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Rackable Systems



The upstart computer maker shook up the server market a few years ago by catering to the new breed of Web firms, only to see its business hit a wall -- and its stock get left for dead.

With Rackable's stock down roughly 80% from its peak in mid-2006 and its sales growth effectively stalled, CEO Mark Barrenechea is laying the groundwork for a comeback.

Since taking over as chief executive early last year, Barrenechea has refigured products, overhauled senior management and set the company's sights on new markets, all while strengthening the company's balance sheet.

Now Rackable needs to show it can return to growth in a market dominated by heavyweights like


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And with the financial crisis threatening to choke spending on technology products of all types, Rackable's transformation may be its toughest test of all. "There's no doubt that competition is intense," says Barrenechea, a former


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executive. "We're the small guy in the land of giants. So we have to be different."

Rackable made its initial mark by designing servers that were energy efficient. However, being different now means adopting a new mindset about how Rackable does business.

In July, the company began selling customers its Ice Cube mobile data centers with the option of choosing servers from IBM, one of its main rivals in the server market.

According to Barrenechea, IBM makes servers that are well-suited for companies like telecommunications firms, which need redundant power supplies and other beefy hardware features -- a different kind of design than what Rackable offers. Those customers were once out of reach for Rackable. Now, Rackable can at least sell them a data center.

Reaching new customers is a must. The company counts some marquee Web names among its top accounts, including


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The problem is that those four companies accounted for 64% of Rackable's revenue in the first six months of this year.

Even scarier: A mind-boggling 99% of Rackable's sales in its most-recent quarter were in the U.S. -- a dangerous concentration in any business climate, let alone at a time when the U.S. economy is faltering, and the fastest growth is occurring in developing nations.

"We can't be a one-product company in one geography and in one industry segment," Barrenechea acknowledges. "Our ability to grow in scale is directly related to having multiple product lines, and an ability to compete in a handful of industries and in new geographies."

The goal is to achieve a 50-50 ratio of existing customers vs. customers from a broad base of sectors like oil and gas, financial services and government contracts by year's end.

The Ice Cube data centers -- introduced in 2007 -- are expected to bring in between $20 million and $50 million in revenue in the current fiscal year, and are among the company's most profitable products. The company had fiscal 2007 revenue of $353 million.

Mark Mowrey, vice president of investment strategy at Al Frank Asset Management, which owns Rackable shares, says compared with other high-tech goods (such as PCs), data centers may be less vulnerable to budget cuts that many corporations are expected to make amid a slowing economy.

"Folks may not be so cost-conscious in these kinds of investments, because they can be so mission-critical," says Mowrey.

Rackable also has reorganized its storage business, recently announcing plans to sell the RapidScale business -- which it acquired in 2006 for $38 million -- and subsequently striking a deal to offer


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storage technology.

The bread and butter of Rackable's business remains its servers, which -- like those of rivals -- are based on off-the-shelf x86 microprocessors from


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Advanced Micro Devices

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A Not-So-Special Idea

Rackable sought to rise above the commodity nature of the business with its energy-efficient features and by giving customers more control to configure systems to their particular needs.

Yet that message only goes so far in the cutthroat server business.

Richard Buckingham, vice president of Technical Operations at


, says the company is currently upgrading a chunk of its fleet of 12,000 servers. While the social-networking Web site would seem the ideal candidate for Rackable hardware, Buckingham says the company has no current plans to purchase Rackable servers.

"Do they have a unique product?" Buckingham asks. "No. None of the vendors do."

While he credits Rackable as being among the first to foresee the need for energy-efficient machines, Buckingham believes that advantage has now been matched by all vendors. As a result, decisions on hardware purchases come down to other factors, such as cost and ease-of-use.

Meanwhile, Rackable's small stable of high-profile customers are easy prey for larger competitors that can offer irresistible deals.

Staying Competitive

The only defense is to match rivals on price,

as happened in the second quarter

when Rackable was forced to sign a contract with deep discounts in order to retain an "existing and significant customer relationship." As a result, Rackable's gross margin slid to 9.2% in the second quarter, compared with 23.5% in the first quarter.

Barrenechea says the company made a "tactical" decision in the second quarter to retain a key customer, a concession Rackable will be less prone to make now as it expands its base of customers. Until Rackable achieves that customer diversity, though, it's hard to see what would prevent the same thing from happening over and over again.

Though the company's shares have taken a beating, the stock still trades at 58 times the 17 cents a share that analysts expect Rackable to earn in 2009. Compare that with rivals like IBM and H-P, which have solid track records of growing earnings, and which trade at 11.8x and 10.7x forward earnings, respectively.

Al Frank's Mowrey points out that Rackable looks cheaper on a price-to-sales basis. More importantly, he notes the company's balance-sheet assets account for two-thirds of its stock price, which closed Monday's regular session at $9.89.

The company's roughly $200 million in cash is a nice cushion to have in a downturn when credit is tight, he says. And it gives Rackable the flexibility to go after new markets by investing in engineering and sales staff.

The other appeal of all that cash is that it makes Rackable an inexpensive takeover candidate.

Rackable has been a perennial subject of merger rumors in the past. The challenge for Rackable is to define its future.