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Executives

Mark Paisley - Senior Director, Investor Relations

Mark Barrenechea - President and Chief Executive Officer

Jim Wheat - Chief Financial Officer

Rackable Systems, Inc. (RACK) Q1 2009 Earnings Call May 5, 2009 5:00 AM ET

Operator

Good afternoon. And thank you for joining us on today's conference call to discuss Rackable Systems First Quarter Fiscal 2009 Earnings Results. I would like to remind you that this call is being recorded and simultaneously webcast at investors.rackable.com.

At this time, I would like to turn the call over to Mr. Mark Paisley for opening remarks and introductions. Mr. Paisley, please go ahead.

Mark Paisley

Good afternoon and thank you for joining us to discuss our first quarter FY 2009 earnings press release of this afternoon, which is available on our website investors.rackable.com. I'm Mark Paisley, Senior Director of Investor Relations for Rackable Systems, and I'll be managing the call.

Joining me on the call today are Mark Barrenechea, our President and Chief Executive Officer; and Jim Wheat, our Chief Financial Officer.

Before I turn the call over to Mark, I'd like to bring the following to your attention. The date of this call is May 5th, 2009. This call is the property of Rackable Systems, any recording, reproduction or transmission of this conference call without the expressed prior written consent of Rackable Systems is strictly prohibited. This call is being webcast live and a web replay will be available on our website for approximately 90 days.

Our presentation today contains forward-looking statements reflecting management's expectations about our markets, business, products, operating plans, general business outlook, financial performance and anticipated acquisition of substantially all the assets of Silicon Graphics Inc. or SGI, as well as events and circumstances that have not yet occurred.

Statements containing words such as will, expect, believe, project and intend and other statements in the future tense are forward-looking statements. Any statements contained in this press release that are not statements of historical fact may be deemed forward-looking statements.

Actual outcomes and results may differ materially from the expectations expressed or implied in these statements, due to a number of risks and uncertainties, including the risk that conditions to closing of the acquisition of the SGI assets may fail; liabilities assumed by Rackable in the acquisition of SGI assets may be greater than anticipated; key personnel may not remain with Rackable following the closing of SGI Asset acquisition; the anticipated synergies from the acquisition SGI assets, and the potential cost reductions may not be achieved; the combined operations may not be successfully integrated in a timely manner, if at all and the economic conditions impacting the purchasing decisions of Rackable Systems' customers.

Rackable Systems operates in a very competitive market and increased competition as in the past, that may continue to cost pricing pressure on Rackable Systems product which would negatively affect Rackable Systems gross and operating margins as well as of the financial measures and a significant portion of company's revenues come from a small number of customers. And so the delay in placing order or the failure of significant customer to place additional orders could have a significant negative impact on Rackable Systems financial performance.

Accordingly, we caution you not to place undue reliance on these statements. These and other risks and uncertainties affecting Rackable Systems are set forth in our annual report on Form 10-K under the caption Risk Factors, which is filed with the Securities and Exchange Commission on March 19, 2009 as updated by Rackable Systems' subsequent filings with the SEC, all of which are available at www.sec.gov.

We expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.

We will be disclosing non-GAAP financial measures in this presentation. For a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures, please see our press release of today, which is posted on our website at investors.rackable.com.

I'll now turn the call over to Rackable Systems' CEO, Mark Barrenechea.

Mark Barrenechea

Thank you, Mark and thank you everyone for joining us. Today I'll provide an overview of our fiscal year 2009 Q1 results as well as market conditions.

Jim will into the details on the quarter and I'll spend the balance of the time on our pending purchase of Silicon Graphics assets. Although we were pleased with our sequential revenue growth of 14% quarter-over-quarter and our working capital performance resulting in increased cash and decreased inventory in a difficult market, we are less satisfied with our gross margin and overall performance.

I do want to go back to comments I made on our last earnings call as it relates to the economy and business environment. We continue to be in a deflationary economy, supply chain challenges are increasing as suppliers take less inventory risk, resulting in increase in lead times.

