Excluding sales to Microsoft Corporation, we believe that a majority of the server systems that we sold in 2007, 2006 and 2005 ran on the Linux operating system and are subject to the GNU General Public License. While litigation involving the SCO Group’s claim against IBM that Linux is an unauthorized derivative work of the UNIX^® operating system has been stayed due to SCO’s bankruptcy filing, if it ultimately results in a ruling that users of Linux must pay royalties to SCO or others, that could impede broader Linux adoption and could materially harm our ability to sell our products based on the Linux operating system. In addition, Microsoft has publicly claimed that Linux infringes 235 or more of Microsoft’s patents and has entered into transactions with Novell inc. and other Linux distributors under which the parties reportedly agree, among other things, not to sue each other’s customers for potential patent infringements related to Linux. It is possible that a party (including Microsoft) could prove a claim for proprietary rights in the Linux operating system or other programs developed and distributed under the GNU General Public License. In addition, the GNU General Public License is a subject of litigation, and it is possible that a court could hold these licenses to be unenforceable in that litigation. Any ruling by a court that the Linux operating system or significant portions of it may not be copied, modified or distributed subject only to the minimal restrictions contained in these licenses, that users or distributors of Linux must pay royalties to Microsoft or others or that these licenses are not enforceable could also impede broader Linux adoption and materially harm our ability to sell our products based on the Linux operating system. Further, because potential customers have often invested significant capital and other resources in existing systems, many of which run mission-critical applications, customers may be hesitant to make dramatic changes to their datacenter systems. The failure of our customers and potential customers to replace their legacy server systems and adopt open standard-based modular technologies could have a material adverse impact on our ability to maintain or generate additional revenues.

We rely primarily on our direct sales force to generate revenues, and may be unable to hire additional qualified sales personnel in a timely manner or retain our existing sales representatives.

To date, we have relied primarily on our direct sales force to sell our products in the United States. Because we are looking to expand our customer base and grow our sales to existing customers, we will need to continue to hire qualified sales personnel if we are to achieve our anticipated revenue growth. The competition for qualified sales personnel in our industry, and particularly in Silicon Valley, is very intense. If we are unable to hire, train, deploy and manage qualified sales personnel in a timely manner, our ability to grow our business will be impaired. For example, in the past it has taken us up to six months to hire a qualified sales executive and it may take a newly-hired sales executive up to nine months after hiring to become productive, resulting in aggregate lag time between the commencements of the search to productivity, in excess of one year. We hired a new senior vice president of sales and he is in the process of integrating himself into our company. In addition, if we are unable to retain our existing sales personnel, or if our sales personal are ineffective, our ability to maintain or grow our current level of revenues will be adversely affected. In addition, a large percentage of our revenue is generated from a small number of customers. If we are unable to retain the sales personnel who are responsible for those customer accounts, our business could be negatively impacted.

We are continuing to develop and execute upon a channel strategy to generate additional sales and revenues, and the failure to successfully expand channel sales might affect our ability to sustain revenue growth and may harm our business and operations.

An increasing portion of our sales strategy is to develop our sales efforts through the use of resellers and other third parties to sell our systems. We may not be successful in building or expanding relationships with these third parties. Further, even if we do develop and expand these relationships, they may conflict with our direct sales efforts in some territories. Ineffective marketing of our products by our resellers or disruptions in our distribution channels could lead to decreased sales or slower than expected growth in revenues and might harm our business and operations.

Our sales cycle requires us to expend a significant amount of resources,and could have an adverse effect on the amount, timing and predictability of future revenues.

The sales cycle of our products, beginning from our first customer contact to closing of the sale, often ranges from three to six months. We may expend significant resources during the sales cycle and ultimately fail to close the sale. The success of our product sales process is subject to factors, over which we have little or no control, including:

• the timing of our customers’ budget cycles and approval processes;

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• our customers’ existing use of, or willingness to adopt, open standard server products, or to replace their existing servers or expand their processing capacity with our products;

• the announcement or introduction of competing products; and

• established relationships between our competitors and our potential customers.

