The company's proprietary design allows for greater density of servers as they take less space, which also allows for greater air-flow, resulting in improved thermal management. Other benefits of Rackable System's design are improved remote management, ease of serviceability, and flexible and efficient power distribution.
Rackable's servers (including Foundation Series and Scale Out Series) are based on open standard x86 processors from Advanced Micro Devices (NASDAQ:AMD) and Intel (NASDAQ:INTC) and run on Windows or Linux operating systems. Due to its low cost, the market for x86 servers is the fastest growing part of the server market, expected to grow shipments by 39% between 2006 and 2010, as per market research firm IDC.
Due to the leveraging of continuing price-performance improvements associated with high-volume components, the company has been able to focus its R&D efforts on differentiating the size, energy requirements, and thermal efficiency of its systems. The company also offers a number of storage solutions, including RapidScale storage appliances (acquired from Terrascale Technologies in September 2006) that provide scalable shared storage solutions. In addition, the company uses reseller and original equipment manufacturer [OEM] relationships to provide additional server and storage offerings.
In 2006, servers accounted for 90% of revenues, and storage systems accounted for the remaining 10%. Rackable has sold products to more than 300 customers, including companies with large Internet businesses, as well as customers with high-performance computing requirements in vertical markets such as semiconductor design, enterprise software, federal government, entertainment, financial services, oil and gas exploration, and biotechnology and pharmaceuticals.
To date, virtually all of the company's revenue has come from the United States (91% in 2006); however, the company is working to establish a presence in Ireland (5% in 2006), which should also reduce its effective tax rate, and is focused on growing revenue from China (1% in 2006). Revenue from other regions accounted for the remaining 3% in 2006. Rackable Systems went public in June 2005. Rackable Systems operates in an intensely competitive market, which is characterized by very large competitors controlling large segments of the market.
The company competes against EMC, Hewlett Packard (NYSE:HPQ), Hitachi Data Systems, Ltd., and Network Appliance (NASDAQ:NTAP) in the storage market and IBM (NYSE:IBM), Hewlett-Packard, Dell (NASDAQ:DELL), and Sun Microsystems (SUNW) in the server market. These companies compete for the same customers and control the majority of the server and storage market. Sun's T1000 and T2000 servers, with a significantly smaller footprint and 70 watt power requirement, compete directly with Rackable's offering.
Dell's offering of high-end servers with AMD chips has further intensified competition in the server market. While Rackable had an early lead in the market for high-density, low power servers, we do not believe they hold a sustainable competitive advantage as the greater resources of Dell and HP have caught up with Rackable. Initial signs of trouble surfaced during the fourth quarter of 2006, when increasing price competition cost the company about two points of gross margin, or close to $2 million, as it was forced to revise contract terms with one of its top three customers in order to keep the business.
Conditions worsened in the first quarter of 2007, when gross margin fell to 12.5%. This exemplifies the risks of Rackable's business model in that there is little differentiation in industry standard-based servers. Memory shortages in the second half of 2006 also took a toll on the company as AMD shifted from DDR memory to DDR2, causing the company to pay more than anticipated for memory. This is expected to reverse itself in coming quarters.
Rackable's servers are based on open standard x86 processors from Advanced Micro Devices and Intel (INTC). According to Gartner's 2006 worldwide server report, the server market continued to grow at a healthy rate, with blade servers and x86 showing the greatest strength while RISC continues to decline. Although server shipments totaled 8.2 million, an increase of 8.9% from 2005, overall revenue within the server market was nearly flat year-over-year. In 2006, server revenue totaled $52.7 billion, an increase of only 2% from 2005.
By comparison, Rackable generated $360.4 million in revenue for the year, or less than one percent of the overall market. According to Gartner, the x86 server market slowed down in the fourth quarter of 2006 due to the market transition to multicore (quad-core) processors and demand for virtualization, a technology that allows a server to run multiple operating systems and software applications simultaneously. Both technologies give servers more computing power, thereby reducing demand for new servers. This was further supported by recent IDC research findings, which concluded that increasingly popular alternatives to conventional x86 architectures are having a negative impact on server shipments.
We believe that the trend towards virtualized servers will accelerate as multi-core technology develops into a greater number of cores, giving a single processor the ability to run an increasing number of simultaneous tasks. As such, IDC forecasts that worldwide unit demand for x86 servers will grow by just 39% between 2006 and 2010, down from an earlier forecast of 61%. This means a loss of 4.5 million unit in shipment and $2.4 billion in revenue from the forecast for the years 2006 to 2010. IDC expects the X86 market to grow its unit market share to 94% in 2011 from 93% in 2006. Based on revenue, the x86 enjoyed 50% market share in 2006, which is expected to grow to 56% by 2011.
Although Rackable had a lead on high density, low power servers, the competition has caught up. We believe that this market is less of a niche and will be the trend going forward, as enterprises seek to reduce power requirements of their datacenters. As the market grows, it will become increasingly competitive. We do not believe that Rackable's servers contain enough proprietary technology to insulate them from price competition, and as a result, the company has had to cut prices in order to maintain volumes. Moreover, Rackable is at a disadvantage with its small size as it will have to continue a high level of R&D investment in an attempt to differentiate itself.