And lastly, component pricing volatility remains high. Further, customer CapEx spending continues to be slow and in some cases contracted. We continue to see this contraction in parts of our customer base and expect the volatility to continue as our customers continue to work through their 2009 operating budgets.

Having said that we do see an increase in Q3 on RP activity though it is too early to tell if that will turn into increased bookings and revenue. Nonetheless the increase in RP activity is encouraging to us.

Our first quarter FY'09 revenue was 44.4 million. Non-GAAP first margin was 6.3%. Pending cash and investments balance increased to approximately a 181 million. Revenue for the first quarter increased sequentially 14% over Q4 FY'08.

Year-over-year revenue for the first quarter decreased 35%. Revenues for our storage and service businesses increased sequentially over Q4 FY'08 by a 164% and 29% respectively.

As the gross margin, I'd like to discuss how we were negatively impacted by three factors and how we are responding to them. First, we carried inventories purchased pre-September crisis of last year at higher prices relative to current market prices.

We needed to discount these inventories to correct market prices to remain competitive. We will work through the remaining higher price inventories this quarter.

Secondly, customer concentration. While we remain 100% committed to the internet data center market, gross margins are under enormous pressure in this segment. Our customer concentration risk will be addressed with our pending purchase of Silicon Graphics assets.

And lastly, we experienced increased competitive pressures from larger supplier offering aggressive bundled deals in Q1. We intend to address this with our new and expanding product and service portfolios. Post our expected integration of Silicon Graphics assets, we expect to stabilize our non-GAAP gross margins in the 20. As I discussed last quarter, Rackable is executing in a strong R&D cycle and continues to set the industry standard in delivering power efficient servers and the smallest possible footprint.

During the quarter, we introduced the CloudRack C2, the unified cabinet that combines extreme densities with break-through energy efficiency for cluster computing and storage.

In an environment, where the cost of power threatens to exceed the cost of hardware, CloudRack C2 delivers dramatic bottom-line savings with power exceed by eliminating stranded power, which is a data center's power capability paid for but ultimately unused.

It assures maximum power usage, growing efficiency and extreme sever densities with near 1300 cores per cabinet. CloudRack C2 capitalized is an ultra efficient, rack centric, ecological design.

In addition, we announced full support of Intel Xeon processor, 5500 Nehalem series in more than 30 of our server configurations. We also delivered two ICE Cube modular data centers last quarter.

Finally, we announced last week an expansion of the army storage stores product series, which provides flexible, reliable and cost effective external storage expansion for wide range of performance and capacity oriented storage environment.

The new SC 2024, SC 2124 and SC 3116 delivers a period performance with industry leading densities and are designed to add performance and storage capability to any Rackable server. Target markets include storage agnostic bulk storage, high performance databases and video storage and streaming.

I'd now like to turn the call over to Jim to comment on our quarterly performance and then I will be back to a final update on Silicon Graphics assets. Jim?

Jim Wheat

Thank you, Mark. Before I begin, please let me add to what Mark said earlier about our use of non-GAAP financial measures. Our non-GAAP financial measures appear in our press release issued today along with the required reconciliation table.

In this call, I will be discussing earnings, gross margin, operating expenses and some other items on a non-GAAP basis, which are reconciled in those tables. If an item is not specified as non-GAAP, then I'm referring to a GAAP number in my remark.

As Mark said earlier, for a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures, please see our press release of today, which is posted on our website at investors.rackable.com.

Our revenue for the first quarter came in at 44.4 million, compared to 67.8 million in the year ago quarter. This was primarily driven by a seasonally weak Q1, continued turmoil in the economy, reduced IT budgets, greater competition and general uncertainty.

Sequentially, first quarter revenue increased 14% due to the strong performance of two of our key customers. In addition, we recognized revenue for more than 25 new customers in the first quarter, including myYearbook.com, the third largest social network in the U.S., which adopted Rackable Systems, data center, service solution to support its fast growing web infrastructure.