We expend substantial time, effort and money educating our current and prospective customers as to the value of our products. Even if we are successful in persuading lower-level decision makers within our customers’ organizations of the benefits of our products, senior management might nonetheless elect not to buy our products after months of sales efforts by our employees or resellers. If we were unsuccessful in closing sales after expending significant resources, our revenues and operating expenses will be adversely affected.

If we are unable to protect our intellectual property adequately, we may not be able to compete effectively.

Our intellectual property is critical to our success and our ability to compete. If we fail to protect our intellectual property rights adequately, our competitors might gain access to our technology. Unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology despite our efforts to protect our intellectual property. For example, in September 2005, we filed a patent infringement action against one defendant in response to which the defendant counterclaimed that two of our patents are invalid and not infringed. In addition, we previously initiated two patent infringement actions against six defendants, seeking to enforce our intellectual property rights. We obtained consent judgments and permanent injunctions against five of the defendants, and reached a confidential settlement with the sixth.

However, litigation is inherently uncertain, and there is no assurance that any litigation we initiate will have a successful outcome. Monitoring unauthorized use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where we have two patent applications pending but do not have any issued patents, and the laws may not protect our proprietary rights as fully as the laws of the United States. Any claims or litigation that we have initiated or that we may initiate in the future to protect our proprietary technology could be time consuming and expensive and divert the attention of our technical and management resources whether or not the claims or litigation are decided in our favor. We currently have a small number of patents issued in the United States and a number of utility patent applications pending. These patents may be limited in value in asserting our intellectual property rights against more established companies in the computer technology sector that have sizeable patent portfolios and greater capital resources. In addition, patents may not be issued from these patent applications, and even if patents are issued, they may not benefit us or give us adequate protection from competing products. For example, issued patents might be circumvented or challenged, and could be declared invalid or unenforceable. Moreover, if other companies develop unpatented proprietary technology similar to ours or competing technologies, our competitive position will be weakened.

If we are found to have violated the intellectual property rights of others, we could be required to indemnify our customers, resellers or suppliers, redesign our products, pay significant royalties and enter into license agreements with third parties.

Our industry is characterized by a large number of patents, copyrights, trade secrets and trademarks and by frequent litigation based on allegations of infringement or other violation of intellectual property rights. As we continue our business, expand our product lines and our product functionality, and expand into new jurisdictions around the world, third parties may assert that our technology or products violate their intellectual property rights. Any claim, regardless of its merits, could be expensive and time consuming to defend against. It would also divert the attention of our technical and management resources. Successful intellectual property claims against us could result in significant financial liability, impair our ability to compete effectively, or prevent us from operating our business or portions of our business. In addition, resolution of claims may require us to redesign our technology, to obtain licenses to use intellectual property belonging to third parties, which we may not be able to obtain on reasonable terms, to cease using the technology covered by those rights, and to indemnify our customers, resellers or suppliers. Any of these events could negatively affect our competitive position and materially harm our business, financial condition and results of operations.

If we lose the services of one or more members of our current executive management team or other key employees, or if we are unable to attract additional executives or key employees, we may not be able to execute on our business strategy.

Our future success depends in large part upon the continued service and enhancement of our executive management team and other key employees, including, for example, Mark Barrenechea, who joined our company as our chief executive officer, at the end of April 2007. Changes in management can be disruptive within a company, which could negatively affect our operations, our culture and our strategic direction. All of our employees are “at will”, and their employment can be

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terminated by us or them at any time. The failure of our management team to seamlessly manage employee transitions, or the loss of services of any of these executives or of one or more other members of our executive management or sales team or other key employees could seriously harm our business. Competition for qualified executives is intense, particularly in Silicon Valley, and if we are unable to continue expanding our management team, or successfully integrate new additions to our management team in a manner that enables us to scale our business and operations effectively, our ability to operate effectively and efficiently could be limited or negatively impacted.

If we fail to maintain or expand our relationships with our suppliers, we may not have adequate access to new or key technology necessary for our products, and, as a result, our ability to deliver leading-edge products may be impaired.

In addition to the technologies we develop, our suppliers develop product innovations at our direction that are requested by our customers. In many cases, we retain the ownership of the intellectual property developed by these suppliers. In addition, we rely heavily on our component suppliers, such as Intel and AMD, to provide us with leading-edge components. If we are not able to maintain or expand our relationships with our suppliers or continue to leverage their research and development capabilities to develop new technologies desired by our customers, our ability to deliver leading-edge products may be impaired and we could be required to incur additional research and development expenses.