During 2006, the company significantly increased its R&D expenses, which were up 507.3% over 2005. Moreover, to support additional growth, the company increased its sales force. As a result, selling and marketing activities as well as general and administrative expenses increased. All this caused operating margin to fall to 3.2% in 2006 from 11.0% in 2005. With a concentrated customer base, including 52% of revenue from its top three customers, and 80% of revenue from its top 10 customers, Rackable can't afford to lose a customer. As a result, it has been meeting matching competitors on price.
On a positive note, RACK's direct sales model has helped drive sales in the Internet vertical. The company currently has nine active customers out of the top 20 Internet sites in the United States, with Yahoo! (NASDAQ:YHOO), Amazon (NASDAQ:AMZN), and Microsoft (NASDAQ:MSFT) as its top three customers. We believe there are numerous opportunities in other verticals, such as financial services and other data intensive operations, which at this point are virtually untouched as nearly 84% of revenue came from Internet companies in the third quarter.
For fiscal 2006, Microsoft and Yahoo! accounted for approximately 34% and 26% of revenues, respectively. The company believes that its RapidScale storage product can reach $20 million in revenue with 60% gross margins in 2007. In order for Rackable to turn the corner, we believe that RapidScale will need to be successful.
Finally, the company has replaced its CEO with industry veteran Mark Barrenechea. Although a change in direction for the company could be positive, much of its troubles are currently coming from the competitive dynamics of the industry. Once Mr. Barrenechea unveils a strategic direction for the company, we will have better visibility as to when a potential turnaround could occur.
INDUSTRY OUTLOOK- NEUTRAL
The outlook for the Computer Hardware industry is Neutral relative to the S&P 500. While we had been cautious on the sector pending implementation of Financial Accounting Standard No. 123R, also know as FASB 123R, requiring that companies expense employee stock options. Companies with a June fiscal year-end began to report results including the impact of options in the September 2005 quarter.
Thus far, the impact of reduced earnings on a Generally Accepted Accounting Principals [GAAP] basis has appeared to be minimal, reassuring us that once all companies begin complying with FASB 123R during 2006 that the impact on stock prices will be minimal. Although enterprise spending has rebounded modestly during 2004 and 2005, we have yet to see a significant acceleration in spending on Information Technology by large enterprise customers.
We believe that while Chief Information Officers [CIOs] have increased spending in order to keep up with requirements of the business, most are still in the cost savings mode that has existed over the past five years. As confidence in the economy increases, we believe that this mentality will gradually shift from one of cost savings to increasing efficiencies. As this mentality changes, we expect to see increased spending on new technologies, such as Voice over Internet Protocol [VoIP], and an overall acceleration in growth industry wide.
Offsetting our optimism on the future of enterprise spending are concerns about consumer spending. Rising interest rates and a potentially slowing housing market have taken a toll on consumer spending of technology products, leading to disappointing results from companies with consumer exposure. We therefore look to companies with new technologies and mostly enterprise exposure for out-performance in 2006, while other industry participants languish in a still lukewarm environment.
The global market for servers was $52.7 billion in 2006 with top 5 vendors accounting for 85% of this. By comparison, Rackable generated approximately $360 million in revenue for the year, or less than one percent of the overall market. The company serves a niche market for customers that have intensive data requirements as its products use a much smaller footprint than competing products.
On June 5, 2007, Rackable Systems announced the transfer of Gautham Sastri from the post of chief operating officer to the executive vice president of its RapidScale unit. On April 30th, Rackable Systems announced that Mark J Barrenechea would replace Tom Barton as Chief Executive Officer in an effort to turn around the company's recent results. Mr. Barrenechea has 20 years experience in the technology field and has served in senior operating and managing roles at Oracle (NYSE:ORCL) and CA (NASDAQ:CA).
On May 9, 2007, Rackable Systems announced that its DC powered servers had been deployed by RightNow Technologies, a provider of on demand Customer Relationship Management [CRM] solutions, to power its hosted enterprise solutions in the company's Chicago data center.
Settlement of Patent Infringement
On May 8, 2007, Rackable Systems announced the settlement of a lawsuit filed against Super Micro Computer in September 2005 for the infringement of two of its United States patents, U.S. Patent No. 6,496,366 and U.S. Patent 6,850,408. This follows an April 25th order regarding pending summary judgment issue that among other things, awarded Rackable Systems summary adjudication on the enforcement of its 366 patent, ruling that there was no inequitable conduct in patent prosecution as alleged by Super Micro. Terms of the settlement were confidential.
