360 Degrees of Rackable

Alan Farley, Bob Faulkner and Michael Comeau examine the server maker from all angles.
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Editor's Note: In this edition of "360 Degrees,"

RealMoney

commentators take a look at

Rackable Systems

(RACK)

, which plummeted like a rock after its earnings report last week from $34.90 to $21. The momentum money has fled, but do its fundamentals make it worth picking up off the garbage heap?

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"360 Degrees" is a feature that takes advantage of our varied stable of contributors to

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, who offer analysis of stocks and the markets from all angles -- fundamental vs. technical, short-term trader vs. long-term investor.

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Pro-RACK, by Bob Faulkner

Rackable has lost 60% of its market value since the end of April, and roughly half of that loss came in the week since the company reported its second-quarter results July 27. The quarter was pretty good, but it was overshadowed by tepid guidance that led to a high-speed exodus by the hot-money crowd. Given the concern over the slowing economy, as well as a fair amount of mixed messages from other companies, few have been willing to step up to the name.

The fundamental questions: Are the fundamentals deteriorating, and is the bloom is off the rose? From my perspective, the answer is no.

There's nothing in the second-quarter results to suggest the company isn't executing according to plan. Both revenue and EPS were above street consensus (momentum players need that). While gross margins were essentially flat and at the high end of expectations, operating margins deteriorated a bit (-220 bps) as the company scaled up to support higher growth.

Three quarters ago, Rackable indicated it would double its direct-sales force; that target was achieved. In addition, the company launched several R&D projects to support and enhance new servers. The balance sheet strengthened nicely as well. Cash from operations was approximately $6 million, and the cash account increased $7 million. The company's accounts receivable declined $2 million, pushing days of sales outstanding down five to 47 days. Inventory declined $13 million, with days of inventory falling 21 days to 62.

At the product level, Rackable had outstanding performance from its Scale Out Series (blade servers; 17% of revenue). Off a small base, sales increased 332% year-over-year and 208% quarter-over-quarter. The DC (direct current) option reached 50% of units shipped (vs. 37% in first quarter) indicating customers are increasingly focused on the energy-saving capabilities of DC.

Intel

's

(INTC) - Get Report

new Sossaman processor received a warm reception from Rackable accounts, jumping to 15% of revenue and 24% of units (vs. below 10% of units in first quarter). Storage (11% of revenue) was also a big winner in the quarter, increasing 63% year-over-year and 79% quarter-over-quarter. With a single contract from a customer outside of its top three to deliver approximately 5 petabytes (a big number) of storage over the second half, management appeared confident in meeting its target for this segment (15% of revenue exiting the fourth quarter).

The company is making visible progress in its diversification efforts. The top three accounts accounted for 67% of revenue vs. 77% in the first quarter. Twelve accounts generated more than $1 million in revenue vs. seven in the prior period. Fifty-two accounts generated more than $100,000 vs. 40 in the first quarter.

Guidance for September is what ignited the selloff in the stock. Revenue should be in the $80 million to $85 million range (down 4% to 10% quarter-over-quarter), with gross margins in the 22% to 24% range. Pro forma EPS was expected to be 18 cents to 21 cents. This compares with the current consensus of $85 million and 21 cents. Guidance for the fiscal year is for revenue of $345 million to $355 million and pro forma EPS of 98 cents to $1.02. This compares with the consensus estimate of $345 million and 96 cents.

Management suggested the conservative revenue numbers for the third quarter are the result of evaluations being performed by clients on AMD servers vs. the new Intel solutions. And the less-than-robust EPS estimates are due to the new sales staff and development projects. To any momentum account, this is the exit sign because the wind is out of the sails. But the real question is has competition and the economy slowed Rackable down, or is this a necessary pause to build for future growth?

From my perspective, the most significant sign that Rackable sells something that others don't is the 35% sequential increase in server units containing the DC power option. Furthermore, I have since learned that the bulk of these were for production operations (vs. being "tested"), and were it not for shipment scheduling, the increase could have been as high as 70% in the quarter. Energy efficiency is a reality in every organization, and Rackable has alternatives that give it a competitive edge.