Among our 10% customers in the first quarter, were Amazon and Microsoft. Internet and financial vertical markets represented 72% and 13% of total revenue for the first quarter of FY '09 respectively. From a growth perspective, the internet and telco vertical markets revenue increased sequentially over Q4 FY '08 by 89% and 35% respectively.

First quarter international revenue represented 18% of total company revenue. International revenues increased 130% over Q4 FY '08 and 60% on a year-over-year basis.

Storage revenue for the first quarter represented 25% of total company revenue. Our storage was up sequentially 164% while year-over-year sales decreased 11%. Our service business grew sequentially by 29% and year-over-year by 20%.

Our customers are more eager for additional services with the acquisition of Silicon Graphics' assets; we will be able to offer a greater range of global services.

Gross margin for the first fiscal quarter of 2009 was 6.1% compared to 25.9% in the year ago quarter. Non-GAAP gross margin for the first quarter of 2009 was 6.3% compared to 26.4% in the year ago quarter. Mark addressed gross margin in his opening remarks.

In the first quarter, R&D expense was 3.2 million, compared to 3.5 million in the year ago quarter. Sales and marketing expense was 4.2 million, compared to 6.4 million in the year ago quarter. G&A was 9 million, compared to 7 million in the year ago quarter. G&A expenses in Q1 FY '09 include approximately $3.5 million of acquisition related charges. We expect additional acquisition related charges during the second quarter as well. Not including these acquisition related charges in the first quarter, G&A decreased 22% on a year-over-year basis.

First quarter total operating expenses were 16.4 million, compared to 16.9 million in the year ago quarter, essentially flat. Non-GAAP operating expenses were 14.8 million, which excludes 1.6 million of stock based compensation charges compared to 13.9 million in the year ago quarter.

Total non-GAAP operating expenses, not including both acquisition related charges and stock-based compensation charges totaled 11.3 million representing a 19% decrease versus a year ago. During the first quarter, we had what we viewed as excellent cash and working capital management. Our accounts receivable decreased by 13 million due to solid collection and we continued to de-risk our business, by decreasing accounts payable by 9 million. We also lowered inventory levels by 12 million. We continue to run leaner and more efficiently.

Q1 FY '09 operating loss was 13.7 million, compared to operating profit of 0.7 million in the year ago quarter. Non-GAAP loss from operations was 12 million, compared to non-GAAP operating profit of 3.9 million in the year ago quarter. We reported a Q1 net loss of 13.6 million compared to net income of 2.6 million in the year ago quarter.

Non-GAAP net loss was 7.2 million compared to non-GAAP net income of 3.5 million in the year ago quarter. Q1 net loss was $0.46 per share compared to net income per share of $0.09 in the year ago quarter. Non-GAAP net loss was $0.24 per share for the first quarter of 2009 compared to a non-GAAP net income of $0.12 per share in the year ago quarter.

At the end of the first fiscal quarter, total employee head count was 276, down 42 employees sequentially and 72 versus a year ago. The year-over-year decrease can primarily be attributed to streamlining actions we discussed in our prior earnings call.

As for the balance sheet, total cash, cash equivalents and investments increased during the first quarter to 181.2 million, an increase of over $0.5 million when compared with the Q4 fiscal '08 quarter.

I would like to take a moment to highlight a few financially related topics in connection with our acquisition of Silicon Graphics assets. First, reporting related to the SGI assets we expect to acquire will be consistent with Rackable's reporting on an annual calendar basis. And since the closing of the transaction is expected to occur in the middle of this quarter, we expect to begin having a business impact from the acquired Silicon Graphics assets during our second quarter.

Finally, we will be among the first companies to have implemented FAS 141R which governs the accounting for business combination. Among other things, this will result in the majority of transactions cost to be expensed in the period incurred.

