Rackable (RACK): Playing with the Big Guys

Today Rackable (RACK) had plunging stock price syndrome after the company announced that Q1 2007 earnings would be below expectations, that is to say, negative. How negative, we will have to wait until the earnings release.

At the analyst conference for Q4 2006 (see my summary) guidance for Q1 2007 was revenues between $70 and $75 million due to seasonality and lumpiness in largest accounts. They said to expect gross margins at low end of range. There are lots of details about why Q4 worked out the way it did and what Q1 might be like in the answers to analyst questions.

What did the press release say? "Total revenue for the first quarter of 2007 is expected to be in the range of its previous projections of $70 - 75 million." No change there. But "the company anticipates a net loss for the first quarter of 2007, on both a GAAP and non-GAAP basis," because "gross margin for the first quarter [is] to be approximately 30% lower than previously communicated." The details: price competition, a cancelled order, a severance package, and some tax obligations.

Management leaves some bright looking crumbs for investors: a greater than one book to bill ratio, the strongest backlog of orders ever, and cash balances improving to $170 million at the end of the quarter.

So how much is the stock worth today (which is to day, should you buy it because it is beneath that price, or should you sell it if you own it above that price)? It was at $55.75 per share within the last year; today the stock is below $15. What changed?

Rackable is in a position that is common in all industries, including technology. It had a good idea and executed well on it. It grew rapidly, from $53 million in annual sales in 2003 to $360 million in 2006. Investors (including me; I own the stock) got overly enthusiastic by projecting a straight line of increasing sales and profitability.

Sales revenues had not been bad, continuing to increase through Q4 2006. But Q1 2007 revenues will not only be sequentially (and seasonally) down; they will be below Q1 2006. In addition, starting with Q3 2006 earnings have taken a beating.

Rackable was noticed by the big guys because it was becoming a big guy. It was taking out full page ads in Infoworld; it was winning big contracts from YouTube, Microsoft, and other Internet search/portal players who liked Rackable's innovative approach to server farms. Sun, IBM, HP and Dell took a look and said: this has got to stop. Any one of these companies has the financial resources to take some losses in order to underbid Rackable. And reports are that this has been happening lately.

In order to keep its customers Rackable has cut its prices in specific situations. But it does not sell servers one at a time. It sells systems on a large scale. A few price cuts in a few specific situations and it is in the red.

Just as when the stock was bid up high based on future expectations, the pricing of the stock today depends on your model of future sales and earnings. No one actually knows what will happen; but some of us will guess right, and will at least guess in the ballpark, and some will be way off.

I think Rackable will pull through, but I see plenty of downside danger. To a fair extent they should be able to meet anything Sun, Dell, or HP can throw at them because Rackable has a superior (and patented) technology. They have the advantage of being a niche player: the other guys might be willing to underbid for a while, but they have other distractions and no one wants to be the head of the division that is bleeding money within a company that has many divisions.

The need for the type of server installations that RACK sells is growing rapidly. I think management was right to do what it took to keep their market share. They have enough cash that they can't be forced out of the game easily.

Rackable is not, today, a stock for short-term investors. It is a risky stock for long term investors. But today it has cash equal to 42% of its market share; the immediate downside is limited. I admire the guys at IBM, Sun, Dell, and HP, but I think Rackable may be the nimble running back that dodges the heavy defenders and makes a good run.
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See my summary of the Q4 2006 Rackable analyst conference