Founded in October 1999, Rackable Systems, Inc. (RACK) is a leading provider of high-density compute servers and high-capacity storage systems, based on an open architecture approach, targeted at data center "scale-out" deployments, or the deployment of a large number of inexpensive modular servers. The company's proprietary design allows for greater density of servers as they take less space, which also allows for greater air-flow, resulting in improved thermal management. Other benefits of Rackable System's design are improved remote management, ease of serviceability, and flexible and efficient power distribution. Rackable's servers (including Foundation Series and Scale Out Series) are based on open standard x86 processors from Advanced Micro Devices (AMD) and Intel and run on Windows or Linux operating systems. Due to its low cost, the market for x86 servers is the fastest growing part of the server market, expected to grow shipments by 39% between 2006 and 2010, as per market research firm IDC.
Due to the leveraging of continuing price-performance improvements associated with high-volume components, the company has been able to focus its R&D efforts on differentiating the size, energy requirements, and thermal efficiency of its systems. The company also offers a number of storage solutions, including RapidScale storage appliances (acquired from Terrascale Technologies in September 2006) that provide scalable shared storage solutions. In addition, the company uses reseller and original equipment manufacturer (OEM) relationships to provide additional server and storage offerings. In 2006, servers accounted for 90% of revenues, and storage systems accounted for the remaining 10%. Rackable has sold products to more than 300 customers, including companies with large Internet businesses, as well as customers with high-performance computing requirements in vertical markets such as semiconductor design, enterprise software, federal government, entertainment, financial services, oil and gas exploration, and biotechnology and pharmaceuticals. To date, virtually all of the company's revenue has come from the United States (91% in 2006) however, the company is working to establish a presence in Ireland (5% in 2006), which should also reduce its effective tax rate, and is focused on growing revenue from China (1% in 2006). Revenue from other regions accounted for the remaining 3% in 2006. Rackable Systems went public in June 2005. According to Gartner's October 2007 server report, Rackable Systems is the fourth largest x86 server providers in North America. Also, in the third quarter of fiscal 2007, it was the fastest growing server provider in North America, outgrowing Sun Microsystems, Dell, Hewlett Packard and IBM on an unit percentage basis.
Rackable Systems is a leader in low-power consumption servers, with products that use a much smaller footprint and use 30% less power than traditional products offered by competitors. RACK's Foundation Series servers are high-density, rack mounted server systems designed specifically for scale out datacenter environments, utilizing a half-depth back-to-back chassis design to increase the physical server density as it only takes half a slot in the rack, reducing floor space requirements. The Foundation series accounts for the bulk of RACK's revenue, with the remaining revenue coming from its Scale Out series of blade servers introduced in 2004 and small but growing storage business. When deployed in cabinets, Foundation Series servers offer approximately twice the server or processor density of traditional rack mounted solutions. Rackable has built a patent portfolio around features unique to these high density servers, including placement of input and output (I/O) in front of the unit and the air flow pattern that allows for greater concentration of servers. The company plans to double its density profile in 2008 and push its power envelope to 85% efficiency and unveil third generation 1u/2u serviceability to the market in 2008. We believe that power savings will be a key focus of large datacenters in the future as processing densities have increased to the point where datacenters are not able to utilize space as they lack sufficient power. IDC estimates that Kilowatt per rack (cabinet) is expected to accelerate to 20 servers per rack in 2010 from 7 servers per rack in 2006. Moreover, from an economic standpoint, the cost to power a server for three years is approximately equal to the cost of the server. We expect both economic and environmental concerns to drive the use of low power consumption equipment.
As with its servers, Rackable's storage systems are differentiated as cost effective, high-density, high-performance products. To further bolster its storage offering, RACK recently acquired privately-held Terrascale Technologies, Inc., a leading developer of next-generation storage solutions for high performance enterprise class cluster and grid applications. Terrascale's clustered storage systems eliminate the performance bottleneck inherent in legacy NAS architectures by delivering a single file system solution that scales nearly linearly in both capacity and performance, enabling customers to realize improved manageability, storage utilization, and is available in addition to up to tens of gigabytes per second of I/O throughput. Based on this technology, in late 2006, Rackable launched its RapidScale line of storage appliances. RapidScale uses a cluster file system with a proprietary architecture that is scalable, allowing it faster performance than traditional NAS or SAN solutions, delivering over 100 Megabytes per second I/O to Linux servers. This line compliments the company's Foundation Series Storage Servers, which are available for network attached storage (NAS) and iSCSI appliances and are designed as cost effective solutions, leveraging an open architecture approach and industry standard components. On the high-end, Rackable has its OmniStor storage array for high-performance enterprise applications available in fibre channel, serial ATA and SCSI deployments. OmniStor systems work with StorView management software, by nStor, for a single management point regardless of how many systems are on the network. Rackable is working on open standards, which should help drive storage sales to a broader range of customers.
Rackable Systems recently launched ICE Cube, the company's new modular data center environment designed to augment or replace traditional data centers. ICE Cube's unique, highly-efficient cooling technology can reduce cooling and air handler power costs by up to 80% over traditional brick-and-mortar data center environments and 50% reduction in electricity consumption and facilities cost. During the quarter company announced an expanded partnership with Raytheon, a certified Rackable Systems reseller, which helped the company to offer ICE Cube to its government customers. During the third quarter, the company announced that Rackable Labs came into operation which leads to new designs and technologies that brought a significant change in its data center dynamics. In 2007, Rackable also announced the availability of servers based on the new Quad-Core Intel Xeon Processor 5400 series. In 2008, the company launched C4108 server based on Quad-Core Intel Xeon Processor 7200 and 7300 series. In addition, Rackable introduced 11 new servers utilizing the company's Eco-Logical C1001 1U half-depth chassis. Rackable Systems' servers and storage are built-to-order and are delivered in fully racked and cabled in cabinet sizes holding up to 88 systems or 704 processing cores.
