Rackable Systems Racking Up Profits (RACK)

| About: Rackable Systems (RACK)
This article is now exclusive for PRO subscribers.

Rackable Systems Inc. (Nasdaq: RACK) is a supplier of high caliber servers and storage systems. Servers are basically high-power computers without the frills (no monitors, sound cards, CD-ROMs, etc) and they are used for a variety of computational purposes from powering search engines like Google (NASDAQ:GOOG), handling hard-core computing jobs like running weather pattern models, semiconductor design and oil and gas exploration, among others.

Storage is just that - the vault for storing vast quantities of information associated with the tasks that the servers are running. Rackable makes all of its equipment "open source," meaning that they use industry standard parts like chips from Intel Corp. (NASDAQ:INTC) and Advanced Micro Devices Inc. (NASDAQ:AMD), and disk drives from Seagate Technology (NASDAQ:STX). This strategy is in contrast to other industry players, like Sun Microsystems Inc. (NASDAQ:SUNW) that use proprietary parts that can't be obtained elsewhere.

Basically, this equipment is the plumbing for compute intensive companies in a bunch of different industries, and Rackable has been able to capture key players in many of these industries such as Yahoo Inc. (YHOO) and Microsoft Corp (NASDAQ:MSFT) in internet search, Amazon.com Inc. (NASDAQ:AMZN) in online commerce, Schlumberger (NYSE:SLB) in oil and gas exploration, nVidia (NASDAQ:NVDA) in semiconductor design and Deutsche Bank AG (NYSE:DB) in finance.

Rackable is headquartered in Milpitas, CA and went public June of 2005.

The company has been doing well, delivering growth and performance since they IPO'ed last June. They have also done a rather large secondary offering, the type of thing that can be a make or break for a stock that's young on the markets. Often times, the additional liquidity (read: supply) that a secondary offering puts on the market can tank a stock unless it's on strong footing. Rackable handled the offering with hardly a hiccup.

More to the point, though, is that I think that over the past six months or so, Wall Street and the rest of the investing community have started to catch on to the Rackable story. So look, there are a lot of people that do servers, Dell Inc. (DELL), Hewlett-Packard Co. (NYSE:HPQ) and IBM (NYSE:IBM) are a few of the gorillas in the space and they have the resources behind them to compete and compete agressively. Additionally, in the area of storage, Network Appliance Inc. (NASDAQ:NTAP) basically owns the space. With these monsters well entrenched, the big question is whether a little up-start could compete in an arena like this.

But here's the thing: a server is not just a server any more. There was a time when a server was just a box and one was as good as another. Now, though, as computing needs have gone through the roof and the costs of running a huge data room full of servers and storage boxes, especially for a company like Yahoo, are rising fast, servers need to be optimized for concerns such as physical space conservation, power usage and heat dissipation (when you pack computing processors close together a lot of heat is generated and needs to be dissipated so that it doesn't ruin the equipment). Rackable has patented design features on their servers that do exactly those things, so they provide significant value to their customers over comparable servers from guys like Dell, HP and IBM.

It took the investing community a little bit of time to really sink its teeth into the value proposition and growth prospects for Rackable, but when it did, it did in a big way.

Following on the above, there are a lot of growth drivers for Rackable. As compute intensity increases in any and/or all of the industries that Rackable sells into they stand to gain a greater market share as their value proposition becomes more important. As just one example of many, think about the area of internet search - do you think that next year the same amount of computing power will be able to deliver what Yahoo wants to deliver or what Google wants to deliver? I highly doubt it, and it's Rackable that stands to benefit when they pile more servers into their data rooms.

Another area of growth for Rackable is going to come from industries adopting open source style equipment. Industries such as internet were really the first to adopt open source equipment in a big way and there have been some other sectors that followed closely behind. Some sectors, probably finance most notably, have been much slower to move from proprietary systems to open source systems, but, as in the case of Deutsche Bank, they are starting to make the move. As some of these holdouts move over to open source equipment, it opens up a larger market opportunity for Rackable.

Of course, here's where I have to be a wet blanket. I like the company a lot, but since it went on its bull run it's now trading at over 60x analysts' estimates for 2006. Even with a growth rate of 37%, we're talking about 1.65x PEG ratio. Some people may be comfortable with that, but I'm just not. My take from the valuation standpoint is simply to hold off until the reins get pulled in a little bit. From an operating metrics standpoint, it's a tough industry to be in and margins reflect that. Gross margins are just a bit over 20% and profit margins are below 5%, but the hope is to make up for the low margins with massive volume.

As far as comparables go, it's really tough to say that Dell or HP are true comparables because the server boxes that they sell have very little that's specialized about them, which means that they provide a lot less value and have a lot less "stickiness" with their customers. That said, these two obviously trade at much lower multiples than Rackable does, but this is likely warranted to some extent given the much higher growth rate of Rackable.

All in all, this is a solid company with a good management team that seems to know the industry well and have a good grasp on the competitive landscape. If nothing else, you have to consider the fact that these guys are going up against behemoths like Dell, HP and IBM head to head and winning - not just on price, mind you, on the strength of the product and its features. This is key here because those three have the resources to stomp on someone who is solely trying to compete on price.

The stock is expensive right now, but with any luck that won't last forever. I would easily be a buyer of this as soon as it falls into a more reasonable valuation range.

RACK Price Performance Since IPO