Every credible trade rag that evaluates microprocessors has given the new Intel solutions a thumbs up. Coupled with the fact that the Intel parts support the higher-performance memory of DDR2 (AMD's Opteron currently does not), it stands to reason that firms running large server farms will take the extra time to evaluate the pros/cons of the different offerings. Could the delays just be a smokescreen from clients? Sure, but the majority of Rackable accounts are very large Internet companies whose demand for increased capacity is not deteriorating.

A company can't grow its top line without a sales function of some form, and Rackable isn't the exception to that rule. But as I previously mentioned, ramping that organization takes time and becomes a temporary drag on margins. However, that's not a permanent situation if they've hired the right people.

If you believe Rackable's fundamentals are intact, are the technicals so decidedly negative that the stock will be dead money for years? The key to this is just how quickly Rackable's fundamentals regain "momentum." Once again, I'll turn to the history of hot money for guidance.

Go back to one of the great momentum names of the 1990s,

Cisco

. Before it completely pulled ahead of its competition (yes, it had competition back then), the company made tepid comments about its third-quarter outlook in early February 1997. Over the next couple of months, the stock declined 35%, as investors were convinced the magic carpet ride was over. Unfortunately, some of those same investors missed out on the 120% gain over the subsequent 52 weeks as Cisco's fundamentals "recovered."

I'm not suggesting that Rackable is another Cisco, just that one of the great aspects of momentum players is their detachment -- they use a set of rules that works for them in much the same way as program trading. A gradual recovery over the course of a year or more will not cut it. A quarter or two to relight the fire, and the hot bucks will be back like white on rice.

At the time of publication, Faulkner was long Rackable, Intel and Intel Calls

RACK and Ruin, by Alan Farley

This column was originally published on

RealMoney

on July 31 at 11:04 a.m. EDT.

I was shocked to read analysts and traders defending Rackable during its post-earnings death plunge Friday. A few respected commentators, including

RealMoney

's Bob Faulkner, even told readers they were adding to current positions. I strongly disagree with the idea that the torrid session was a buying opportunity in any way, shape or form.

The decision to buy more stock implies that Friday's selloff was the best possible time to take on added risk in this demolished issue. I believe the stock is headed lower and will continue to do so for months or years to come.

Of course, there will be bounces along the way, and even a countertrend rally to squeeze overeager short-sellers. That isn't what I'm talking about here. Those who pounded the tables last week are long-term players, not short-term opportunists, so they must believe the stock will trade higher in 2007. That's a very poor bet, in my opinion.

Here are 10 reasons why Rackable Systems isn't a buy now, by any stretch of the imagination.

1. The Gap

Friday's gap down triggered a massive 39% decline. This is a spectacular nosedive for any stock, but it is huge for an issue that trades an average of 1.26 million shares a day; we're not talking about a thin little issue that might have been manipulated by a handful of big players.

Consider the psychological damage to shareholders stuck in positions between $32 and $42. These battered investors will keep a major overhang on price development until they're washed out of the system.

With the enormous gap, this process could easily take two years or more. In the meantime, every rally will be seen as an opportunity to dump stock.

2. Volume

The selloff rose to almost 22 million shares traded by Friday's close. That's more than 17 times the average daily volume. This confirms a shock event of extraordinary proportions. Blind optimists might think the extreme numbers represent a selling climax, but they're wrong. The stock dropped out of two-month support, which denotes a breakaway move that predicts far lower prices.

3. Triangle

See the two-month congestion pattern? It's a descending triangle with well-defined support and resistance levels. Friday's selloff completed this bearish pattern and issued a major selling signal. The breakdown predicts a measured decline that matches the spring selloff between $56 and $31. That yields an eventual target between $10 and $15.

