RACK is Back: Rackable Gets Nose Up

As I've reported in the past (See my RACK page) in 2005 Rackable Systems was a small but rapidly growing company taking market share mainly from Dell, HP, and Sun. When they got big enough to be noticed, in 2006, they found themselves being underbid on contracts for their racked Internet server systems. This led to a nasty dilemma: bidding low enough to keep building market share meant losing money on a deal. The situation hit bottom in Q1 2007 with revenues sinking to $72 million, the lowest since 2005, and losses of $0.36 or $0.13 per share, depending on whether you prefer GAAP or adjusted accounting.

On Thursday Rackable reported that Q2 2007 revenues had risen sequentially to $82.2 million, though that was still down 7% from year-earlier. GAAP EPS was a loss of $1.42, but non-GAAP EPS worked out to $0.02.

Better still, much of the GAAP and even non-GAAP expense was non-cash. In Q2 cash and equivalents increased by $10.5 million, ending at $180.6 million. That is an astonishing 53% of RACK market capitalization today.

There is a new management team in place, too.

One drag on the quarter was a $20.6 million write-down of obsolete inventory. This had to do mainly with two issues: DDR1 memory becoming obsolete more quickly than expected, and the shift towards Intel CPUs, leaving some AMD components (not necessarily AMD processors) dead in the water. That sounds like bad new for AMD, but management pointed out that the new Barcelona chips are being certified this quarter and interest in them appears to be strong. Rackable had a successful collaboration with Oracle and is also introducing servers ready for virtualization in Q3.

Management expects growth to accelerate in the second half of 2007 and to be in the black on a non-GAAP in the second half of the year. GAAP gross margins should turn positive as well.

Storage revenues increased to 10% of the total; this is a relatively new area for Rackable. They also have not done much on the international front, with only 6% of sales outside the U.S.

They continue to differentiate their product in order to prevent Dell and HP from undercutting them with pricing. They are integrating their RapidScale technology into new products and hope to see some results from that as well.

They are optimistic enough to be hiring sales staff and already increased their engineering headcount by 20%. The resulting increase in operating expense will make the nut needed for profitability bigger, but management realizes they have little choice but to grow or fold.

It is too early to confidently bid up the stock price, which only about 50 cents above its 52-week low. However, with one more quarter of increased revenues and increased EPS, I think current investors will see renewed interest in this innovative company.

More data:

Rackable investor relations page