Rackable Systems (RACK) Priced to Scoop Up

Rackable Systems (RACK) had a bad Q4 2006 in which revenues hit a record but net income plunged (see my analyst conference summary). Last week it reported Q1 revenues that plunged and a bloody net loss (see summary). I bought stock at several points last year; it has been a major drag on my portfolio. So why am I scooping up as much as my portfolio rules allow? Am I still trying to catch a falling knife?

Could be. Falling knives sometimes fall to zero; and that has happened to stocks in my portfolio in the past. That is one good reason for diverified portfolio rules. If you take three risky positions (normalized to 1) and one falls to zero but one goes to 2 and one goes to 4, you have doubled your money with very little net risk. The question is, did you do your research, do you really know what the risks are with each stock and therefore with the portfolio.

In an auction system like the stock market a substantial portion of stocks will have prices that are unsustainably high or low. When there is enthusiasm stocks can get priced as if their revenues have already grown by factors of 10 (or back in 1999, by infinity for some stocks). The same thing happens when people all dump stock on bad news: often the auction value goes far beneath the underlying value of the stock.

This is easy to see with Rackable Systems. On Friday, April RACK ended at $11.27 per share giving it a market capitalization of $322 million.

The company had $170 million in cash on March 31, 2007, which is 52.8% of its market capitalization. It has positive cash flow in Q1 of $9.6 million. If it starts making money again its effective tax rate will be very low due to NOLs (Net Operating Losses), which are losses it accumulated during its startup phase that can be credited against future profits.

Q1 was its worst revenue in a year, yet it had $72 million in revenues, or an annual run rate of $288 million. Q1 is typically seasonally weak.

Belt tightening alone can restore the company to profitability. As I explained in Rackable: Playing with the Big Guys, server technology competitors saw how well RACK was doing. Unable to compete on technology, at least one began bidding at below cost in order to stop Rackable in its tracks. In Q4 Rackable's management went for market share, reducing bids in order to keep clients. Since then they have realized that failure to make a profit is just as great of a threat as losing market share. So now they are continuing to compete with their superior technology, cutting their own costs, but refusing to match what management called "irrational competitor pricing."

I expect that, with its cash cushion and existing level of sales, even if things are tough going forward Rackable's stock price is at or near its low.

The upside potential is substantial. One good quarter (revenues above $80 million with GAAP net income of over $2 million) should send the stock price into the high teens.

Rackable is expanding from just selling servers to selling storage equipment as well. They are expecting about $20 million in storage revenues this year that they did not see last year. Storage is a very competive field, just like servers, but reports are Rackable has great technology.

Then there is always the possibility of a buyout. Rackables technologies are protected by patents. For Sun or HP an acquisition of RACK would make a fair amount of sense given the ability to acquire customers, cash, and NOLs all in one swoop.