* We depend on our compute server products for the majority of our revenues. If market acceptance of our compute server products does not continue, we may not be able to achieve or sustain growth.

Sales of our compute server products accounted for 84% of our revenues during the first three quarters of fiscal 2008 and 91% of revenues in fiscal 2007. If our compute server products fail to maintain market acceptance, or if we are unsuccessful in developing improved products or products to replace or supplement our current server product lines, we may not grow our business and revenues as we expect. Further, because our customers are engaged in large-scale data center implementations, if customers believe that new generations of our products will become available in the near future, this perception may cause customers to delay or cancel existing orders, which would affect our ability to generate revenues in accordance with forecasted levels.

We rely on contract manufacturers to manufacture our products, and our failure to successfully manage our relationships with these contract manufacturers could impair our ability to deliver our systems in a manner consistent with required volumes or delivery schedules, which could damage our relationships with our customers and decrease our revenues.

We rely on a very small number of contract manufacturers to assemble and test a majority of our products. None of these third-party contract manufacturers are obligated to perform services or supply products to us for any specific period, or in any specific quantities, except as may be provided in a particular purchase order. Moreover, none of our contract manufacturers has provided contractual assurances to us that adequate capacity will be available to us to meet future demand for our products. If our contract manufacturers are not able to maintain our high standards of quality, are not able to increase capacity as needed, or are forced to shut down a factory, our ability to deliver quality products to our customers on a timely basis may decline, which would damage our relationships with customers, decrease our revenues and negatively impact our growth.

Our customers require a high degree of reliability in our products and services, and if we cannot meet their expectations our relationships with our customers could be damaged and demand for our products and services will decline.

Because our customers rely on our products and services for their enterprise or mission critical applications, any failure to provide high quality products and reliable services, whether caused by our own failure or failures by our suppliers or contract manufacturers, could damage our reputation and reduce demand for our products and services. Some of our products, such as our ICE cube line, are particularly complex and carry a higher per unit price. A failure of products in our ICE cube line would therefore potentially be more costly to us, with the risk and potential cost to us increasing proportionately with the number of products we sell from this line. In addition, delays in our ability to fill product orders as a result of quality control issues, such as an increase in failure rates or the rate of product returns, may negatively impact our relationships with our customers and harm our revenues and growth.

* Uncertainty in the credit market may negatively affect the value of auction rate securities owned by us and our ability to liquidate these securities.

Our investment portfolio as of September 27, 2008, includes various auction rate securities (“ARS”) with a cost of $9.1 million. ARS are variable-rate debt securities. While the underlying security has a long-term maturity, the interest rate is reset through Dutch auctions that are held at pre-determined intervals, usually every 28 days. In the past, liquidity for ARS was

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provided by this auction process that allowed investors to roll over their holdings or obtain immediate liquidity by selling the ARS at market. Recent uncertainty in the credit market has negatively affected these auctions and certain of these auctions have not had sufficient bidders to allow investors to complete a sale of ARS. In February 2008, auctions related to the $9.1 million of ARS currently owned by us have failed. These are the only ARS investments in our portfolio as of September 27, 2008. Due to the uncertainty of liquidity, we have classified these investments of $8.7 million as long term and have included such investments in non current assets. We have recorded an unrealized loss of $0.4 million on such investments to other comprehensive income. In the future, failed auctions for our ARS may affect our ability to liquidate these ARS until a future auction is successful, a buyer is found outside of the auction process, the underlying securities have matured or the securities are recalled by the issuer. In addition, failed auctions may affect the fair value of our ARS and may result in an impairment charge.

Maintaining and improving our financial controls and the requirements of being a public company may strain our resources and divert management’s attention.

We are subject to the reporting requirements of the Securities Exchange Act of 1934 or the Exchange Act, the Sarbanes-Oxley Act of 2002 and The NASDAQ Stock Market Rules. The requirements of these rules and regulations have increased our legal and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources.

