Rackable Systems: Should Be a Bumpy Ride

| About: Rackable Systems (RACK)

In my report dated November 6, I indicated that visibility might not be improving at Rackable Systems (RACK). Instead, storm clouds may be gathering.

After a dismal third quarter that was a disappointment to every bullish analyst, the Company has promised big sales increases for Q4 and 2007.

Margins, however, will remain a challenge. RACK is competing for the top tier of Internet companies for the bulk of their business. These sales are becoming increasingly competitive as the “Rackable Advantage” in the low-end server/storage market continues to evaporate.

The Company has blamed a large portion of margin pressures on the yearlong effort to expand its sales force. Analysts were assured that this effort was completed in Q3 and the benefits would be seen in Q4, 2007 and beyond. The new sales force had “hit the ground running,” according to CEO Tom Barton.

This week, the first storm hit as VP of sales Tom Gallivan inexplicably resigned. Neither he nor the Company could give any reason for the resignation. Gallavin’s employment agreement allows for him to receive $171,000 severance and he must grant a full release to any claims against the Company.

But Gallivan is walking away from much more. He received $294,866 in commission/bonus in 2005. With the “blockbuster” quarter coming up, one would assume that he would have been getting an even larger bonus in 2006 (but he left on December 11). It also appears from the most recent filings that Gallivan will be forfeiting over $120,000, in mostly low priced shares/options.

Clearly this was not of the Company’s making as no replacement is waiting in the wings. Before joining the Company in 2002, Gallivan was Director of Sales at Sun Microsystems (NASDAQ:SUNW) so he was certainly qualified.

I suspect that Gallivan had some problem within the Company unrelated to his sales position that forced his resignation. I doubt he would have left just before bonus time for problems related to sales or personal reasons. If forced out, I would expect he would have gotten better severance and possibly some option vesting.

RACK traded down to about $30 on the news. It had been consolidating at $32-33 support after peaking recently at $37-38. A 50% retracement of gains since August would be at $27-28, another area of good support. With options expiring Friday, I think the stock stays around $30, but could weaken more next week.

I would consider a short-term trade at $28.

Longer term, I think that the storm clouds are still gathering, as margins will remain a problem.

For those that care about stock-based compensation expense, GAAP earnings at RACK will be an even bigger problem in Q4 and 2007. According to the Q3 filing, the Company has $38.9MM in compensation charges to be expensed over the next 1.6 years. That should just about negate the high end of earnings projections.

Most of the Street will, of course, focus on non-GAAP numbers.

RACK 1-yr chart:

RACK 1-yr chart

Disclosure: the author currently has no position in RACK or any other stocks mentioned.