4. 200-Day Moving Average

The triangle set up along support from the 200-day moving average. Most stocks will recover when they're able to hold this key price level for a month or two. The sharp breakdown through this line in the sand confirms the intensity of the decline and marks another major selling signal that everyone, including value players, should respect.

5. Accumulation/Distribution

The severe decline in on-balance volume on Friday indicates wholesale selling by institutions with the horsepower to trigger numbers of this magnitude. That leaves a massive population of retail bagholders in the stock. These people can't support price stability in the weeks ahead because they're more emotional than their professional counterparts.

One major OBV sell signal is very hard to see in this extreme chart. The indicator actually broke red line support in the session

prior

to the earning release. Ironically, this early breakdown signaled technically minded shareholders to sellout positions ahead of the news shock.

6. Red Bar/Green Bar

Let's look at price action in the two-month trading range. Note the size of red and green volume histograms on the buy and sell swings during this period. With few exceptions, volume increased during selloffs and decreased during rallies. This bearish trend peaked in the five days leading into earnings, when three selling spikes dominated price action.

7. Insiders

The volume pattern also suggests that smart money and insiders began exiting the stock in May and continued to do so ahead of earnings. It also suggests that aggressive short sellers took fresh positions on the brief declines within the congestion pattern. Their payday has now come, so perhaps they'll bring some lift to the stock before selling pressure resumes.

8. Daily Range

Why didn't buyers step in to support Rackable Systems on Friday, if it was such a great opportunity? Note how the stock couldn't trade up to its opening price after the first five-minute bar in the session. This denotes extremely weak demand. It also broke the initial trading range to the downside and closed under that level heading into the weekend.

Friday's price action is even worse than it looks, because the broad market moved higher all day, showing forgiveness to a wide range of recently beaten-down issues. Considering that value bulls didn't want to touch this stock on a buyer's day, that suggests that little demand will show up in the weeks ahead.

9. Parabola

This weekly chart is as ugly as it can get. It shows a parabolic rally followed by a parabolic decline. There's a rule for parabolas that I've never seen violated in years of studying chart patterns: A parabola never reinflates once it's broken. It doesn't matter if tulips or tech stocks triggered the original mania; the end result is the same.

10. History

Finally, history warns us to watch out below when a stock drops on heavy volume in a high-percentage gap down. The Rackable Systems gap down looks exactly like

Apple Computer

's

(AAPL) - Get Report

gap down in 2001. What you can't see on the historical chart is that it took that stock almost three years just to trade back to the high of the gap down bar.

That's dead and buried money, like the lead weight in the portfolios of trapped Rackable Systems shareholders.

The Decline Is Unwarranted, by Mike Comeau

Rackable remains a highly compelling growth story, driven by an explosion in capital spending by Internet companies. Unfortunately, the stock has gotten absolutely hammered due to muted third-quarter revenue guidance, related to a slowdown at one customer, likely

Amazon

. I was very bullish on Rackable going into the quarter, but this hiccup makes me more of a cautious bull.

However, Rackable's customer concentration metrics are improving, with a lower reliance on its top 10 customers, and it's clearly making headway in building up its customer list. Competition is heating up --

Sun Microsystems

(SUNW) - Get Report

and

Hewlett-Packard

(HPQ) - Get Report

are coming up with their own energy-efficient servers -- but as of yet, I see no evidence of anyone making headway against Rackable's patent-protected technologies.

I see the decline in Rackable as unwarranted. Valuation-wise, the stock is now trading at 20 times expected full-year earnings with $7 a share in cash, which could make it an attractive takeover target due to its highly impressive customer list and intellectual property. However, my positive outlook isn't contingent on such an event.

While it's not for the squeamish, I see upside in the stock from current levels. I think it's a good candidate for covered-call strategies.

Michael Comeau is a research analyst at TheStreet.com. In this role he performs stock analysis for

TheStreet.com Breakout Stocks

, and is also a regular contributor to RealMoney.com.

Alan Farley is a professional trader and author of

The Master Swing Trader

.

Bob Faulkner has been in the investment business for 18 years with an exclusive focus on technology stocks.