The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. This can be difficult to do. As a result of this and similar activities, management’s attention may be diverted from other business concerns, which could have a material adverse effect on our business, financial condition and results of operations. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the NASDAQ Global Select Market

* We have material weaknesses in our internal control over financial reporting, and these material weaknesses create a reasonable possibility of material misstatements in our financial statements.

As a publicly traded company we must maintain effective disclosure controls and procedures and internal control over financial reporting. This can be difficult to do. In connection with the preparation of our financial statements for the year ended December 29, 2007, we determined that we had two material weaknesses, and therefore determined that our internal control over financial reporting was not effective, and therefore created a reasonable possibility of material misstatements in our financial statements. These material weaknesses related to our accounting for inventory valuation and accounting for income taxes, as more fully explained in Part I “Item 4. Controls and Procedures” in this Quarterly Report on Form 10-Q and have not yet been remediated.

In order to improve and to maintain the effectiveness of our internal control over financial reporting and disclosure controls and procedures, significant resources and management oversight will be required. We have begun the process of remediating these material weaknesses, but this process will take time, and we will not be able to assert that we have remediated these material weaknesses until the procedures that we put in place have been working for a sufficient period of time for us to determine that they are effective. As a result of this and similar activities, management’s attention may be diverted from other business concerns, which could have a material adverse effect on our business, financial condition and results of operations. If we are unable to remediate these material weaknesses, or in the future report one or more additional material weaknesses, there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. This could result in a restatement of our financial statements, as it did in our Form 10-Q for the quarterly period ended March 29, 2008, or impact our ability to accurately report financial information on a timely basis, which could adversely affect our stock price.

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ITEM 6. Exhibits

Exhibit Index

		Incorporated by Reference
Exhibit Number	Exhibit Description	Form	Ex. No	File No.	Filing Date	Filed Herewith
2.1	Asset Acquisition Agreement, dated December 23, 2002, by and between GNJ, Inc. (f.k.a. Rackable Systems, Inc.) and Registrant	S-1	2.1	333-122576	2/4/2005
2.2	Share Purchase Agreement dated as of August 29, 2006, by and among Rackable Systems, Inc., Rackable Systems Canada Acquisition ULC, Terrascale Technologies Inc. and the other parties identified on Schedule A thereto.	8-K	2.1	000-51333	8/30/2006
3.1	Amended and Restated Certificate of Incorporation.	10-Q	3.1	000-51333	8/12/2005
3.2	Amended and Restated Bylaws.	8-K	3.6	333-122576	3/7/2008
4.1	Reference is made to Exhibits 3.1 and 3.2.
4.2	Form of Specimen Stock Certificate.	S-1A/2	4.2	333-122576	5/2/2005
31.1	Certification required by Rule 13a-14(a) or Rule 15d-14(a).					X
31.2	Certification required by Rule 13a-14(a) or Rule 15d-14(a).					X
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)					X

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

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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/ James D. Wheat
By:	James D. Wheat
	Chief Financial Officer
	(Duly authorized and principal financial officer)

Dated: November 4, 2008

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Exhibit Index

		Incorporated by Reference				Filed Herewith
Exhibit Number	Exhibit Description	Form	Ex. No	File No.	Filing Date
2.1	Asset Acquisition Agreement, dated December 23, 2002, by and between GNJ, Inc. (f.k.a. Rackable Systems, Inc.) and Registrant	S-1	2.1	333-122576	2/4/2005
2.2	Share Purchase Agreement dated as of August 29, 2006, by and among Rackable Systems, Inc., Rackable Systems Canada Acquisition ULC, Terrascale Technologies Inc. and the other parties identified on Schedule A thereto.	8-K	2.1	000-51333	8/30/2006
3.1	Amended and Restated Certificate of Incorporation.	10-Q	3.1	000-51333	8/12/2005
3.2	Amended and Restated Bylaws.	8-K	3.6	333-122576	3/7/2008
4.1	Reference is made to Exhibits 3.1 and 3.2.
4.2	Form of Specimen Stock Certificate.	S-1A/2	4.2	333-122576	5/2/2005
31.1	Certification required by Rule 13a-14(a) or Rule 15d-14(a).					X
31.2	Certification required by Rule 13a-14(a) or Rule 15d-14(a).					X
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)					X

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

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