Friday, February 02, 2007

Color on earnings: Rackable Systems (NASDAQ:RACK)

Several firms commenting Rackable Systems (NASDAQ:RACK) after co offered cloudy outlook for 1Q/FY 2007.

- First Albany believes RACK is facing a perfect storm of intensifying competition that has yet to play out. With the recent deceleration of the U.S. x86 unit growth to negative territory, Rackable's large size deals are easy targets for other OEMs desperately seeking growth and revenues to leverage fixed costs; unfortunately, Rackable cannot effectively retaliate against their predatory tactics, given its limited customer reach and product breadth. The company's increasingly undifferentiated products and large customers' inordinate pricing power further contribute to the pressure on margins.

Reiterates Underperform rating.

- RBC lowers their estimated upside FTM P/E to 30x (was 35x) but kept their downside P/E assumption of 20x due to net cash per diluted share of ~$5.45. Rackable is currently trading at 25x firm's current FY07 estimates, but after-hours trading levels suggest downward pressure on this multiple. Accordingly, in the near term firm believes the stock will reflect the potential for further downside execution relative to Street consensus.

Firm lowers 12-month price target to $25 (was $30) given the reduced long term operating targets and the recent volatility in quarterly execution. They now assume a probable, though not certain, FTM price downside/upside scenario of $15/$35 (was $15/ $40) on execution below/above their new estimates. Firm continues to rate the shares Outperform with a Speculative risk assessment on a 12-month basis, given the potential return-to-target and upside/downside profile.

- Thomas Weisel notes that Very poor execution shakes confidence in Rackable story somewhat, but strong growth potential still exists and all the bad news seems to be out there. The stock is expected to be range-bound, until evidence of improvement emerges, but current valuation appears to be assuming a lot of bad news, thus, the current level appears to be a good entry point for patient investors.

Issue No. 1 - the gross margin shortfall: Four major factors negatively affected gross margin: 1) 170bp shortfall due to DRAM procurement issues; 2) 120bp hit due to predatory pricing on one major deal; 3) 60bp hit due to slippage of a 1mn high-margin storage deal and 4) 30bp due to supply chain mis-management. The good news is that most of the issues are short term in nature, and even the predatory pricing seems unsustainable.

* Issue No. 2 - reducing guidance: Three major factors here: 1) the DRAM issue will also affect 1Q07; 2) more aggressive pricing is now being assumed throughout 2007 and 3) no large new deals are expected in 1Q07, which means seasonality hits and revenue are expected to be well below consensus.

* The good news: Management is still extremely confident in its ability to deliver more than $500mn in revenue for 2007, although it is lowering the bottom of its range to reflect a slower start to the year and risk of further slippage. In addition, new margin guidance of 18-22% assumes a lot of worse-case developments, thus, there is a strong possibility that new consensus EPS estimates will undershoot their true potential.

Notablecalls: RACK looks like a low downside/high upside/very high risk investment. One for longer term investors that can stomach volatility. As for the s-t, stock will probably stay range-bound for a while, as the confidence has really gotten hit. It will take time and hard evidence for the mkt to get more positive on the stock.

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