In addition to its differentiated products, RACK's direct sales model has helped drive sales in the Internet vertical and maintain strong gross margins. The company currently has nine active customers out of the top 20 Internet sites in the United States, with Yahoo, Amazon, Microsoft and Facebook its top four customers. We believe there are numerous opportunities in other verticals, such as financial services and other data intensive operations, which at this point are virtually untouched as approximately 70% to 75% of revenue comes from Internet companies.
Although Rackable has suffered from aggressive competition, we believe the company's new CEO Mark Barrenechea is focused on maintaining its competitive advantage of power efficient and leading-edge technologies, which it had drifted away from. To drive sales of its products into verticals where it is not already strong, RACK plans to work with select resellers. The company also plans to growth through strategic acquisitions. We believe that the company has an advantage over its competitors and that it can turn a profit by matching its competitor s regular prices. In 2008, the company plans to provide software as a service & data content and also enter into e-retailing and human capital management over the internet that includes loss of data content, power cooling and density benefits. It also plans to refocus its international efforts into Europe, U.K., France, Germany, Nordex and Italy.
Rackable Systems operates in an intensely competitive market, which is characterized by very large competitors controlling large segments of the market. The company competes against EMC, Hewlett-Packard, Hitachi Data Systems, Ltd., and Network Appliance in the storage market and IBM, Hewlett-Packard, Dell, and Sun Microsystems in the server market. These companies compete for the same customers and control the majority of the server and storage market. Sun's T1000 and T2000 servers, with a significantly smaller footprint and 70 watt power requirement, compete directly with Rackable's offering. Moreover, Dell has built itself on disruptive pricing and has been a very aggressive competitor over the past few quarters. As a result, Rackable has had to cut prices in order to stay competitive. Although environmentally issues will help awareness, economics ultimately drive most business decisions and if Dell can Beat Rackable's prices by 30%, the total cost of ownership for three years is at parity.
While Rackable had an early lead in the market for high-density, low power servers, we do not believe they hold a sustainable competitive advantage as the greater resources of Dell and HP have caught up with Rackable. Initial signs of trouble surfaced during the fourth quarter of 2006, when increasing price competition cost the company about two points of gross margin, or close to $2 million, as it was forced to revise contract terms with one of its top three customers in order to keep the business. Conditions have worsened throughout 2007 as gross margin continues to fall, and is now expected to be in the 9.0% to 11.6% range for the full year.
Rackable's servers are based on open standard x86 processors from Advanced Micro Devices (AMD) and Intel. According to Gartner's 2006 worldwide server report, the server market continued to grow at a healthy rate, with blade servers and x86 showing the greatest strength while RISC continues to decline. Although server shipments totaled 8.2 million, an increase of 8.9% from 2005, overall revenue within the server market was nearly flat year-over-year. In 2006, server revenue totaled $52.7 billion, an increase of only 2% from 2005. By comparison, Rackable generated $360.4 million in revenue for the year, or less than one percent of the overall market. According to Gartner, the x86 server market slowed in the fourth quarter of 2006 due to the market transition to multi-core (quad-core) processors and demand for virtualization, a technology that allows a server to run multiple operating systems and software applications simultaneously. Both technologies more efficiently use computing resources, thereby reducing demand for new servers. This was further supported by recent IDC research findings, which concluded that increasingly popular alternatives to conventional x86 architectures are having a negative impact on server shipments. We believe that the trend towards virtualized servers will accelerate as multi-core technology develops into a greater number of cores, giving a single processor the ability to run an increasing number of simultaneous tasks. As such, IDC forecasts that worldwide unit demand for x86 servers will grow by just 39% between 2006 and 2010, down from an earlier forecast of 61%. This means a loss of 4.5 million unit in shipment and $2.4 billion in revenue from the forecast for the years 2006 to 2010. IDC expects the x86 market to grow its unit market share to 94% in 2011 from 93% in 2006. Based on revenue, the x86 enjoyed 50% market share in 2006, which is expected to grow to 56% by 2011. We believe Rackable's lack of differentiation in the x86 server market will force the company to discount its price to maintain its market share.
Although Rackable had a lead on high density, low power servers, the competition will eventually catch up. We believe that this market has become less of a niche and will be more mainstream going forward as enterprises seek to reduce power requirements of their datacenters. As the market grows, it will become increasingly competitive. We do not believe that Rackable's servers contain enough proprietary technology to insulate them from price competition, and as a result, the company has had to cut prices in order to maintain volumes, resulting in falling revenue and profit margins. As a result the company expects to write down excess and obsolete inventory. Moreover, Rackable is at a disadvantage with its small size as it will have to continue a high level of R&D investment in an attempt to differentiate itself. During 2006, the company significantly increased its R&D expenses, which were up 507.3% over 2005. Approximately 30% of a server s power consumption comes from the processor, meaning that RACK s R&D focus is on parts that consume less power and take more resources to improve efficiency.
In addition, to support additional growth, the company increased its sales force. As a result, selling and marketing activities as well as general and administrative expenses increased. All this caused operating margin to fall to 3.2% in 2006 from 11.0% in 2005. With a concentrated customer base, including 57% of revenue from its top three customers, and 83% of revenue from its top 10 customers, Rackable can't afford to lose a customer. As a result, it has been meeting matching competitors on price. Rackable is now focusing on growing sales within its "non-core" customers, or customers outside of the top three. While competition for this group of customers will likely be less intense, the company has a lot of work to do as non-core customers only accounted for 43% of revenue in the third quarter. Moreover, we expect prices to fall rapidly across the board and smaller customers will not be immune from price competition.