On April 26th, Rackable Systems announced results for the first quarter of 2007, ended March 31, 2007. Total revenue for the quarter was $72.0 million, down 14.7% from the $84.4 million reported in the first quarter of 2006. Gross margin slipped to 12.5% in the quarter, down from 23.1% in the year-ago quarter and 18.8% in the previous quarter. Operating expenses for the quarter were $26.9 million, compared to $10.2 million in the year-ago quarter and $21.6 million in the previous quarter. The increase in operating expenses was driven by a $4.1 million increase in general and administrative expenses, due to increased professional services expenses.
As a result of falling margins, net income in the quarter was a loss of $10.2 million, or $0.36 per share. Excluding a tax benefit and including stock based compensation, ESP were -$0.41, compared to $0.24 in the year-ago period and $0.04 in the previous quarter. Cash flow from operations was $10.4 million in the quarter and cash & equivalents was $170 million, compared to $160 million at the beginning of the quarter.
As the company had previously stated, intense price competition in its top three accounts were the reason for falling gross margins. Pricing at its remaining customers was comparable to historical levels. During the quarter, RACK's top three customers accounted for 52% of revenue and its top 10 customers accounted for 80% of revenue. For the second quarter, the company is expecting revenues in the $75 million to $85 million range, with some improvement in gross margin due to favorable DRAM pricing.
Shares of Rackable Systems are currently trading near their 52-week low price. With our forecast for a loss in 2007 and minimal profits in 2008, we shift our valuation methodology to a P/S metric. The company currently trades at 1.0 times our 2007 revenue estimate. Although this is not an expensive valuation, struggling technology companies can trade at a discount of 25% to 50% of sales.
Rackable continues to compete in an aggressive environment with stiff competition from market giants, Dell and HP, forcing management to lower its gross margin and operating income guidance for the first quarter of 2007. We believe this is a permanent situation as the market for low-power servers has grown in size and is now more attractive for large players.
Although we believe the market for high-density low-power servers will continue to demonstrate strong growth over the next five years, it will be very difficult for RACK to benefit from this growth. In order for the company to regain improved profitability, the company will need to be successful with higher-margin storage initiatives. We therefore maintain a Sell rating and a price target of $9.50 on RACK shares, representing a P/S multiple of 0.76x our revenue estimate of $362 million for 2007.
Due to the market transition to multicore processors and demand for virtualization, the server market, including the market for industry standard servers, appears to be slowing. The global market for servers was $52.7 billion in 2006 with top 5 vendors accounting for 85% of this. By comparison, Rackable generated approximately $360 million in revenue for the year, or less than one percent of the overall market, leaving it at a disadvantage. Increased competition from Dell and HP eroded Rackable's margins in the fourth quarter of 2006. Management has further lowered its gross margin by 30% from the previous forecast for the first quarter of 2007 citing intense competition at its largest customers. Margins are expected to continue to decline in 2007. During the fourth quarter of 2006, competition forced RACK to revise contract terms with one of its top three customers in order to keep the business. Price competition intensified in the first quarter of 2007, when gross margin slipped to 12.5%. Rackable derives a large portion of its revenue from a limited number of customers. Microsoft and Yahoo! accounted for approximately 34% and 26% of 2006 revenues.
INSIDER TRADING AND OWNERSHIP
Institutional holders own approximately 96% of shares outstanding. Top holders include Maverick Capital Ltd., Waddell & Reed Financial Inc., Wells Fargo & Company, and Artis Capital Management, holding 9.8%, 6.7%, 6.0%, and 5.4% of shares outstanding, respectively. Net institutional sales were 8,219,360 shares in the previous quarter. Insiders own about 4% of shares outstanding and have sold approximately 114,135 shares over the past six months. The short interest ratio is around 2 days, which we do not consider meaningful.
Rackable Systems, Inc. is a leading provider of high-density compute servers and high-capacity storage systems, based on x86 processors. According to Gartner, the x86 server markets slowed down in the fourth quarter of 2006 due to the market transition to multi-core (quad-core) processors and demand for virtualisation. IDC forecasts that worldwide unit demand for x86 servers will grow by just 39% between 2006 and 2010, down from an earlier forecast of 61%. The global market for servers was $52.7 billion in 2006 with top 5 vendors accounting for 85% of this. By comparison, Rackable generated approximately $360 million in revenue for the year, or less than one percent of the overall market. RACK faces stiff competition from Dell and HP who could sacrifice profit for market share. As seen in the fourth quarter of 2006, increased competition placed significant pressure on Rackable s margins, which fell to 12.5% in the most recent quarter. Management attributes this to competition for its three largest customers where it has been forced to cut prices in order to continue to sell into the three. Rackable derives a large portion of its revenue from a limited number of customers, weakening its competitive position.
After having the market for high-density, low-power, servers to itself, larger competitors have entered the market where Rackable Systems competes. Industry leaders, such as Sun and Dell, have much greater resources than Rackable and have competed aggressively on price. As a result, Rackable has had to cut prices to its largest customers, which accounts for 52% of revenue. Until Rackable can get a meaningful contribution from higher margin storage products, we believe the company will struggle. We therefore maintain a Sell rating and our six month target price of $9.50.
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