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In the music business they are known as “One Hit Wonders”; artists that have a big hit and then are never heard from again.

I have been warning for months of the problems at Rackable Systems (RACK) regarding margin pressure, increased competition and insider sales. After a depressing Q4 conference call, I think we can add poor management execution and cascading street credibility to the problems at RACK.

While sales for the quarter were within guidance, earnings disappeared as gross margins dropped to19.8% vs. their 23-24% estimate in October. The Company blamed the margin miss on the following:

1. A spike in DDR1 pricing of 20-30% in the quarter that could not be passed through on existing contracts. They responded to this problem by buying over $51MM in DDR1 inventory at peak 2006 prices.

2. A “back-end loaded” quarter where 74% of revenue was generated in December. This was blamed on not having the needed power supplies to fill orders that resulted in overtime, freight and added contractor expense.

3. Soft sales of their RapidScale storage servers. The company is apparently having trouble entering the high margin storage business that is dominated by EMC (EMC), Network Appliance (NTAP), Sun (SUNW), Hitachi and IBM (IBM).

4. Cutthroat discounting by competitors like Dell (DELL), IBM and HP (HPQ) caused one large customer to demand a reduction in an existing contract to match competitor pricing.

Investors responded by sending RACK to a new 52-week low.

I have indicated the competitive problems RACK would face in what is now becoming a commodity business for low-end X-86 servers. Two years ago, RACK was one of the first vendors to offer servers with AMD chips and Linux operating systems. Meanwhile, the major vendors were still trying to push their legacy systems with proprietary software. This gave RACK an edge with the companies looking for an open-source solution for their server farms. The X-86 servers also offered a much lower TOC (total cost of ownership) to the Internet customer that accounts for over 85% of Rack’s business.

Fast-forward to today and everyone has X-86 servers. RACK has only a slight advantage in TOC. Competitors negate this by lowering prices to gain a footprint in key accounts. The large manufacturers get better pricing (possibly under the table) and faster delivery times from chipmakers and other suppliers. They are more experienced in materials planning and inventory control. They also sell high margin products and profitable service contracts. They control their own manufacturing and can more easily absorb the low margin business that helps to cover fixed costs. RACK contracts most of its manufacturing, has no service business and is essentially a “one trick pony”.

The large Q4 discount apparently came from Yahoo. RACK has now set a very dangerous precedent with other customers by allowing this contract to be discounted. The Microsoft (MSFT) account could be next. Unlike RACK, DELL and HP are also huge software customers of MSFT and could really pressure them for their server business. Also, it is probably only a matter of time before another large account, YouTube, transitions to Google servers. The Company has made no allowances for lost customers in 2007.

As the Company struggles, management has decided to forego quarterly guidance in future calls. This is very disturbing, especially for a technology stock in a market that focuses so heavily on quarterly results. Equally disturbing is the fact that the Company refused to speak with analysts after their January 17 pre-announcement that shocked the street. Management has clearly alienated the investment community.

Revenue for Q4 was $106MM and was back-end loaded with 74% of sales in December. Q1 sales guidance was $70-75MM and one has to wonder if they didn’t move some January 2007orders up to make their revenue number in Q4. If they do $75MM in Q1 revenue, 6-month sales will average $90MM. Full year 2006 sales were $360MM, an average of $90MM. In other words, sales at RACK are essentially flat. Management blames the dismal Q1 guidance on “normal seasonality”. However, there was no such seasonality in Q1 of this year when the Company achieved record revenues of $84.4MM. Gross margins declined to 18.8% from 24.9% in 2005. Margins have now declined for five consecutive quarters and are projected to decline even more in 2007. Management warned of potential write-offs if the DDR1 inventory can’t be consumed before customers transition to DDR2 memory. DDR1 memory is being phased out, for DDR2, in the new X-86 offerings from Intel and AMD.

Sales are now projected to be $450-525MM. After $75MM in Q1 revenue, sales will have to average $140MM to achieve even the mid-point of sales guidance for 2007.

Management claims they are “striving” to sell their higher margin servers, but high-end server sales were only $1MM in Q4. RACK’s Scaled Out Series, introduced in 2004 as an alternative to “blade” servers, is simply not selling. Storage sales were about $6MM, but mostly low-end product. The high margin RapidScale storage line is off to a slow start as customers evaluate the product and have delayed orders. Hopefully, their failure in the high-end server market is not indicative of their future success in high-end storage. At this point, literally 99% of RACK’s business is low-end, low margin product in the most competitive of accounts.

Stock based compensation charges in 2006 totaled $20.8MM as management continued to be lavished with $0 cost stock, exercise pre-IPO options and dump their shares. It seems like more than adequate compensation for the worst performing stock in the Russell 3000. In its short life as a public company, insiders and management have sold over $450MM worth of stock. When you include IPO proceeds that made direct payments and preferred stock redemptions, the total is about $500MM, more than today’s entire market cap. The Investment Bankers facilitated most of these sales (thus avoiding Rule 144 restrictions) and collected some very handsome fees. Following the $12 IPO in June 2005 where insiders received about 35% of the proceeds, bankers allowed insiders to sell 5.4MM shares (or 68%) of the December 2005 secondary at $19. They followed up in March 2006 allowing sales of 4.2MM shares (or 56%) at $38. Now, CEO Barton won’t even take their calls.

Since the conference call, RACK has seen two additional downgrades. The stock could see continued pressure back to the $12 IPO price as frustrated analysts and investors throw in the towel.

Rackable Systems brings to mind the “One Hit Wonder” the Baha Men, and their aptly titled tune: Who Let the Dogs Out?

Disclosure: The author currently has no position in RACK or any other stocks mentioned in this report.

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Source: Rackable Systems: A One Hit Wonder?