In addition, we expect a significant amount of deferred revenue associated with SGI's existing agreement to go away under FAS 141R.

Now, I will turn the call back over to Mark.

Mark Barrenechea

Thank you Jim. On the Silicone Graphics. As announced, last week we received court approval to acquire substantially all the assets of Silicon Graphics for 42.5 million in cash plus the assumption of certain liabilities associated with the acquired assets.

The increased purchase price was a result of the auction process approved by the bankruptcy court in New York. Of course approval allows Rackable to complete the transaction under Section 363 of the U.S. Bankruptcy code under the terms of the amended asset purchase agreement between Rackable and SGI.

We anticipate closing the transaction within the next few days, subject to closing conditions in the agreement. Let me provide more detail on the acquired assets. Internationally, on the agreement, we would purchase the equity of the SGI operating subsidiaries. We would also purchase the equity of SGI's U.S. federal business. Essentially, it is SGI's domestic non-federal U.S. business entities that are going through the bankruptcy process.

Further, important assets that we would acquire include receivables, inventory, real estate, fixed assets and core patents.

Lastly, we would also acquire all other remaining cash on hand and the entities specified in agreement at the time of closing. Thus, once the transaction closes, our business will become immediately operational in over 25 countries, including the U.S., Canada, Brazil, UK, Germany, France, Spain, Italy, Eastern Europe, Israel, Japan, China, Australia, India and Korea. Just to highlight the larger I.T markets, this would result in an installed base of over 5,000 customers.

As for assumed liabilities, under the agreement, we would not be assuming Silicon Graphics approximate $150 million of secured debt. We would be assuming certain and select liabilities associated with the operations of the business under the agreement, which would include but are not limited to employee TTL benefits, accounts payables, potential tax liabilities, the majority of the existing supplier service contracts as well as future warranties.

We expect to streamline operations and eliminate redundant positions, resulting in an initial 10% reduction in personnel. We anticipate a global workforce of approximately 1,250 employees soon after closing.

As for synergies, we are focused primarily on expanse related contribution. Revenue synergies are in our upside case, not our base case. As for expense related synergies, we expect to see greater materials purchasing leverage, reduced manufacturing expense, the above mentioned reduction in personnel, combining and eliminating our facilities, overlapping administrative and professional and public company related costs.

Lastly, we expect to institute a reduction in cash compensation across the company. As the economy improves, and company generates a profit, we expect to return cash compensation to normalized levels. We believe that these combined actions were result in accelerated time to synergies and profitability.

The economy remains uncertain, customer spending unpredictable. Because the timing of the transaction, we expect only a partial impact on our results in Q2 from the SGI acquisition. As Jim said before, we'll be one of the first companies implementing the new purchase accounting rules. Given these combined factors, we would not be making any financial projections for our second quarter or full fiscal year 2009. For internal purposes, the company is currently planning on fiscal year 2010, non-GAAP revenues of 500 million USD and non-GAAP gross margin in the twenties.

We believe that completing the Silicon Graphics' assets acquisition will expand the markets and geographies we serve and thus accelerate the diversification of our revenue, expand our gross margin profile, allow us broaden to hardware, software and service offerings we can provide to our 5000 customer installed base.

As I said last quarter, it is in times like this that those that can invest, do invest in order to be in stronger competitive position when the economy recovers. This is the approach Rackable continues to take.

Now, I'd like to turn the call back over to Mark.

Mark Paisley

Thanks Mark. We are now ready to begin the Q&A portion of the call. Operator, let's go to our first question.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And at this time we have no questions from the phone lines.

Mark Paisley

All right. With no further questions, that completes the Q&A portion of the call. Please join us at the UBS Global Technology and Services Conference being held in New York. Our CEO Mark Barrenechea will be presenting on June 8, 2009. Please check our website at investors.rackable.com for further details.

Thank you for your attention this afternoon and participation. That ends today's call.

Operator

This does conclude teleconference. Thank you for your participation.

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