Thursday, April 05, 2007

Color on quarter: Rackable Systems (NASDAQ:RACK)

Couple of firms comment on Rackable Systems (NASDAQ:RACK) after the co reaffirmed its Q1 revenue guidance but said gross margin will be way below previous outlook:

- RBC Capital notes Rackable cited intense competition within its large customer accounts as the key reason for the gross margin shortfall. Firm believes Dell is the primary culprit. 1Q07 book-to-bill ratio was well above 1.0x; ending 1Q07 backlog was at its highest level in the past four quarters; RapidScale has seen increased customer traction; and cash balance increased to $170 million at the end of 1Q07 (was $160.5 million at end of 4Q06).

Firm's forward estimates and investment rating are under review pending the comments to be provided by Rackable's management team on its preliminary earnings call on the morning of April 5, 2007 at 8 A.M. EST.

- Piper Jaffray notes that given the rapid deterioration in Rackable's gross margins, they are downwardly revising their EPS estimates for 2007 and 2008. Firm is now modeling 2007 and 2008 gross margins of 15.5% and 18.5% (down from 20.5% and 21.5%, respectively). 2007 and 2008 EPS estimates are now $0.43 and $0.85, which is a substantial cut from previous estimates of $0.90 and $1.17, respectively.

Firm believes pricing pressure will continue and reiterate Market Perform rating on RACK shares, but lower price target to $16 from $21.

- Cowen says they remain cautious on Rack's shares as it's tough going in the land of giants. Rack cut prices, which hurt gross margins by over 400 basis points. All this similar to the December quarter miss, but worse this time.

Rack has ~60-70% revenue concentration, with three customers, Amazon, Yahoo, and Microsoft. The lack of diversity makes it more difficult for Rack to fend off competition as there are less places to hide, and each of these customers is a marquee name. Firm does not see diversity increasing in the near future.

Cowen notes that even on their prior 2008 EPS of $1.00, half of this was stock options add back. If they include stock comp, even on the old ests the PE is over 30x 2008 ests, and that's before this preannouncement. Thus even with a drop in price below $16, the shares still appear expensive.

Notablecalls: It's surely tough going in the land of giants. Especially when youre a midget. RACK needs scale and in order to have that they need to win market share. The only way to win market share is to sacrifice margins. And that's what they are doing. The problem is they are competing with the likes of Dell, Sun and IBM that can buy hardware at cheaper prices due to very large quantities, not to mention have existing customer relationships. Is RACK's tech superior? Not likely at this stage.

The stock was down a point in after hours action. Aggressive accounts may find the levels reached in after hours a shorting opportunity.

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